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 Wednesday 14 September 2016

PM Bulletin: The BoE and Beyond

 

 

The Bank of England (BoE) will announce its latest rate decision on Thursday. This will be the BoE’s first meeting since early August when the Monetary Policy Committee (MPC) voted unanimously to cut the headline Bank Rate by 25 basis points. This reduction took the base rate down to 0.25% from 0.50% - a fresh record low in the Bank’s 322-year history. In addition, the MPC voted for other measures designed to help it meet its 2% inflation target which, Committee members believe, should help “to sustain growth and employment.” The Committee announced a Term Funding Scheme (TFS) to reinforce the pass-through of the rate cut. It also expanded its Asset Purchase Facility (the Bank’s version of Quantitative Easing) by £60 billion, taking the total stock of these asset purchases to £435 billion. Finally it announced that it would buy up to £10 billion of UK corporate bonds. In doing so, the MPC has effectively taken a page out of the Bank of Japan’s (BOJ) playbook by adopting Quantitative and Qualitative Easing (QQE). This means that the central bank isn’t just prepared to “print” more money, but it is also willing to spend it on riskier corporate debt. Unlike the Committee’s decision to cut rates and introduce the TFS, the Asset Purchase Facility vote was not unanimous. Three out of the nine MPC members (Martin Weale, Kristin Forbes and Ian McCafferty) dissented, arguing that July’s Manufacturing, Services and Construction PMIs may have overstated weakness in the UK economy.

The most recent surveys covering August suggest the dissenters were right. The sharp rebound in the three PMIs led major investment banks JP Morgan and Morgan Stanley to upgrade their expectations for the UK economy, having slashed their outlook in the aftermath of the Brexit vote. Both banks now believe the UK will grow by 1.9% this year and avoid a technical recession. In addition, Morgan Stanley upgraded its third quarter growth forecast to +0.3% having previously estimated it to shrink by 0.4%. That last MPC meeting brought the Bank’s first changes to monetary policy since July 2012 when it raised its Asset Purchase Facility to £375 billion from £325 billion. The last time the Bank made any alteration to its Bank Rate was in March 2009, at the nadir of the Great Financial Crisis, when it cut it to 0.50% from 1.00%. Thanks to this relative inactivity, BoE meetings over the last few years have been chiefly notable for their high boredom quotient. In contrast to speculation ahead of meetings from the US Federal Reserve, European Central Bank (ECB) or Bank of Japan (BOJ), investors haven’t had to exert much effort predicting the MPC’s rate decisions.

This is despite the best efforts of BoE Governor Mark Carney who, in his three years of tenure, has flip-flopped on a number of occasions over the direction of UK monetary policy. His behaviour was capricious enough for one Member of Parliament to describe him as behaving like an “unreliable boyfriend.” Bear in mind, the Bank of England had been threatening to raise rates for the last two years. The Brexit vote in June gave the MPC the cover to loosen monetary policy yet again. In addition, Mr Carney indicated he would take rates to just above zero if growth stalled over the summer. So far, there’s no evidence that it has. Consequently there’s unlikely to be any change to monetary policy this week from the MPC. Last week the European Central bank (ECB) held off from further easing. The central bank kept its three key interest rates unchanged and decided against increasing its Asset Purchase Programme (APP) in either size or duration. In fact, according to ECB President Mario Draghi, the APP wasn’t even discussed by the Governing Council. So it remains at €80 billion per month and will run “through March 2017 or beyond if needed.”

The ECB didn’t rule out providing further stimulus in the future. But they didn’t see much that had changed since their previous meeting with respect to the outlook for growth and inflation. Yet growth is tepid and inflation is running well below the central bank’s 2% inflation target. So, what’s holding the ECB back from announcing further stimulus? Well there are those on the Governing Council (led by Germany) who disapprove of Quantitative Easing (QE) and worry about “moral hazard.” But there’s also the concern that monetary stimulus isn’t doing what it’s supposed to do. Despite being engaged in a programme of QE which is set to pump €1.7 trillion into the Euro zone economy, the central bank has been unable to boost growth or cause inflation. The BoE and beyond Now we turn to next week’s rate setting meetings from the US Federal Reserve and Bank of Japan (BOJ). Japan is undoubtedly the poster-child when it comes to central bank intervention.

The country’s economy has been moribund for over a quarter of a century. This is despite the efforts of the BOJ which has unleashed wave after wave of monetary stimulus, instigating QE back in March 2001. Not only has this failed to kick-start the Japanese economy, but there are signs of its negative impact. Back in January the BOJ surprised markets when it suddenly adopted negative interest rates. This should have weakened the yen substantially, but it had the opposite effect. And if there’s one thing the BOJ doesn’t want, it’s a stronger yen. At its last meeting at the end of July the BOJ disappointed investors despite announcing further stimulus. While it left its bond purchase programme unchanged at an annual rate of 80 trillion yen and held its key interest rate unchanged at -0.1%, the bank said it would increase its exchange traded fund purchases to an annual pace of 6 trillion yen, up from its previous pace of 3.3 trillion yen. This was not the boost investors were hoping for, particularly given all the speculation over the summer that Japan was getting ready to launch “Helicopter Money”. Yet the current set of policy options have been pushed close to their limits.

Expanding bond purchases further is going to prove difficult as the BOJ already owns a large share of government and corporate debt. Cutting rates further when they are already negative risks further undermining financial institutions’ profits to the point where it might impair future credit creation and damage investor confidence. Alternative easing options such as “Helicopter Money” or FX intervention appear to be too controversial at this stage to consider. So far, the BOJ has managed to keep a lid on the yen by saying it would conduct a review of the current policy settings and economic environment at its September meeting. But the most recent comments from BOJ Governor Haruhiko Kuroda and his deputy Hiroshi Nakaso have confused analysts.

