Helicopter time?

While they refused the chance to alter policy in July the Bank of England have indicated a high probability of some easing in August. Why wait three weeks? Some suggest it is to see what the data says, but in practice there will be no really reliable data between the meetings relating to the post vote economy. We have had a weak July PMI reading from Markit, but this is a sentiment survey and it’s hard to gauge whether this weakness will translate into real reductions in spending. The reason for delay can only be to have more time to design the appropriate response, to be able to present the rationale more effectively in the Quarterly Inflation Report, and to consult with the new government to see what the fiscal policy intentions are.

Why is an easing needed? The EU vote is seen as a shock that will reduce growth mainly via weaker investment, though it is possible consumption and exports could also weaken as a result of the hit to confidence. Any policy adjustment should therefore be designed to encourage growth and investment. What are the options?

1 – A rate cut

This seems unlikely to be particularly effective. Companies that need to borrow (generally SMEs) are not restricted by the cost but by the availability of borrowing. Very few companies would borrow more if rates were cut.

The main impact of a rate cut may therefore be via pound. But despite the potential long term advantage of a lower pound for exporters, very little would be gained by driving the pound lower still in the short term. Indeed, a lower pound would probably be bad for growth near term because a lower pound would mean higher prices, lower real incomes and lower consumption. While the lower level of the pound should eventually prove supportive for exports, there is unlikely to be any quick impact when the UK trading arrangements are so up in the air.

2 – More QE

This may be helpful in supporting asset prices, as Bank of England buying of gilts will lead to higher cash balances for the sellers of gilts.But if there is a reduction in expectations of growth the demand for equities and other risky assets will be lower at any given level of gilt yields. So unless the Bank manage to force yields significantly lower with QE, which may be difficult from a very low starting point with inflation rising on the back of a lower pound , the extra cash may just stay as that – cash – much as it has tended to in Japan, and to some extent in past QE episodes in the UK, though this time there is less danger of the extra liquidity being soaked up by bank bond issuance with the banks better capitalised.

 

3 – Helicopter money

As I have written before (“we already have helicopter money, 09/05/2016”), helicopter money is not new or radical, we have already had it when the Bank used QE and the government allowed the deficit to balloon in 2009. In that year,  the Bank of England bought £190bn of government debt, while net debt rose by £178bn and the deficit rose £79bn from the previous year. You can argue that was about automatic stabilisers rather than a change in policy, so wasn’t a structural fiscal easing, but it was nevertheless a fiscal expansion financed by the central bank.

Of course, some argue more is required for this to be a truly money financed operation. If the government issues gilts to finance fiscal easing, and the Bank buys them in the secondary market, some don’t see this as direct financing, but it’s hard to distinguish the real effective difference between secondary and primary market buying. Of course, the gilts remain on the Bank’s and the government’s balance sheet, and could in theory be sold back to the market, but in reality this makes little difference in terms of current policy, so to renew QE at the same time as the government ease fiscal policy would not be that radical a decision.

Is this the best approach here? Well, the Bank doesn’t have control of fiscal policy, so it’s not a policy they can enact. They can provide the QE, but the government needs to make use of it by increased fiscal spending. This would be effective in stimulating demand in the short run, but the danger is that such monetary financed easing is perceived as inflationary in the longer run. However, I doubt this will be an immediate problem. Other questions about the sustainability of the UK government finances could also be raised, but I would argue this is likely to be seen as less of an issue if new debt is being bought by the Bank of England. It is nevertheless a risky strategy.

4 – Other confidence building measures

The main risk to the UK is a loss of confidence by firms who were planning to invest or foreigners planning to buy UK assets. There is little monetary policy can do about the fundamental issues, which depend on the government negotiating sensibly with Europe. Probably the most important thing the Bank can do is provide optimistic forecasts for the economy, which they can do without contradicting previous forecasts if they implement some easing measures (even though the impact of those measures will depend largely on confidence effects).

What will they do? It’s certainly not clear, and I would not see a rate cut as a foregone conclusion. The decision not to cut in the past had some valid reasons related to bank profitability, and although some of these have been addressed by reducing the banks’ capital buffer, there are certainly some who argue that a rate cut might do more harm than good by putting pressure on banks’ margins. The probable impact of a higher pound from no rate cut may not be a bad thing from these levels, preventing excessive GBP declines. (It is unlikely the pound will recover a long way). So more QE, with the decision on helicopter money effectively left up to the government may be the order of the day.

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