This article was first published in The Sunday Telegraph – 02nd October 2022
Since the 2008 global financial crisis, we have become used to cheap money, with low interest rates and quantitative easing (QE). The latter has involved the Bank of England printing money in order to buy government bonds known as gilts. Last year QE had reached £895 billion and the Bank owned almost one-third of the national debt.
The trouble is that 14 years of cheap money has created major problems. And we have relied on it as the way out of our economic problems.
First, it has led to rampant asset price inflation. With record low interest rates it wasn’t just the stock and bond markets that did well, so too did the housing market. Of course, little new housing supply and a large increase in the population played its part. But at its core, cheap money kept mortgage rates low and encouraged people to take on huge borrowing.
Secondly, it has led financial markets not to price properly for risk. When the cost of borrowing is next to zero, all assets – including the risky ones – are cheaper than they should be.
Thirdly, it has led zombie companies to survive. This has played a part in our low productivity story, although there are many other more important issues there, such as low investment and a lack of training and skills.
Finally, it led to an environment in which inflation could take hold – as it has over the past year or so.
The Bank is belatedly trying to fix these problems by exiting its own cheap money policy. But this will create problems of its own, which will then be compounded across global financial markets as many other central banks do the same.
The markets want higher rates, but the economy may not be able to cope. That means that although it is vital that we wean ourselves off cheap money, the speed, scale and sequencing of monetary policy tightening must be gradual. It needs to be sensitive to the performance of financial markets and of the economy.
Last year the Bank should have tightened monetary policy. Instead, it was loosened.
At the start of 2021, it was clear that inflation would rise: annual inflation was 0.4 per cent in February and was no longer falling. Eighteen months ago the economy would have coped with higher interest rates. It was, after all, set to rebound as pandemic restrictions were lifted. Instead, the Bank kept base rate at 0.1 per cent, told banks and firms across the City to prepare for negative interest rates, and engaged in further QE.
This catastrophic error was due to its misreading of inflation. At that time I posed the question, which “P” would the rise in inflation be? Would it pass, persist or become permanent? I thought inflation would persist. The Bank felt it would pass through quickly. It has persisted.
Our current inflation problem is triggered by supply-side factors including bottlenecks because of the pandemic and war in Ukraine, and has been exacerbated by poor monetary policy. It has not been triggered by an overheating domestic economy. In fact, domestic demand is weak. Consumer price inflation is 9.9 per cent. The Bank’s inflation target is 2 per cent. Following the energy price cap, inflation looks set to peak around 13 per cent this autumn and decelerate next year.
There is clearly a need to escape from the cheap money trap. But there is now no easy way to do this.
Even before the mini-Budget, the markets expected base rate to peak at 4.5 per cent and remain elevated. Following the mini-Budget rates are expected to rise further and sooner and to peak higher, over 6 per cent. A large rate hike is expected at the next policy meeting.
The Chancellor failed to reassure the markets before or after the mini-Budget. But the day before it, the markets were unsettled anyway by the Bank’s decision to hike rates 0.5 per cent to 2.25 per cent when many were expecting and hoping for a bigger move, and by its announcement it would sell gilts as part of £80 billion of quantitative tightening (QT).
Alongside necessary gilt issuance and new issuance expected from the mini-Budget it meant additional sales from the Bank of England. The Bank should stop this QT. It does not need to sell gilts now.
The picture has since become more unclear, with the markets dubbing it “quantitative confusion”. The Bank has now suspended its QT until the end of October, when it will resume for monetary policy reasons.
Then last week it said it would buy £65 billion of gilts, temporarily, for financial stability reasons. A number of pension funds – not all of them – had participated in risky actions through leveraged positions as they bought derivatives from investment banks.
As rates rose, collateral requirements on these derivative trades rose, forcing the funds to sell gilts into a falling market and pushing the price of gilts lower. It was good the Bank stepped in to help and stop a doom loop. But it has now emerged that regulators and the Bank were aware of this risky practice. Surely they should have sought to outlaw it in the first place?
It seems that too many parts of the system and economy have become addicted to low rates and cheap money. As Warren Buffett famously said during the financial crisis, it is only when the tide is out that you can see who is swimming naked.