Last week, the new Governor of the Bank of England, Mark Carney, made his first major announcement, setting out a new policy of “forward guidance” on interest rates. Expectations were running high but the markets were underwhelmed. In our view the new Governor is putting too much faith in monetary radicalism. Here we explain why.
In a speech to the Wold Economic Forum in January 2013, the then prospective governor of the Bank of England Mark Carney laid out his vision for the scope of future monetary policy:
“I would take issue with the view that monetary policy is maxed out. There continues to be monetary policy options in all major economies……..for monetary policy the immediate priority is to ensure economies reach escape velocity”
At the time we took issue with his view that monetary policy alone could act as the sole driver of a sustained economic recovery. Now as he begins to deliver on his commitment through the policy of “forward guidance”, we lay out why we think this single mindedness will eventually prove misguided.
At first glance there is much to recommend Carneys commitment to greater monetary policy transparency. Linking the direction and level of future UK interest rates to a clearly stated unemployment target and opening up the Bank of England own models to public scrutiny should create greater certainty about long term borrowing costs. In a balanced economy this could be expected to increase credit availability and encourage business to invest and help promote longer term growth. However, by ignoring key aspects of the UK’s current economic situation and placing such emphasis upon just one of the available policy options, Carneys commitment to monetary policy radicalism runs the risk of undermining the recovery it is designed to promote.
Similarities with the US are only partial
At the time of Mark Carney’s announcement linking future interest rates to unemployment levels, many commentators noted the similarities with US policy. However, we would point to the experience of the US, where economic recovery has only been achieved through the powerful combination of very low interest rates, extraordinary monetary policy (QE), a recapitalised banking system and relative fiscal forbearance. For the UK, where the Government remains set on its path of fiscal austerity, and where PPI claims have hindered the banking sectors’ moves to recapitalise, we believe at least two of these essential pre-conditions are absent. While we concede that the UK economy could de-couple from the US experience we would view such an outcome as unlikely given the absence of robust growth elsewhere in the global economy.
Could the focus on residential housing jeopardise the recovery?
So if some of the pre-conditions for recovery are not fully in place, why has recent UK economic data pointed to recovery? The answer to this almost certainly lies in the one area of Government policy that is both expansionary and has successfully encouraged the banks to lend: residential housing. Here both the Funding for Lending and Help to Buy schemes have encouraged a rapid improvement in credit availability by offering an implicit state guarantee. For banks with little appetite to take on greater balance sheet risk, mortgage loans carrying partial Government guarantees are the perfect way to fulfil loan growth targets while minimising risk. This has the effect of boosting house prices (that are arguably already too high) and the consumption that devolves from it, but does little to promote longer term and more sustainable economic activity. More worryingly recent declines in broad money supply suggest that rather than boosting overall credit growth, improved mortgage availability is coming at the expense of credit flows to other sectors of the economy, actually jeopardising the longer term prospects for recovery.
The problem is solvency, not liquidity
In pursuing this policy we fear that Carney’s experience at the Central Bank of Canada is leading him to confuse the solvency crisis that still informs banking sector decision making in the UK, with the liquidity crisis that hit the Canadian banks in 2008. Then, by cutting interest rates and giving clear guidance on future policy he was able to encourage the solvent Canadian banks to lend and the prudently indebted household and business sectors to borrow. Unfortunately, here in the UK the banking sector is inadequately capitalised and the household sector remains highly indebted. Encouraging banks with insufficient capital to lend to heavily indebted borrowers secured against an over-valued asset class, looks like another banking crisis in the making.
It is therefore our belief that the nature of this peculiarly British recovery may in turn hamper Carney’s ability to deliver against his longer term interest rate commitment. Should UK house prices continue to rise, dragging consumer spending with it, the repercussions for inflation could be significant. Already market expectations for the path of future inflation have risen to around 3% and close to the level where the Monetary Policy Committee would have to consider changing policy. While a temporary move above this level would be manageable, any suggestion that pricing had “ceased to be well anchored” would have to provoke an immediate response.
Thumbs down from the markets
All of this helps explain the markets immediate reaction to Carneys comments. Rather than provoking the expected decline in bond yields and a fall in sterling, investors actually pushed both bond yields and the currency higher in a move that clearly highlights their scepticism over the sustainability of the guidance.
So if the actions of the new chancellor are creating an increasing misallocation of available credit, what policies would we like to see him pursue? Firstly we would advocate a greater study of the experiences of Japans lost decade, where low interest rates, and poorly targeted asset purchases proved incapable of generating a meaningful recovery in the absence of fiscal reform and banking sector solvency.
Secondly, we would look to the Bank of England to exercise its role as banking regulator with greater prudence. The unfortunate truth is that the UK banking sector remains undercapitalised and unable to act as a conduit for monetary policy as a consequence. Self –interest, self-denial and bad luck are all partly to blame, but while the sector continues to nurse material unrealised losses it unrealistic of the new governor to expect improved credit flows simply because he has given guidance on the longer term level of interest rates.
Finally we would encourage taking a more responsible attitude towards the fiscal side of the economic debate. While public intervention in the political world of fiscal policy is potentially dangerous, showing such public confidence in the abilities of monetary policy to create economic recovery is taking pressure off the Chancellor to change the direction of his current economic policy. The US and Japanese experiences both suggest fiscal policy is an essential part of building an economic recovery, only a brief look at the continued problems in Europe will attest to that.