Richard Silveira considers the actions the UK central bank could take in the face of rampant inflation, a cost-of-living crisis and a probable recession
Pre-COVID-19, few observers thought that the high inflation of the 1970s might return to the UK. In the years since the global financial crisis, inflation has remained close to 2% and the Bank of England (BoE) has been doing its job. Fast-forward to 2022 and a new paradigm has emerged. Inflation is in double digits, the UK is experiencing a cost-of-living crisis and the economy is entering recession.
In the short term, there is consensus that the BoE will need to raise rates into 2023, though it has little room to manoeuvre between reducing inflation and inducing deeper recession. Though not a direct mandate of the BoE, it may find itself defending the currency – and by proxy, inflation – as markets discern the UK's prospects. In the longer term, the BoE will need to address questions such as: what is the legacy of sustained zero interest rate policies and quantitative easing (QE), and does the inflation mandate remain a sensible option?
These are not hypothetical questions. Monetary policy cannot continue to function in the short term; the BoE needs a cohesive strategy that will address both current inflation and future challenges together. To navigate these issues, we need to look at the period from the financial crisis through to COVID-19, when central banks stepped in as they never had before. In this context we can gauge the BoE's challenge, and possible directions it could take.
A quiet decade of excess
Relative to the past three years, 2009–19 was quiet. Things did happen: the European debt crisis, Brexit and Donald Trump’s time in the White House. However, at no point did the global economy stop: trade continued to flow and inflation remained low and stable. Problems did not become points of global contagion as the financial crisis had years earlier, or the pandemic later. The European debt crisis, for example, was resolved (in the short term at least) by a resolute European Central Bank (ECB), with its chief Mario Draghi stating that the Bank would do “whatever it takes” to ensure the security of struggling peripheral EU countries.
A quiet decade, then – but one of excess. Central banks globally cut rates close to zero, and sometimes below. In addition to setting rates directly, they printed money via QE, predominantly to purchase government bonds. Yield curves collapsed under the weight of central bank purchases and cheap debt reigned for governments, companies and individuals. Markets re-adjusted their expectations of what central banks would be prepared to do. Years earlier, the term ‘Greenspan put’ was coined to reflect the actions that the US Federal Reserve (Fed) would enact to stabilise a falling market, but this was different. With fiscal tightening (austerity), central bankers became the lender of first resort and not the last. Bad economic news often led to a market rally on the basis that it would yield further QE.
Why is this relevant now? Because these actions make the inflation problem more difficult and unpalatable to tackle. Borrowing costs will increase in the bid to bring inflation down; businesses will fail and households will struggle with debt, particularly through higher mortgage repayments. This always happens in a rate-rise cycle, but this time it will be grisly. Chronically low interest rates are not healthy for the economy, representing moral hazard in perpetuating credit-based growth and asset price inflation that cannot continue ad infinitum.
At some point, the music stops. As journalist and author Christopher Snowdon notes: "A company that cannot service its debts when interest rates are at 5% should not be in business and a person who cannot pay their mortgage unless interest rates are the lowest they've been in the Bank of England's 300-year history should never have been lent the money".
A monetary policy tightrope
The BoE has signalled intentions to return inflation to 2%, with base rate increases and the sale of gilts held under QE (quantitative tightening, or QT). But how will this materialise in policy? Following the decision in September to cap energy prices – and the relative calm of a(nother) new government minus the free-market economics – inflation is forecast to have peaked at 10%. However, that doesn't mean a rapid and smooth return to the low pre-COVID-19 inflation. Inflation is prone to a ratchet effect, whereby price increases are not easy or quick to undo once established in expectations and company bottom lines. This can be compounded by a wage-price spiral if price expectations and wage expectations continue to reinforce each other. Given the government's aggressive stance against unions, prolonged strike action across the economy, seeking higher pay agreements, is also possible.
The BoE will need to make difficult choices to force inflation down and keep it down. Strip away cheap credit and the economy will struggle. Governments, households and businesses will face a cost of credit not seen in almost 15 years. What will the BoE do if recession takes hold while inflation remains above its target?
