Why The Bank of England Needed Brexit to Begin Raising Interest Rates – Part Three

In parts one and two of this article, we looked in depth at the actions and intentions of the Bank of England starting in 2009 when the bank launched its quantitative easing programme, all the way up to the end of October 2017 with the BOE just a few days away from raising interest rates for the first time in a decade.

We pick up our investigation commencing on November the 2nd, 2017 – the date in which the bank officially began to tighten monetary policy.

The decision to raise rates was supported by seven out of nine committee members (governor Mark Carney was one of the seven). Whilst the quarter point rise to 0.5% only reversed the rate cut from August 2016, it did nevertheless bring the Bank of England into line with the Federal Reserve and the Bank of Canada, both of whom had already started to raise interest rates. Quantitative easing remained unchanged at £435 billion of bond purchases so far.

The minutes for November’s meeting provided an outline for why monetary policy had now become less accommodative. The two primary reasons were inflation running at 3% and unemployment being at its lowest since the mid 1970s. The spare capacity that the BOE routinely raised in its communications had continued to erode as the unemployment rate fell. Therefore, in the bank’s eyes, a small reduction in stimulus was warranted to return inflation ‘sustainably‘ to target.

But it was the subject of Brexit that attention was predominately focused on. There was a recognition that business investment was being affected by the uncertainty surrounding the process, and that the fall in the value of sterling was the dominant factor driving inflation above 2%. The BOE was now projecting that inflation would slowly return to target by the end of the forecast period in 2020 as the effects of sterling’s devaluation reduced. But these projections came with a proviso. They were conditioned not only on a ‘range of possible outcomes over the UK’s trading relationship with the EU‘, but also on the assumption that households and businesses were basing their future decisions in the belief of a ‘smooth adjustment‘ to a new trading relationship with the union.

Comments shared by committee members in the run up to the meeting – particularly those made in September – were recognised as having ‘led some investors to reassess their view of interest rate prospects.’ In other words, by telegraphing in advance what the bank intended to do, the Bank of England successfully managed to shape investors perception in favour of an earlier than expected rate hike. As per the Federal Reserve in the U.S.

Outside of Brexit, historically low volatility in equity markets was also cited as a positive, with indexes enjoying new record highs since the last inflation report back in August 2017. This was taken as another sign that the global economy was in the midst of a sustainable recovery. As for signalling their future intentions, the BOE stated that their November inflation report was,

conditioned on a market path that implied two additional 25 basis point increases in rates over the three year forecast period.

But ‘considerable risks‘ to the outlook remained, chiefly due to Brexit. The MPC issued an assurance that they would respond to risks ‘insofar as they affect behaviour of households and businesses and the outlook for inflation‘.

Incidentally, the two committee members who opposed a rise in interest rates were John Cunliffe and Dave Ramsden, who were of the view that there was,

insufficient evidence so far that domestic costs, in particular wage growth, would pick up in line with the Inflation Report’s central projection.

At the time of the meeting wage growth stood at 2.3%. The minutes as well showed that Cunliffe and Ramsden thought that,

recent experience suggested that wage growth could continue to be less responsive to falling unemployment than past experience would suggest.

A few days after the rate hike, Mark Carney appeared on Peston on Sunday where he was asked if the UK economy would suffer any ramifications in the event of a ‘no deal‘ Brexit.

In the short term, without question, if we have materially less access (to the EU’s single market) than we have now, this economy is going to need to reorient and during that period of time it will weigh on growth.

Carney was also reported as saying that in the event of a ‘bad deal‘ with the EU, the Bank of England would be unable to respond by cutting interest rates due to the inflationary pressure it would cause. We will explore this in more detail as part of the conclusion.

A couple of weeks on, new unemployment figures were released showing those out of work unchanged at 4.3%. Earnings also remained static at 2.3%, 0.7% behind inflation. This made for six consecutive months of negative pay growth.

