Has the Bank of England (BOE) already tightened policy too much? Since November 2017, the UK has witnessed a series of policy tightening measures, ranging from two small rate hikes, to an ending of lending schemes and a requirement for banks to hold more capital, thus limiting their ability to lend. For instance, official interest rates rose from 0.25% to 0.5% in November 2017 and then from 0.5% to 0.75% in August 2018.
Each of these measures may not seem onerous. After all interest rates, even now, are at a low level. But when combined the net effect of all these measures has been a significant policy tightening. In addition, micro – and macro-prudential policy measures have encouraged banks to adopt a tough lending stance.
The economy may be vulnerable
Perhaps in this environment it is no surprise that bank lending and monetary growth have slowed. Yet the fact that this has occurred, alongside continued political uncertainty surrounding Brexit, suggests the economy is vulnerable in the near term to downside risks, whether at home or from overseas.
Last year the countercyclical capital buffer (which aims to ensure the banks have sufficient capital to protect against potential economic shocks) was raised from 0.75% to 1%. A small tweak, admittedly. But when the countercyclical capital buffer was cut from 0.5% to 0% in the summer of 2016, the Bank of England’s Financial Policy Committee then claimed that – as banks leverage their lending – that reduction in the buffer would allow banks to increase credit supply by £150 billion and that it would have an immediate impact on lending to people and firms.
Last year’s hike in the buffer should thus not be overlooked; possibly adding £11 billion to capital needs directly and further constraining their ability to lend. In addition, various lending schemes have ended: for instance, the term funding scheme ended in February 2018, having allowed a host of banks to have access to cheap central bank funds for up to four years.
Lower growth could further complicate the outcome
Against this backdrop the BOE released its latest quarterly Inflation Report last week. The Bank lowered its growth forecast for this year, from 1.7% to 1.2%. It also cut its growth forecast for 2020 and continued its trend since the global financial crisis of a decade ago of lowering its estimate of the UK’s trend rate of growth, which it now sees as only 1.4%, largely because of low productivity growth. Bizarrely, such a low trend rate of growth may make the Bank reluctant to suddenly switch to easing, as it suggests the economy could not grow at a sustained rate above 1.4% without triggering higher inflation.
The Inflation Report has since been followed by official data that has confirmed the economy slowed towards the end of last year, with quarter on quarter growth of 0.2% in the fourth quarter, from 0.4% the previous quarter. By the end of the year, parts of the economy appeared at a standstill – this left growth last year at 1.4%.
Brexit may be a culprit, but not the only one
The Governor, Mark Carney, at the press conference last week, attributed the slowdown and potential weakness of the economy to Brexit. I do not disagree with a large chunk of what the Governor said, as I have said it myself, many times. Brexit uncertainty – not least the lack of clarity this close to the end of March – is dampening economic activity, delaying or deterring some investment. But it is not the only factor. And that is often overlooked.
Indeed, the UK has not slowed in isolation. As the Bank stated in its Inflation Report, “Quarterly euro-area GDP growth averaged 0.2% in 2018 H2, lower than 0.4% in 2018 H1 and substantially lower than the average of 0.7% over 2017.” As in the UK, the euro area, too, has witnessed a tightening of monetary conditions over the last year, as the European Central Bank has moved to normalise policy.
Global factors have also combined to dampen activity in the UK as well as the euro area, including the previous escalation of trade tensions, and the volatility seen in financial markets last autumn. Markets, too, are worried about a slowdown in China, although policymakers there have ample room for manoeuvre.
But let’s not be too pessimistic
All this helped contribute to the abrupt shift in US Fed policy as we entered 2019. While the world economy has slowed, it may be premature to become too pessimistic. Labour markets show solid employment stretching from the US, to the UK and Japan, and even in the euro area, the unemployment rate, while still high, is at its lowest rate since the end of 2008.
The Bank’s mandate is to meet the 2% inflation target and, subject to that, support the government’s economic policy. Inflation pressures appear to be easing, as the previous impact of sterling’s devaluation wears off, and domestic inflation pressures are subdued. That being said, it would be wise to keep a close eye on wage growth, which has risen recently, in response to high levels of employment, and if this continues, then it could feed into higher prices.
Despite this, our expectation – and that of the Bank, too – is that inflation will be subdued. Much will depend upon what happens after March, in terms of the UK’s future relationship with the EU and how this looks set to impact future policy, economic activity and spending and investment plans. But as the Bank acknowledged last week there is still a wide array of possible outcomes.
So, uncertainties over Brexit persist, UK economic growth has slowed, and inflation has decelerated. This has led the BOE to keep rates on hold now, but depending upon the Brexit outcome, it is less clear-cut as to when and in what direction the next policy move will be. Keeping policy options open is necessary, as too might be having a bias to ease.
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