11 July 2016

Financial Times: Focus on Bank of England’s policy response to Brexit

While interest rates at 0.5 per cent are currently at a historic low, they are high when compared to rates in several other developed markets, and therefore likely to be the first tool the MPC turn to. BoE governor Mark Carney has stated some of the adverse effects of negative rates on the banking sector, so zero per cent is likely to be the floor for now. This may well be revisited in the future, especially since negative rates appear to have a more durable effect on lowering yields, weakening the currency and encouraging investors to move from negative yielding cash to positive yielding risk assets.

Other monetary policy measures are likely to be considered, including quantitative easing via the government and corporate bond markets. Macroprudential policy has already been eased as the Financial Policy Committee cut requirements for countercyclical capital buffers, giving banks the capacity to lend up to an extra £150bn.

How quickly they ease is also under debate. Given the disappointment over growth and inflation, there seems little risk of any central bank “over-easing”, despite concerns over financial stability. Go too quickly, though, and there is a real risk that the monetary policy cupboard looks bare.

As a government bond investor, the fall in interest rates and reintroduction of QE is likely to support government bond valuations, but broader question marks remain over the efficacy of monetary policy.

Unemployment has continued to decline - this implies the current growth is exceeding the country’s potential growth rate. Consequently potential growth rates must now be very low. Fiscal policy may be best placed to sustainably boost potential growth rates, rather than monetary policy.

Chancellor George Osborne has abandoned his current fiscal targets, and recent Conservative party leadership contender Stephen Crabb’s “Growing Britain Fund” may be a sign of policy shifts to come. Despite being downgraded by credit rating agencies the fall in UK government bond yields suggest that demand remains strong. If fiscal stimulus is used and deployed correctly, boosting productivity and longer term growth rates should sow the seeds for a move to higher government bond yields.

Whilst the uncertainty is likely to weigh on growth in the short term, the longer term impacts from the EU referendum remain to be seen. A decline in immigration is likely to reduce potential growth rates and exacerbate the burdens of an ageing population. The impact on net trade is also likely to be negative, as trade with our neighbouring countries is expected to be hindered. This, coupled with low growth rates and stagnant trade globally, limits the upside from any new trade deals.

The MPC is likely to keep a close eye on the move in the exchange rate. The UK has an exceptionally large current account deficit and is still running a fiscal deficit as a result of the last recession. As a result, like Blanche DuBois, the UK has had to rely on the kindness of strangers. At current levels, sterling looks only modestly undervalued when compared with most fair value metrics and the potential for further declines looks high. [...]

Of greatest concern to government bond investors is the spectre of inflation. Headline inflation rates continue to reflect prior declines in commodity prices, while stable core inflation rates continue to suggest little risk of outright deflation. The fall in sterling is likely to boost inflation in the short term, but the negative growth shock is likely to keep domestically generated inflationary pressures muted for now. Current valuations, however, do not provide much of a cushion should inflation or growth surprise positively over the coming years. [...]

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Related article on Financial Times: BoE forecast to delve into credit market

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