With 2017 winding down, and attention turned towards the Christmas festivities, the Bank of England left interest rates unchanged at 0.5% in December, two days after inflation rose to 3.1%. Around the same time the final set of unemployment figures for the year were issued, showing no change to the percentage of people without a job. Pay expanded slightly to 2.5%, but it was now seven straight months since earnings dropped below the rate of inflation.

Meanwhile, in the United States, the Federal Reserve rounded out the year with their 4th rate rise since Donald Trump secured the U.S. Presidency in 2016.

***

After reading a prepared speech at the Bank of England’s November inflation report press conference, Mark Carney was asked by the Guardian’s economics editor Larry Elliott why the decision was taken now to begin raising interest rates:

The report doesn’t really say there’s been any material change in the economy since the last one. A lot of the inflation we’ve seen over the last year has been caused by the one off impact of sterling’s devaluation which will wash out of the system. As the MPC itself said, there’s a lot of Brexit uncertainty affecting the economy in a negative way at the moment and that uncertainty may well dissipate over the coming months. So why does the MPC feel the need to do this right now rather than wait to see what happens in the economy over the next few months?

Mark Carney had this reply for Elliott:

On the waiting point…you can always wait…but you have to have the discipline ultimately of the target. And if you’re deviating from the target you have to get something for it. And we have stretched in order to get quite a bit for it – 325,000 jobs, supporting growth, and supported by other factors – but as you get to the end of that trade off, you’re not getting anything to it except for missing your target further out.

When Carney took over as BOE governor on the 30th of June 2013, inflation was 2.9%. It had been above the bank’s 2% target since December 2009. It was not until February 2014 that inflation fell back below 2%, and was to remain there for three years. Was having the ‘discipline of the target‘ a new found concept that did not apply to preceding years?

If we travel back as far as 2011 when Mervyn King was governor, we find inflation running as high as 5.2%. In spite of that, not once did the BOE openly contemplate raising interest rates. In fact, they became even more accommodative with the resumption of quantitative easing. Slow economic growth, the Euro Zone crisis and higher energy prices were the key reasons presented for rates to remain unchanged and for stimulus to continue. In their forecasts, the bank expected inflation to steadily fall back in 2012, which it did to an average of 2.8%. They allowed for measures such as the coalition government’s VAT rise (seen as partly to blame for the rise in inflation) to work its way out of the system rather than increase rates as an antidote.

Based on their own actions, the bank’s 2% target for inflation was not a leading concern during the onset and aftermath of the ‘great financial crisis‘. A fact picked up by the Daily Telegraph in 2011:

It is quite evident that it has abandoned its statutory remit of delivering the Government’s annual inflation target of 2 per cent in favour of focusing on GDP growth.

Seven years later, and the Bank of England’s 2% target not only still exists, it has gained in prominence to now become a decisive factor in deciding when interest rates should rise. Having ‘the discipline of the target‘ begun to matter in the wake of the EU referendum as inflation gradually crept up above 2%.

Establishing the importance of the target takes us back to the beginning of Mark Carney’s tenure as governor, when the BOE’s first significant measure was to launch a new initiative called ‘forward guidance‘. With inflation at 2.7%, the bank stated that they would only consider raising interest rates once the unemployment rate had fallen to 7%. The rate was 7.8% when the guidance was published. As discussed in part one, the bank updated their forward guidance six months later in conjunction with the February 2014 inflation report. The official explanation went like this:

Despite the sharp fall in unemployment, there remains scope to absorb spare capacity further before raising Bank Rate.

The bank’s 7% target was therefore abandoned in favour of no specific target at all. What was clear however was the consummate timing of the update. This extract from part one explains:

At the time of the inflation report (published on February the 12th), unemployment stood at 7.1% (in the three months to November). In April 2014, the rate dropped below 7% to 6.9%, marking a five year low. What is important to recognise here is that unemployment figures in the UK are published two months behind the current month. The April figures, therefore, covered activity only as far as February. This means that the BOE updated its forward guidance in the same month that unemployment fell below the original threshold of 7%. By doing so, it avoided having to enter into an immediate debate on a prospective rise in interest rates.

