At its 4 August meeting, the Monetary Policy Committee (MPC) of the Bank of England (BOE) sparked considerable excitement when it announced an ambitious programme of monetary easing via a wide variety of measures. The sharp market moves that followed indicate that the consensus did not expect the MPC to deploy such a wide array of policy options. The BOE also forecast the UK economy slowing to marginally positive growth rates and inflation rising to (slightly) above the 2% target.
At the press conference following the announcements, BOE Governor Mark Carney was at pains to suggest there is plenty of scope to augment the existing policy easing, but he was also clear that this was intended to be a significant and decisive policy response.
Given the lags in monetary policy and the fact that the BOE’s own forecasts show growth returning to 2% (annualised) within two years’ time, why did the BOE embark on such an aggressive monetary easing programme? And, given how low rates are already, will it make any difference?
Before we try to answer these questions and assess the market implications, let us remind ourselves of the breadth of the MPC’s recently announced actions:
- Cut the Bank Rate (policy rate) by 25 basis points to 0.25%, and indicate that the MPC expects to ease further towards but remain above zero (at which point they will cease further interest rate reductions).
- Restart the quantitative easing (QE) programme by buying £60 billion of nominal gilts (UK sovereign bonds) over a six-month period, which according to PIMCO calculations equates to 120% of gross nominal issuance.
- Restart term financing for UK banks via a four-year Term Funding Scheme (TFS) with interest rates close to the Bank Rate.
- Initiate a corporate bond buying programme by purchasing £10 billion in sterling-denominated corporate bonds in the secondary market (out of an eligible universe of £150 billion, according to the Bank of England).
- In conjunction with the BOE’s Financial Policy Committee, ease capital requirements on UK banks and building societies.
Explaining policy decisions
One way to delve beneath the announcement into the thinking that culminated in these policy decisions is to look at the various strategies the BOE could have employed given initial conditions, and what their potential payoffs could be, as well as the associated risks. After all, we have very little hard data with which to gauge the scope of the post-Brexit growth slowdown, so I suspect that much of the MPC’s debate centred on how much they should do now versus waiting to see the hard data. And clearly there was debate: Amongst the nine-person MPC, there were dissenters both on the corporate bond buying programme (Kristin Forbes) and on the increase in QE (Kristin Forbes, Ian McCafferty and Martin Weale).
Having access to the very same, very limited set of data ahead of the MPC decision, we at PIMCO believe the MPC was wise to go for an aggressive policy response.
Let’s start with those initial conditions, and the BOE’s central forecasts for the UK economy. In the run upto the historic June vote on the UK’s membership in the European Union, real GDP growth had been running at a modestly above-trend 2% level (see Figure 1), whilst inflation remained stubbornly below the 2% target, both on the headline CPI measure (see Figure 2) and on an underlying basis.
Broadly speaking, UK monetary policy was on hold in the run up to the EU referendum. An above-trend growth rate was expected to raise CPI to target in due course, although the MPC was happy to wait for clear evidence of an upward push on prices before raising official interest rates. Then, in the aftermath of the EU vote, confidence slipped sharply: The widely followed purchasing managers’ index (PMI) fell to levels not seen since 2009.
Policymakers faced a thorny decision: Wait and see whether the fall in the PMI translates into a genuine fall in activity, or act quickly to try and stem any fall in future activity. One argument for the former is that the policy stance already appeared expansionary, as shown by the above-trend growth rate ahead of the EU vote. One argument for the latter is that inflation is already below target, and thus any material slowdown risks pulling down inflation further and putting downward pressure on medium-term inflation expectations, making the task of subsequently raising inflation (and inflation expectations) even harder than it already is. We believe the MPC was right to opt for the latter after weighing the potential risks and benefits. With interest rates already close to zero and inflation below target, the costs of subsequently dealing with any potential inflation overshoot seem very manageable when measured against the challenge of pulling up inflation if downward price pressures turn out to be stronger than expected.
There is also this added bonus: If the UK economy performs better than expected, the MPC can now claim some of the credit, and if the economy deteriorates, then the MPC can at least gain some solace from the fact that it wasn’t as if they didn’t try. In effect, we could say the MPC has stacked the odds in its favour!
Potential outcomes: monetary and fiscal
What is the likelihood the policy arsenal works as intended? For a start, we believe this monetary response will be supported by a fiscal response later in the year as the UK’s new Chancellor, Philip Hammond, looks to reset fiscal policy. With the fiscal deficit currently at around 4% of GDP, there is not much scope to raise the deficit (unless growth deteriorates further), but there is still the ability to scrap the proposed tightening of up to 1% of GDP per year for the next four years (source: UK Office for Budget Responsibility).
There is also the scope to initiate some form of infrastructure programme, which may not provide much of a short-term boost, but it could generate much-needed medium-term productivity improvement and may support business confidence in both the short and the medium term.
As I wrote in last month’s blog, “Brexit Aftermath: Outlook for the UK”, our expectation is for growth to fall to just above zero over the next 12 months before recovering back towards the 1.5% to 2% levels we had ahead of the Brexit vote. This outlook was predicated on a protracted set of negotiations over the UK exit from the EU, a modest slowdown in consumer spending and a more significant slowdown in business investment. We expected a monetary response and got one, and we expect a fiscal response as well. We see little reason to change those assumptions or expectations.
Policy: next steps and investment implications
That does not mean that the MPC will sit on their hands in the months and quarters ahead. Certainly there remains a high degree of uncertainty over the path of real activity, and the MPC has already indicated that if the economy follows the forecast, the Bank Rate will likely be reduced again to close to but above zero. To my mind this suggests the Bank Rate will reach a terminal level of 0.1%, where it will likely stay for at least our cyclical (six- to 12-month) horizon. The BOE’s current QE programme will be enacted over the next six months, and the fact that the BOE will be buying corporate bonds for the next 18 months suggests that if needed, the QE programme can be extended further. At this stage it is hard to estimate whether there will be further rounds of QE, but from an investment standpoint, what we can say is that very easy UK monetary policy will be with us for the cyclical horizon. That inturn suggests that despite their current low levels, UK gilt yields will remain at these very suppressed levels and indeed it is possible that long bond yields could fall further given the new source of demand coming from the QE programme. The BOE’s highly accommodative stance should also enable the British pound to remain weak.
It’s also important to ask what impact, if any, these measures will likely have on the banking industry. Lower rates and a flatter yield curve certainly put pressure on banks’ profitability; however, the other policy measures – term financing operations (TFS) and easing of capital requirements – were designed to cushion the potential reduction in profitability. PIMCO’s financials credit analysts also note that the underlying commercial banking businesses of the UK banks are still highly profitable, and as such the new monetary policy measures should not seriously hamper the functioning of the banking system.
In summary, I applaud the MPC for their policy response at the August meeting. Given the range of risks to the UK economy, a strong policy response trying to limit the slowdown in growth appears to be the right policy response, despite the lack of hard data at this juncture. To repeat the words of BOE Chief Economist Andy Haldane in a 30 June 2016 speech, “I would rather run the risk of taking a sledgehammer to crack a nut than taking a miniature rock hammer to tunnel my way out of prison”. Whether it turns out that the policy sledgehammer does indeed crack the nut remains to be seen, but at least we know it won’t be for want of trying.