The Bank of England could be about to unveil a bumper monetary policy package

Despite keeping interest rates on hold at the 4th July meeting, the minutes of the Monetary Policy Committee indicated that “most members expect an easing in August” (even long-time hawk Martin Weale has shifted to a dovish stance). Subsequently, markets are pricing in a staggering 98.3% probability of a rate cut at the next meeting in 8 days’ time. With UK data expected to deteriorate over the next few months, market pricing seems appropriate.

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However, something else that stood out from Governor Carney’s 30th June speech (other than his expectation of some summer monetary policy easing), was this: “In August, we will also discuss further the range of instruments at our disposal.” With interest rates close to zero, Governor Carney could be indicating that the BoE is limbering up to provide a bumper stimulus monetary package, alongside an interest rate cut, akin to that unveiled by the ECB in March this year.

Here are five options that could be available to the MPC.

  1. Quantitative easing

 A renewal of the BoE’s quantitative easing programme seems the most likely easing measure that the MPC could take outside of cutting interest rates; the ultimate goal of the policy being to facilitate an expansion of private bank lending, via central bank asset purchases. Should this occur, we would expect the belly of the UK government bond curve to be well supported. In particular, gilts with maturities in the 7-15yr range could benefit given that there are fewer bonds in this maturity bucket (assuming the BoE aims to make purchases in line with its QE reinvestment rules which we have discussed here) and this is the duration neutral part of the curve. More pertinent to the UK perhaps would be what Fathom Consulting have coined “Operation Anti-Twist” (based on the FOMC’s 2011 “Operation Twist”) which would entail selling long dated gilts and buying short dated gilt issues. This would engineer a steeper yield curve and could support those with longer term pension liabilities looking for higher yields.

  1. Corporate bond purchases

In order to improve market liquidity in 2009-2012, the BoE purchased corporate bonds as part of its QE programme. Though this is not necessarily an imminent priority – there does not appear to be a corporate funding crisis; GBP non-financial investment grade corporate spreads did spike up, but have fallen since the referendum – this nevertheless presents a credible policy option.

If the BoE were to resume corporate bond purchases, along the same criteria used previously (which was much stricter than that currently used by the ECB, especially with regards to rules regarding credit ratings), I estimate that the investment universe would be in excess of £100bn, with utility companies representing the lion’s share of eligible purchases. Real estate companies also appear set to benefit notably from corporate QE, which could offer some targeted support to a sector that’s already been particularly hard hit.

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  1. Further support for bank lending

Earlier this month the BoE reduced the UK countercyclical capital buffer rate – for banks, building societies and large investment firms – to zero from 0.5% until at least June 2017. Governor Carney noted that this will lower UK banks’ required capital buffers by £5.7bn, essentially freeing up capital for them to lend to the real economy. Should upcoming data warrant it, the BoE could extend its Funding for Lending Scheme (FLS), to further ease credit conditions for households. The current scheme incentivises banks to boost lending, with a skew towards small and medium sized enterprises – arguably those who will be hardest hit from the ongoing uncertain outlook. They could however extend this scheme in a further targeted manner, for example, towards mortgage lending in a bid to subsidise loans for house purchases (should market conditions warrant this). The FLS has been extended many times since it was introduced in July 2012, with the last extension taking place in November. Though we have previously questioned the success of the scheme, we could potentially see another amendment.

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  1. Joined up fiscal and monetary policy response

Investors and markets are positioned for a low growth, low inflation world, but this could be about to change. With the limits of global monetary policy arguably exhibiting diminishing returns to scale, there is now the potential to see expansionary UK fiscal policy working alongside monetary policy. Given the reshuffling of the cabinet, Osborne’s fiscal tightening and austerity budget have fallen by the wayside and it is time for Hammond to show his hand. Given the unusual circumstances, the new chancellor could plausibly move his autumn statement to coincide with the BoE meeting on the 3rd November and offer something original. If he takes the advice of the IMF and OECD, both of which have been calling for a boost in infrastructure spending, we could potentially see the government opting for pro-growth infrastructure projects, funded via bonds that the BoE ultimately buys.

  1. Negative rates

Could the BoE introduce negative interest rates, like we’ve seen in the Euro area and Japan? In theory yes, but in practice I believe that this is some way off.  Negative rates are still in their experimental phase (Jim has noted some great anecdotes on this here and here) and the BoE still have some leeway with regards to traditional monetary policy. With interest rates at 0.5%, there is still space for a few cuts before we reach the zero bound and have to contemplate any unconventional measures.

