It was only last Monday that I pointed out that the Bank of England was asleep at the wheel in the new version of the currency wars. Since then there has been rather a big change and I do not mean so much the new Prime Minister Liz Truss but a potential policy move. Plus there is the fact that the new currency wars are heating up with the Japanese Yen printing 142 overnight. Let us start with the currency issue which can be expressed simply. A fall against the US Dollar in particular raises inflation especially via commodity costs. This year particularly energy.
Yesterday saw a speech from Catherine Mann of the Bank of England who addressed this issue in June.
A priori it is ambiguous as to how domestic policy should react to higher policy rates abroad – raise policy rates commensurate with the foreign tightening path to contain the currency depreciation at an additional cost to activity in the medium term, or undertake a more modest or gradual rate increase to moderate the impact on activity but at the cost of more currency depreciation and inflation in the near term.
She was looking at a situation that I point out regularly which is that central banks can find themselves in a position where monetary policy can be set by matters external to the economy. We have seen this at its most extreme in places like Argentina and Turkey where currency falls have led to high interest-rates. Many central banks have bumped up against a smaller version of this recently as the US Dollar has risen. Next we can look at what she thought was the policy prescription.
These are very stylized scenarios and in no way represent MPC thinking, but, along with other data, research, and projections, they did inform my policy decision to vote for an increase of Bank Rate of 50 basis points at the last meeting. In the current context with historic inflation rates already evident, and with a large central bank (at least one!) pursuing a robust tightening, the UK’s exposure and sensitivity to global financial spillovers…..
Whilst she deserves credit for considering the issue as many at the Bank of England have closed their minds to it she then trapped herself in its groupthink. Because it raised interest-rates by 0.1% and then 0.25% when it has done it at all it thinks that 0.5% is a big deal or “bazooka” when in fact it looks more of a peashooter when others are looking at 0.75%. Also a 0.5% rise looks small when inflation is in double-digits.
What about yesterday?
Having praised her previous willingness to consider the exchange-rate I am afraid she was in a mess yesterday. Look at this nonsense.
Like the self-fulfilling prophecy on recessions, if firms believe that monetary policy will keep the Phillips curve from shifting, then they will incorporate that into their price expectations.
Does anyone believe this? I doubt there is even a single form that does. The next bit is simply embarrassing.
It is encouraging that long-term expectation metrics apparently remain anchored and consistent with the 2% target. It appears that the credibility of monetary policy is intact.
Just as a reminder the Retail Prices Index is recording annual inflation of 12.7% and the measure they target ( CPI) is at 10.1%. That is hardly “anchored and consistent with the 2% target”. The last sentence is not far off delusional.
Let me break this down using a sentence of hers. I have just looked at the first bit.
Expectations are formed from inflation outcomes
So this is going really badly and the next bit is that they have done too little too late.
central bank actions
It is incredible rather than credible.
and from credibility of the target
I am even more unclear how something that the vast majority know at best very little can be in play.
and the institutional setup
Amazing reality denial and a consequence of a point I have made many times over the years. It is that theory trumps reality in their world no matter how often the theory fails. They are like a child that will not give up their comfort blanket.
She does hint at a glimmer of understanding that bigger moves are now necessary.
When thinking about the tightening undertaken to date, my concern is that the gradual pace of increase in Bank Rate has not tempered expectations enough, allowing the embedding of the short-term inflation overshoot into the persistent drift in medium-term expectations.
She was asked about the issue via a question and here is the reply.
BoE’s Mann: Whether BoE Should Raise Rates By 75Bps Is An Important Question – Must Ensure Inflation Expectations Do Not Drift Further From Target ( @LiveSquawk)
Extra Borrowing
Let me know factor in what has rapidly become the next expectation.
Incoming Prime Minister Liz Truss has drafted plans to fix annual electricity and gas bills for a typical UK household at or below the current level of £1,971 ($2,300). ( Bloomberg)
This would be quite a change in likely inflation terms having an impact of 3.6% in RPI terms and 2.7% in CPI terms on inflation in October. Because we would avoid this.
Energy bills in the UK were due to jump 80% from October to £3,548 a year for the average household, ( Bloomberg)
There is of course a price for this as we shift the bill from consumers to taxpayers.
The policy could cost as much as £130 billion over the next 18 months, according to policy documents seen by Bloomberg.
The first issue is that the pattern of UK inflation will change quite markedly and will be considerably lower as we leave 2022 and move into 2023. Next is that economic prospects will improve as a further decline in real wages is avoided. People’s post energy disposable income will be higher. So even though inflation will be lower there is a case for interest-rate rises to be boosted as Catherine Mann unwittingly pointed out.
The MPC has the tools and the independence to return inflation to target once energy prices have stopped rising. We will not tolerate a persistent overshoot and will stay vigilant even when headline rates start to come down.
Actually they have tolerated a persistent overshoot because inflation was rising to 6% before Ukraine.
Comment
It has been a while since we have seen fiscal policy driving monetary policy but we may well be on course for that in the UK. Should it happen the clear fiscal expansionism will have several impacts. I have already looked at the better trajectory for the economy but there has already been an impact on longer-term borrowing with the UK ten-year yield reaching 3%. But with the currency issue in play the Bank of England could take the opportunity to make a more decisive interest-rate rise this time around. It will have the benefit of seeing whether the ECB raises by 0.75% on Thursday.
Another area that seems likely to be impacted is explicit QT and the emphasis below is mine.
In the event that gilt sales should proceed, the MPC agreed at its meeting ending on 3 August 2022 to set an amount for the reduction in the stock of purchased gilts held in the APF over a twelve-month period from the point at which the policy was voted on.
There is going to have to be a lot of hard thinking about QE in the months ahead. Many of the points I have made about various parts being ill thought out are about to be in play. But in simple terms will we get QE rather than QT?