The Bank of England (BoE) made a huge policy error and now they are scrambling to correct it. Back in December 2015, the US Federal Reserve decided to raise interest rates for the first time since the financial crisis from their historic low of 0.25%. US growth was running at around 2% and the economy had firmly escaped deflationary risks. Financial markets had even comfortably come through the withdrawal of the QE drug.
In an alternative universe, the UK could have been very close behind. UK growth barely lagged that of the US at over 2%. Core inflation (stripping out the effect of falling oil prices) sat comfortably within the 1% lower bound of the BoE target. The 2015 general election had produced a decisive victory for the Conservative party. In the absence of a credible opposition under Jeremy Corbyn, political stability and fiscal responsibility seemed guaranteed until 2020 if not longer.
The growth trajectories of the US and the UK were well synchronised. It seemed that the beginning of a tightening cycle in the States would soon be followed in the UK. Just as UK unemployment hit 5%, a rate consistent with what economists call the ‘equilibrium’ or ‘natural’ rate – at which point wage inflation begins to accelerate necessitating higher interest rates, the EU referendum campaign began.
The Brexit Effect
Predictions from government, business lobby groups and indeed the Bank of England themselves of economic catastrophe in the wake of a ‘Leave’ result spooked financial markets. The pound sold off heavily as the referendum date neared. Some market participants even considered that the BoE may cut interest rates on the day of the result, beginning a monetary policy divergence between the UK and the rest of the developed world.
The extent of the angst in markets following the result was palpable. Now, over a year on, we know that consumer spending has been fairly robust and the result itself did not trigger an automatic recession. Given this, it is easy to forget that there was a real and justifiable sense of fear. The UK economy recovered from the financial crisis on the back of consumers. If their spending had dried up following the vote, there would have been no parachute to catch the faltering economy. Business investment remained lacklustre and the Treasury under Osbourne was planning to cut rather than expand spending in the event of a Leave vote.
So it would be unfair to criticise the BoE too harshly for their actions in the wake of the referendum result. Providing liquidity, reducing borrowing costs and extending QE showed that the BoE was serious about ensuring financial markets could cope with this the post-referendum shock.
A Serious Policy Error
But in hindsight, it is hard to see the move as anything other than a serious policy error. Since the FED began to raise interest rates in 2015 the headline policy rate now sits at 1.25%. Meanwhile, the UK base rate has moved in the other direction, down to 0.25%. It now seems like a lifetime ago that these two economies were about to follow each other into a tightening cycle. Instead, there has been a huge divergence in US and UK monetary policy.
However, the divergence in policy had been much more dramatic than the divergence in the real economies. UK growth, although subdued, remains resilient coming in above forecast at 0.4% for Q3 last week and unemployment keeps breaking new lows. This leaves the BoE with a lot of catching up to do if they are to give themselves some room to manoeuvre in the event of a disastrous no deal Brexit.
In the meantime, lower rates do not appear to have done anything substantial to help the UK economy. At the zero lower bound (i.e. when rates are very close to zero) the effect of increasing monetary accommodation is simply to increase the overall level of debt in the economy (consumer lending and especially car finance continues to grow faster and faster). This higher level of debt will only serve to exacerbate financial instability rather than bolster business investment. It is clear that there are few businesses out there whose caution to invest is because borrowing is too expensive.
Business concerns are around the long-term structural effects of Brexit on the UK’s economy. This is not something that the BoE can or should be trying to solve. In an era of restrained government spending since the crisis, the expectation on central banks to manage our economies has grown. But it has become clear that their power to manage the real economy has been exhausted.
The BoE is beginning to realise this. Next week’s interest rate decision will be a momentous moment. For many young people, it might be the first rate rise they will remember. There is no doubt it will bring challenges but it is the right thing to do. The Bank may have made a policy error but it is not too late to rectify. Beginning a tightening cycle now will allow the BoE to build the policy buffer necessary to see the UK through the much bigger challenges to come.
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