Last week, we got the distinct impression that change is in the air. A number of central banks, including the Bank of England, suggested that years of ultra-easy money may soon be over. In the UK, political and economic evidence of the fragile economy contrived to leave the impression that a shift in economic policy is coming.
Until now, the US Federal Reserve has been the only major central bank to put some blue water between the post-crisis monetary policies, including quantitative easing (QE), and the future. It has raised interest rates 3 times since the end of 2015, and most people think one or two more hikes are on the table this year, possibly with more to come in 2018, depending on what happens to inflation and in the economy.
Fed Chair, Janet Yellen, and others on the Federal Open Market Committee remind us they are “withdrawing monetary accommodation” rather than tightening as such. Periodically, they refer to some of the negative and unintended consequences of persistently low interest rates, such as bloated levels of asset prices—for example in commercial real estate and high yield bonds—and high levels of consumer and student debt.
Cue the Bank of England, European Central Bank (ECB) and Bank of Canada. All three central bank governors said last week that they, too, were close to the point of withdrawing some monetary accommodation. With real estate prices, which barely faltered in 2009, continuing to rise strongly, Bank of Canada Governor Stephen Poloz gave an interview hinting that the two interest rate cuts amounting to 0.5 per cent, enacted in 2015 when oil prices were falling, might soon be reversed.
Meanwhile, at the ECB meeting in Sintra, Portugal last week, Mario Draghi acknowledged that the central bank might consider withdrawing monetary stimulus, bearing in mind the gathering Euro Area economic pick-up, so as to leave the overall policy stance neutral. He also noted that deflationary forces in Europe had been replaced by reflationary forces.
Bellweather bonds
In support, the publication of consumer sentiment measures showed the best levels since the Euro-crisis began in 2011. After the summer, analysts expect the ECB to announce a decision to taper QE, or wind down the €60 billion monthly volume of asset purchases.The Euro rose to its highest level in a year against the US dollar, and, importantly, German bond yields ticked up significantly, doubling in a week. At about 0.47 per cent, the 10-year yield is still exceptionally low, but it was -0.2 per cent last July, and is now at its highest level since the start of 2016.
Higher German yields are, for now, a good bellwether of the health of the Euro Area economy and of the fading risk of financial stress in the region.
The British position
The UK economics debate was jolted recently when the Bank of England’s Chief Economist, Andy Haldane, said after the June Monetary Policy Committee meeting (which saw a 5-3 split vote for unchanged policy) that it would be prudent to tighten policy before the end of the year. His boss, Mark Carney, told a City audience soon after that it wasn’t yet time to do so, unless other parts of the economy offset weaker consumer spending.Last week, though, Mr Carney said that some removal of monetary stimulus is likely to become necessary if those things happened. You may say this is splitting hairs—but within the context of central bankers’ utterances, it was a shift in position.
Against the backdrop of sticky 3 per cent or so inflation, then, we should expect the Bank to reverse the 0.25 per cent fall in the policy rate announced in the wake of last year’s Brexit referendum.
The change in expectations didn’t do much for Sterling against a feisty Euro, but it pushed it above $1.30, its highest level since last October. Yields on 2 year gilts, which are used to price fixed rate mortgages, rose to 0.36 per cent, compared with just 0.09 per cent two weeks ago. These and 5 year gilts are now at their highest levels since before the referendum.
Trouble ahead?
How can this be, you might say? Isn’t the UK economy slowing down, even at risk of a recession? Indeed, it is, and this certainly puts the Bank in a bind.Just last week the Office for National Statistics confirmed a feeble 0.2 per cent rise in first quarter GDP, and told us that in the first 3 months of 2017, the household savings ratio collapsed to 1.7 per cent compared to 6.1 per cent a year ago, and the lowest since records began in 1963. This is a tale, not about high levels of consumer optimism especially with the corrosive impact of Brexit ahead, but rather about rising levels of consumer debt and weak disposable income, partly due to low wages and salaries and specifically this time to a rise in tax payments.
The bottom line is that every time the savings ratio has plunged like this, it has invariably rebounded soon after, and that spells weaker consumer spending, possibly even a contraction.
The times are a-changing
Can the Bank even think about higher interest rates with this going on? It can—for two reasons.First, because of inflation, the Bank may think that it’s better to “remove accommodation” slowly (and while it can), rather than wait.
Second, and more importantly, fiscal policy is about to get a bit looser, as the government prepares to tilt way from austerity—without looking like it’s following Labour’s manifesto. Planned savings in the Conservative manifesto have already been jettisoned. Last week we heard the dress rehearsal for a relaxation of public sector pay caps, likely to be announced in the Budget this autumn.
Indeed, it is politically clear that if the government is going to survive the winter, the Budget will have to be turned upside down, with tight spending targets relaxed, and tax receipts boosted across fair broad area to accommodate them. Public opinion, and a Chancellor, who is now more secure, make this kind of change very likely.