Evidently there are many tools in the toolbox (and I have focused predominantly on the tried and tested), but will the BoE look to use them? Every monetary policy meeting should be noted in your diary, every meeting is ‘live’. Roll on the next BoE monetary policy decision.

Discuss Article

  1. Borris Hollywood says:

    It is astonishing that such a strong consensus has emerged that the BOE should lower rates and restart QE.

    Based on the most recent public data from the BOE (the May Bankstats) the biggest component of credit in the UK economy, household credit, is growing at 4% pa which is the highest since pre-GFC. These rates of growth tend to move in broad trends following employment levels (which are the highest ever) and household balance sheets (which are robust thanks to 8 years of debt repayment). So it is far from clear that monetary policy with rates at 0.5% is too tight.

    Of course Brexit is an unexpected event that will produce a shock to confidence. But shocks to confidence are a threat to the economy only to the extent that households and financial institutions cannot absorb losses owing to stretched balance sheets. Today both household and bank balance sheets are robust. In 2005 RBS had GBP 17bn in loss absorbing equity, today it has over GBP 40bn, for example. For the consumer interest payments on mortgages are currently about 8% of income, that is the lowest since at least 2002, and almost 70% less than in 2007. The rate of economic growth may slow but there simply aren’t any trip wires to cause the economy to fall on its face.

    Worse, however, is that this consensus believes that there is little risk to preemptive stimulus and also that QE is today will be an effective policy tool.

    For example, Mr Chris Giles writes in the FT regarding the BOE: “The risks of too much stimulus generating too rapid growth and inflation are minor relative to those of standing by as the economy slides.” This is not so obvious.

    There are risks to further monetary stimulus.

    Household borrowing is already growing at its fastest rate since 2008: as of May Bankstats, credit card loans are growing at 6% pa, personal loans 12%, and mortgages 4%. Cheap financing (the latest average for a 2 yr fixed mortgage with a 75% LTV is just 1.8%) is boosting house buyer purchasing power and pushing up prices in a supply-constrained market. Taylor Wimpey, the UK builder, reported prices up nearly 6% yoy, Barratt Development reported prices up nearly 11% yoy, and Bovis Homes reported prices up 15%! Double digit house price inflation is not healthy.

    And if you are not convinced that monetary policy is already too accommodative in the UK then consider that banks sacrifice about 50bps of margin writing new mortgage business versus their current stock of mortgages, that is a 20% hit to their profits. The incentive for banks to grow their lending as rates head lower is not there. There is already evidence from Lloyds Bank that they are defending their margins instead of growing their lending: “the open mortgage book increasing 1 per cent slightly below market growth reflecting actions to protect the net interest margin.” Kristen Forbes touched on this in a recent Telegraph article, but it has yet to become a central part of the debate.

    Mr Giles also writes: “the right action involves… restarting quantitative easing.” This shows a lack of understanding about QE and how it works.

    QE “works” when the individual decisions of market participants combine to make a market malfunction. For example, in the US in 2007/8 every bank was trying to sell mortgage backed securities at the same time in order to raise capital. Consequently the cost of mortgage credit born by households rose to an insanely high level compared to the cost of debt for the government. QE worked in the US by lowering the mortgage cost on households thereby freeing up consumer spending and enabling house purchases.

    Similarly in the Eurozone QE is working because the cost of credit for businesses and households in Spain/Italy during 2011/12 was extremely high (9%) versus the cost of credit in Germany (2%). Easing the debt burden in Spain and Italy is hugely helping those economies: Spain has added 1mln employed people since 2012.

    The point here is that QE works when distortions in credit markets, which place a heavy cost on households or businesses, are removed. Today credit costs for households in the UK are at historic lows and UK credit markets are operating just fine so there simply isn’t any clear use for QE. Without elevated credit costs to tackle, QE undertaken in the UK will only and directly distort what are at present reasonably well-functioning bond markets since the BOE already owns about 25% of all Gilt issuance and close to 70% of certain individual bonds.

    As in Japan QE will be effective in the UK only in keeping the exchange rate weak and thereby pushing up living costs.

    Aggressive policy action now could be a very big mistake, especially since it is not even clear that monetary policy in the UK is too tight. Why is it that so many smart economists agree that rate cuts and more QE is the answer to Brexit uncertainty?

    Posted on: 28/07/16 | 4:51 am

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