Monetary policy is the shock absorber for the economy. That has been the message since the financial crisis. It is a message that has been reinforced today by the Bank of England. Six weeks after the Referendum the Bank announced a significant and comprehensive policy boost.
The policy rate was cut from 0.5% to 0.25%. A new term funding scheme was introduced to ensure that lower rates are passed onto borrowers. There will now be up to £10 billion of buying of high quality corporate bonds. And quantitative easing (QE) will be expanded by £60 billion from £375 billion to £435 billion, with buying of gilts.
In addition, the Bank hopes that these measures will have a stabilising effect on confidence as well as on activity. If not, the Bank has kept open the option of doing more. The Governor made clear that policy rates could fall further, towards zero, but they will not go negative. Indeed, the other areas announced today could be expanded as well. Of the measures, I saw less of a case for buying of corporate bonds, but the fact that this was announced allows the Bank to expand the scale and variety of assets bought, if it so wishes. Currently, four-fifths of corporate loans and about half of mortgages are floating rate, and so should benefit. Savers, however, will suffer.
This is a huge policy stimulus. Although the Bank of England was responding to the Referendum the reality is that the UK is adding to a global policy stimulus that is being seen across the G20. And, incidentally, global growth in the first half of the year has been relatively solid.
Let’s consider here some of the key issues arising from the Bank’s action.
Was it needed? It is still early days to determine the immediate economic impact of the Referendum. Although I think Brexit will be a longer term positive for the economy I made clear before the Referendum – including in written evidence to The Treasury Select Committee – that a vote to Leave would be equivalent to a short-term economic shock. And that is what we may now be seeing, hence a policy stimulus is justified.
The outlook for the economy, depends upon the interaction between economic fundamentals, policy and confidence. Since the Referendum there has been a sharp fall in confidence, reflecting many factors, and in turn this has dented business activity.
There will be some who will argue that the Bank may have over-reacted, based on limited data. That is possible, although, I think the near term balance of risks in the economy supports the bulk of the action taken. Inflation is not the most immediate problem, even though the Bank believes the weaker pound will lead to a temporary rise in inflation. So the Bank was justified in responding to fears of a slowdown.
Will the Bank’s actions be effective? While a short period of political instability and uncertainty over policy has fed some of the recent fall in confidence, my feeling is that the biggest danger in recent weeks has been that of a self feeding downward spiral, with a fall in confidence feeding a downturn in activity. The economy has already received a boost from a weaker pound. Now it is being given a further monetary injection and there is every likelihood of a fiscal boost too. The latter may include cuts to corporate taxes as well as an infrastructure boost. If so, the net effect will be a boost to demand and an incentive to invest.
The Bank of England is forecasting 2% growth this year. That seems fair. It now expects growth of 0.8% next year (previously it said 2.3 %), helped by today’s policy measures. But growth could be higher than that, helped by additional fiscal easing, and some recovery in confidence. In 2018 the Bank expects growth of 1.8%. That also may be too low.
The challenge is that after seven years of growth the UK may be at the stage of the economic cycle where it usually slows. Moreover, the recovery, while seeing solid job growth, is heavily dependent upon low rates. Despite this, the scale of the overall stimulus is significant and may yet provide a surprise to growth on the upside.
What will be the consequences? By combining a rate cut with a term funding scheme, the Bank is ensuring that the benefit of lower rates are passed onto borrowers, whether they be people or firms. The expanded QE scheme should ensure that rates remain low across the yield curve. And another consequence may be to encourage a shift into riskier assets, helping equities and corporate bonds. UK interest rates also look set to remain low for a long time.
One question though for all investors is what constitutes a risk free asset? Before the financial crisis, one of the big worries was whether markets were pricing sufficiently for risk. In an environment where interest rates are now close to zero that has to be a concern, but following the Bank’s actions today confidence about the downside risks facing the economy should ease.
Gerard Lyons is chief economic strategist at Netwealth Investments