The central bank is desperate to spark inflation in an effort to reduce the country’s crippling debt load. However, it is unclear whether the BOJ is backing off from negative rates, or ready to cut further as a short-term measure to achieve their policy goals. Meanwhile, the biggest question is what the US Federal Reserve will do next week. Investors are busy parsing and reacting to each economic data release and every Fed utterance. At the Jackson Hole Economic Symposium which took place at the end of August Federal Reserve Chair Janet Yellen highlighted the solid performance of the US labour market and said “the case for an increase in the federal funds rate has strengthened in recent months.” She also said that if interest rates remained historically low, this could hinder the Fed’s ability to fight recession in the near future. She pointed out that by lowering rates the Fed had provided an incentive for businesses and consumers to take out loans and to spend money, thus fuelling the economy. But with interest rates as low as they are, the Fed may not be able to cut them as far as it might have in the past. This is a problem.

The US central bank is anxious to build up enough ammunition to cope with a recession, which some argue is already well overdue. With the headline fed funds currently in a band with an upper limit of 0.50% there’s precious little scope to ease monetary policy should the US economy turn lower. Not only that but Dr Yellen explained that forecasts now show the longer term federal funds rate settling at about 3%. This compares to an average of over 7% between 1965 and 2000. Consequently the Fed will have less scope for interest rate cuts than it had previously, even assuming it can raise them from current levels. Last Friday Boston Fed President and FOMC-voting member Eric Rosengren delivered a market-moving speech. He said that a gradual tightening of monetary policy could now be appropriate and that a failure to remove accommodation could “shorten, rather than lengthen, the duration of this recovery.” In this he appeared to echo the views Dr Yellen expressed at Jackson Hole, and bear in mind that Fed Vice-Chair Stanley Fischer maintained that her speech was entirely consistent with the Fed hiking rates twice this year.

The equity market sell-off which followed Dr Rosengren’s speech was highly significant as it has become apparent that the US central bank is keeping a close eye on stock market behaviour. It shouldn’t, but it is a measure of how things have changed over the past thirty years or so that the Fed (unofficially at least) monitors asset prices when considering its dual mandate of maximising employment and ensuring price stability. If anyone had any doubt about this, it’s worth considering what Stanley Fischer said at Jackson Hole. When asked about negative interest rates Dr Fischer maintained that the “four or five” central banks that had adopted them thought they were “quite successful” and, with the possible exception of Japan, were prepared to stick with them. But in a comment which exposed how the Federal Reserve operates Dr Fischer acknowledged that savers found them difficult to deal with, adding that “although typically they go along with quite decent equity prices.”

The BoE and beyond The point is that the stock market sell-off which followed Dr Rosengren’s speech could influence the Fed’s decision next week. So it is perhaps telling that there was a last minute effort to paddle back from Fed hawkishness. FOMCvoting member Lael Brainard delivered a hastily scheduled speech on Monday. Dr Brainard is seen as highly influential and is part of Janet Yellen’s “inner circle.” She is also one of the most dovish members of the FOMC, so there was some speculation that she may also turn hawk in order to keep next week’s meeting “live” in terms of a rate hike. However, Dr Brainard urged caution, saying that while the US was making economic progress, it would be wise to wait before tightening policy further. This was the last public statement from the Federal Reserve as the central bank now goes into purdah ahead of next week’s meeting. But it seems quite likely that Dr Brainard’s comments are a good reflection of the thinking amongst voting committee members. Certainly, August’s Non-Farm Payroll data together with the latest Manufacturing and Non-Manufacturing PMIs don’t support a tightening of US monetary policy. On top of this, inflation (as measured by the Fed’s preferred Core PCE) is stuck around 1.6% annualised – somewhere short of its 2% target rate.

The Fed is naturally cautious, so it would seem unlikely that it would risk hiking rates amidst this economic uncertainty and risk a severe market disruption ahead of the US Presidential Election. In conclusion, all major developed-world central banks are in a dreadful bind. The ECB and BOJ need to ease further but it is becoming apparent that there are limits to what monetary policy can achieve, for all the talk about “Helicopter Money” earlier this year. This is why central bankers have become ever more desperate in their appeals to policymakers for fiscal stimulus and structural reform. Meanwhile the Fed has to take a gamble. It can raise rates next week and risk a market melt-down like the one we saw at the beginning of the year, just after the December hike. Or it can hold off until the year-end. If the Fed delays, it runs the risk that the economic data over the next three months continues to deteriorate. In that case it won’t be able to hike in December. That means it runs the danger of heading into a recession with interest rates too low for them to be cut to any meaningful degree – unless the FOMC decides to “go negative.” Despite this, the Fed (through Dr Brainard) has given a clear indication that it won’t raise rates next week. If it does, then it will have wrong-footed investors badly. Add in the difficulty that other major central banks have in sparking growth and inflation, and it seems likely that developed world interest rates are set to remain at historically low levels for a long time yet.

Disclaimer:

Spread Co is an execution only service provider. The material on this page is for general information purposes only, and does not take into account your personal circumstances or objectives. Nothing in this material is (or should be considered to be) financial, investment or other advice on which reliance should be placed. No opinion given in the material constitutes a recommendation by Spread Co Ltd or the author that any particular investment, security, transaction or investment strategy is suitable for any specific person.

 

Posted by David Morrison

Category: PM Bulletin


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