Has the Bank of England lost its marbles

Has the Bank of England lost its marbles

August 7th, 2009

…..or does it know something we don’t know? Imagine that the UK economy is like a massive oil tanker. On board, one of the seamen spots an iceberg, and the great ship’s wheel is turned by the captain with a rising sense of urgency. Trouble is, it takes time. The captain yanks on the wheel, but the ship doesn’t respond straight away. What should the captain do? Turn the steering wheel some more, just in case; or wait and see, but risk the possibility that the ship hasn’t turned enough and that by delaying further tugs on the wheel it will be left too late and the ship will then collide with the iceberg? On the face of it, it seems like a no-brainer. Better to turn the wheel too much and miss the iceberg by a large margin, than not turn it enough. But supposing there are two icebergs, and by turning the wheel too much the ship hits the second one. That’s the challenge facing the captain of the good ship UK economy. Yesterday, the Bank of England revealed what may well turn out to have been its boldest move yet. You may recall, some time ago it had agreement from the Treasury to instigate £150bn of quantitative easing, but, prior to yesterday’s announcement, it had only actually introduced £125bn worth. Most commentators thought that this would be enough and that no more money would be created, although some conceded there was an outside chance it would reveal plans to use up its quota and print the remaining £25bn. Yesterday the central bank went against these expectations. Not merely did it announce its intention to print the remaining £25bn, but it also revealed that it has permission to print a further £25bn,which is being made available immediately. It was a big shock. But the Bank of England move was inconsistent with its past actions. This begs the question, has it lost the plot, or does it know something that we don’t know? You may recall, during the run up to this recession the UK’s central bank was late arriving at the rate-cutting party. In June 2007 it actually upped the rate of interest to 5.75 per cent, and as recently as July last year the official UK rate of interest was still 5 per cent. You may also recall that one member of the bank’s rate-setting committee, David Blanchflower, consistently voted against the rest. When rates went up, he voted against the move, and when rates went down, he voted for even bigger cuts. He once went on the record to confess how guilty he felt that he had been unable to persuade the rest of the committee to see things his way, and suggested by inference that the bank’s reticence to cut rates would lead to job losses. Well, looking back with the benefit of hindsight, we can say Mr Blanchflower was right, and the rest of the Bank of England Monetary Policy Committee were wrong. In the US, by contrast, the Fed cut rates far more rapidly. By April last year, for example, the US rate of interest was 2 per cent, a full three percentage points lower than in the UK. It is quite possible that this more precipitate action taken by the Fed is the reason why the US contraction this year is less extreme than the UK contraction. In fairness to the Bank of England, once it woke up the reality it moved swiftly. But, to an extent, by then the damage was already done. The Bank of England left it too late. And there is nothing wise in hindsight about these words; back then this column repeatedly warned that the economic prospects were much worse than most forecasters were suggesting. So, the Bank of England’s first error: it ignored the signs and steered a steady course, oblivious to the impending iceberg, even though plenty of others could see it. On the face of it, the Bank of England is now making precisely the opposite mistake. Just as there were plenty of signs back in the first half of 2008 suggesting the economy was heading for recession, which the Bank of England ignored, those same signs now suggest the recession is all but over, and once again the Bank of England is ignoring them. It is like a speeding motorist coming off a motorway, ignoring the signs saying 30mph, until a speed camera is triggered, but who then slows to 30mph and stays at that speed, even when the next motorway begins, and what’s more, hugs the centre lane. Last month, after its rate-setting meeting had finished, the bank signalled no change in policy and dropped a strong hint there would be no change in August either. And yet since then, even more positive economic data has piled on top of already positive data. And the indicators that this column was especially worried about in 2007 and early 2008, the plummeting Purchasing Managers Indices on manufacturing and services, and the crashing headline RICS index on the housing market, have all picked up dramatically in recent weeks. If you like, the ship’s captain decides the ship has turned enough, then the wind picks up, pushing the ship even further away from the iceberg, and what does the captain do? – why, pull on the wheel even harder. There are a number of possible explanations. Explanation one lies in the latest figures on the UK’s growth. The Q2 data was much worse than expected, and this in turn may have hit the Bank of England models, leading to this apparent panic measure. Explanation number two, and actually this rather builds on the first explanation, the Bank of England’s inflationary report will be out this month. Maybe the bank has seen an early draft, and is worried. Explanation number three, it is worried about the long-term rate of interest. It feels that markets are just not convinced that rates will stay low in the long term, and by taking this action, it will convert them. Explanation number four, it is worried about a double-dip recession, and fears that the recent good news is just temporary. The fact is, of course, lending is still below levels the bank wants. So by printing more money, it hopes to solve that problem. But given that the economy seems to be recovering anyway, why does this lack of lending matter? Would it not be better to give the existing easing more time to work? For some time now this column has argued that if the real objective of quantitative easing is to get money into business, why not bypass the banks altogether and provide the money to venture capital instead? Or if the bank is worried that consumers are in too much debt, why not lend the money to the government for the purpose of a one-off tax credit? After all, £50bn works out at just under £1,000 for every man, woman and child in the country. And by the way, this money would in turn find its way into the banks anyway. The banks, for their part, would have to start becoming more competitive as they fight with each other to get their hands on this new money. And maybe the British public, disenchanted as they are with the banks, will look at alternatives, thereby providing opportunities for new banks – and after all, that is what recessions are supposed to be about, creating vacuums to be filled by new, dynamic businesses. There is a fifth explanation, and it relates to Japan. A report on Bloomberg this morning suggested that Japanese deflation will continue into 2011. Central bankers are terrified they will make the same mistakes seen in Japan over the last two decades. But then again, as has been argued here, the real problem in Japan is an ageing population, a problem which is just beginning here. And there’s not much that monetary policy can do about that. It does not matter how hard the ship’s captain pulls on the wheel if there is a massive leak in the hull. Article author: Michael Baxter from Defaqto,to see more articles by the author go to: http://defaqtoblog.com/iabn/ For financial advice call Mark or Clare at GMP Independent Financial Advisers LLP on 0207 2886400      

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