Now that the bank was no longer operating to a specified unemployment threshold, their definition of ‘spare capacity‘ had become ambiguous. We can only assume that this was by design, in order to give the BOE greater flexibility over the timing of when monetary policy would begin to ‘normalise‘.

Carney raised the possibility of a rate hike four months later (with inflation at 1.9%), only to dismiss the idea shortly afterwards (with inflation down to 1.5%). On this occasion he cited weak wage growth (0.6%) as a primary reason, with unemployment down to 6.5% (a six year low). Other factors included rising geopolitical tensions (one assumes this included the growing conflict in Syria) and turgid growth in the Euro Zone.

The subject of a potential rate rise was roused again by Carney in July 2015 (inflation at 0.1%). GDP was rising, wage growth stood at 2.7%, unemployment continued to fall. It appeared rates could now rise at the turn of the year. A few months later, on delivery of the Bank of England’s November inflation report, the bank talked down the prospect (with inflation at 0.2%). The excuses this time ranged from a weakening global growth outlook and the expectation that inflation would remain below 2% for the next couple of years. The future path of bank rate, they declared, would ‘depend on economic circumstances’ as the data evolved.

To gain some perspective on why the bank raised rates in 2017, let us look at how the decision compared with past communications about potential rate hikes. Inflation at 3%, and the lowest rate of unemployment since 1975, were presented as the principal reasons for the move. On previous occasions over the past seven years, the ‘economic circumstances‘ either showed high inflation and high unemployment, or low inflation and falling unemployment. When it seemed that one aspect of the economy was conducive for monetary tightening, others were used as reasoning for why it could not yet be done. Only since the EU referendum – and the subsequent fall in the value of sterling – have conditions developed allowing for rising inflation and decreasing unemployment to come together. Aside from inflation and unemployment figures, ‘steady‘ consumer spending and growth in manufacturing were cited by the Bank of England as further justifications to raise rates.

However, if you broaden your measure of a supposedly improved economy, the arguments against increasing rates begins to take shape:

  1. GDP growth has been falling for the past few years. In 2014 it was 3.1%. A year later it dropped to 2.2%. In 2016 it fell to 1.8%. Growth in 2017 came to just 1% up to the end of the third quarter in September. The final number (once fourth quarter data is released) is expected to be below the level reached in 2016. Sluggish growth has been a factor before in the Bank of England opting not to raise interest rates. In 2017, it was not.

2. Wage growth was consistently below inflation for much of 2017. The BOE’s own communications over the years showed how prominent this issue was in determining when rates should start to rise. Back in June 2017 the MPC’s Andy Haldane said weak pay growth was a factor in him deciding to vote to keep rates at 0.25%. Even Mark Carney is referenced as saying that he would like to see pay rise above 3% a year before contemplating an increase. This was back in 2015 when earnings growth amounted to 2.5%. The November rate hike came with earnings even lower than that at just over 2%.

3. Political and economic ructions have regularly been used to justify no movement on interest rates. We return to the MPC’s Andy Haldane, who used the uncertainty following June 2017’s hung parliament as a reason for not yet supporting a rate increase. Most significant in recent times, however, has been the uncertainty surrounding Brexit. This has, according to the bank themselves, had a negative impact on both consumer and business confidence. Yet the BOE have successfully managed to craft the narrative that monetary policy cannot stand still throughout the Brexit process, and must instead respond to the data at hand (even though the data used as justification is selective). Therefore, having a specified 2% inflation target is, in this case, a convenient tool and one that the bank is now utilising.

4. Unsecured consumer debt (credit cards, car loans etc), described as a ‘pocket of risk‘ by the Bank of England weeks before raising rates, was back to pre-crisis levels in 2017 at over £200 billion. The picture looks much worse when taking all household debt (including mortgages) into account. This has been consistently on the rise since 2011, and as of the second quarter of last year, came to £1.88 trillion (an all time record). The BOE’s decision to increase rates translates to increased debt servicing costs for swathes of people, in a time of stagnant wage growth and a sustained rise in the cost of living.