The choice of sticking or twisting may lie outside the BoE's control. Between 2009 and 2020, central banks could cut rates to zero and, later, print at will; markets started to price in future QE, and bond-yield dynamics were driven by this rather than risk and return fundamentals. Central bankers did not need to worry about rising borrowing costs; the more you printed, the lower they became. As monetary policy unwinds, it is not simply 2009–20 in reverse.
With the expectation of further QE removed – notwithstanding the recent intervention to stabilise pension schemes – the market will set the price of government debt. If the BoE pauses monetary tightening too soon for the market, sterling and gilts will be sold. Weaker sterling causes higher imported inflation – especially regarding food and energy – and higher gilt yields mean higher interest rates for loans and mortgages. Either way, there will be pain – and, very likely, higher rates.
Is more QE an option?
Can’t We Just Print More Money? is a 2022 book written by BoE economists Rupal Patel and Jack Meaning, intended to educate the public on economics and monetary policy. As higher interest rates bite and households struggle with bills, the public, media and politicians may start asking this question, pressuring the BoE to relax QT or restart sustained QE to lower borrowing costs. Much depends on how the US economy, and by proxy the global economy, fares in the near future. The dollar is the global markets’ reserve currency, in which commodities are priced, and is the currency to which capital flows during market downturns. The Fed sets the direction and pace of global monetary policy.
If the Fed continues to tighten and inflation remains high globally, it will be difficult for other central banks, including the BoE, to move in the opposite direction. In theory, since government bonds are denominated in sterling, the BoE can use QE to reduce bond yields, or even cap them at a given level via yield-curve control, producing arbitrary money via QE to generate demand and suppress yields. Given the UK's reliance on foreign capital to fund a perennial current account deficit – termed the 'kindness of strangers' by the then-governor Mark Carney in 2016 – it's unlikely that the BoE would want to test the market's appetite for the UK going it alone. A second issue is that it would amplify inflation problems via weaker sterling and higher imports, and further increase the nation's debt via the 25% of borrowing that is inflation-linked. That percentage and exposure is significantly higher than for any other G7 economy.
At some point, the Fed will slow down. Its aim is for a 'soft landing', whereby monetary tightening brings inflation down with minimal damage to the economy, and dovetails to a position of neutral policy that is low-inflation with minimal QT or QE. If this materialises, central banks will feel less pressure to align with the Fed, and the markets may permit looser policy, whether through lower rates or QE.
A soft landing in the US cannot be guaranteed, though; like the UK, it is particularly exposed to household mortgage debt and whether repayments can continue. Large-scale defaults triggered the 2008 crisis, and it's not out of the question that the same could happen again. Mortgage rates for 30-year fixed terms in the US have more than doubled from 3% to 7% during 2022 – a similar level to that preceding the 2008 crisis. The major difference versus the UK is that US fixed-term deals tend to be 15 or 30 years instead of two or five years, so the fraction of those re-financing deals is lower in any given year. However, the risk remains, and if we see a repeat of 2008 then rate cuts and QE are back on the table.
Is change needed?
Monetary policy is not without consequence; the ‘quiet decade of excess’ makes the present situation immeasurably worse. Although interest rates remain low by historic standards, the level of borrowing is not. There is more leverage in the system. Neil Hudson of consultancy BuiltPlace has calculated that, based on repayment ratios, a 14% rate in 1980 is equivalent to 3% now. Leverage makes the system brittle. What if the base rate and gilts go to 5%, as markets are pricing? Sixty per cent of UK GDP is consumer spending: new cars, home improvements, shopping, eating out, cinema trips. What happens to that if mortgage costs increase by thousands of pounds per year? Until the end of next year, including Q4 2022, an estimated 1.7 million people will re-finance fixed-rate deals, and two million households on variable rates will see immediate rate increases. The impact will be sharp and sustained while rates remain high to combat inflation.
It's easy to say that rates were too low for too long, but that is what happens if a central bank’s target is price inflation and its only tool is interest rates and QE. You care about the Consumer Price Index being at 10%, but the House Price Index at 10% gets a pass; a credit bubble is allowed – some would argue, encouraged - to develop. As the next stage in monetary policy unfolds, perhaps we should question that orthodoxy.
Richard Silveira is an independent actuary and quantitative developer