And it’s not just the consumer that is impacted when rates go up. Public sector net debt has been continuously on the rise since 2001/2002, and now stands at a record £1.7 trillion (as of 2016/2017). Since 2008/2009, public sector net borrowing has totaled almost £950 billion, resulting in interest payments just shy of £400 billion. With rates now rising, so too will the cost of servicing this debt.

5. Retail consumer spending was under pressure as the BOE moved closer to raising rates. Spending fell 0.3% in September 2017, the fourth decline in five months. Predictably, the uncertainty over Brexit was championed as the cause. A week later it was shown that retail sales dropped 0.8% between August and September, although sales grew 0.6% in the three months up to September. Year on year sales volume, however, was significantly down on previous years.

Figures issued after the rise in interest rates remained poor. Consumer spending declined by 2% for the month of October, the quickest drop in four years. Most recent data showed the first year on year fall in spending since 2012.

6. The construction sector was mired in recessionary conditions at the time of the MPC meeting in November 2017. Construction PMI for September slipped to 48.1 (below 50 is considered a contraction), which media outlets attributed to Brexit uncertainty. Construction output data released in September (when the Bank of England were preparing people to expect a rate hike) showed a contraction of 1.2% for the three months up to June. Output also fell month on month by 0.9% in July. This was the fourth consecutive month that both sets of figures had contracted. Conditions improved slightly come the next data release (three weeks before rates rose), with August output growing by 0.6%. The three months up to August, however, still showed a contraction of 0.8%.

The situation is little improved today. November output did rise by 0.4%, but the latest figures showed it had contracted for the sixth consecutive three month period, falling by 2%. This is the largest fall since August 2012 (when inflation was running above target at 2.5%).

7. The services sector, which accounts for around three quarters of UK GDP, is also experiencing uncertainty. Figures from September 2017 showed PMI had dropped to 53.2, the weakest in almost a year. A month later the impact of Brexit was used to justify slowing business sales and reduced confidence levels.

Latest figures showed firms reporting the slowest growth rate since August 2016. Employment growth in services was also at a nine month low.

To summarise, Brexit uncertainty, a downward trend in GDP growth, a continuing rise in consumer debt, wage growth persistently below inflation, declining retail sales volume and consumer spending, and construction output in negative territory were overlooked in favour of the Bank of England’s inflation target and a reduction in spare capacity. In the not too distant past, these pressures combined would likely have seen the bank balk at the suggestion of raising interest rates. The environment would have been judged as too volatile.

The landscape post Brexit, however, has seen a tangible shift in policy. For example, whereas in 2011 the BOE decided not to temper high inflation by increasing rates, the tone in 2017 was now openly in favour of tightening monetary policy to bring inflation back to the 2% target. This is despite the fact that the depreciation of sterling since the EU referendum would, as the Guardian’s Larry Elliott put it, ‘wash out of the system‘ over time. Much like the VAT rise did under the coalition government (which the BOE stated had contributed to rising inflation). Yet they allowed for this and accompanying factors such as higher energy prices to dissipate without intervention, recognising full well (along with their international counterparts) that to have raised rates in this environment would have caused a widespread economic panic. One which the bank would have been directly culpable for.

Securing the recovery‘ was the dominant narrative post 2008, even if this meant enduring a four year period of above target inflation from 2010 to 2013. By contrast, in 2017, inflation was above target for only nine months before the Bank of England moved to hike rates. Post referendum, ‘the discipline of the target‘ had become a leading tenet of the bank’s remit once again.

***

Rather than be tempted into theoretical assertions, we will attempt to gain further understanding of why the Bank of England chose this moment to tighten monetary policy by citing one of their own officials.

On the 15th of November, 2017, deputy governor for monetary policy Ben Broadbent delivered a speech at the London School of Economics titled, ‘Brexit and Interest Rates. Marrying the two subjects together, he began with what had been the bank’s position leading up to their first rate rise in ten years; namely, that accommodating above target inflation could only be sustained provided that spare capacity remained evident in the economy. To quote Broadbent directly:

As unemployment has declined that position has become harder to maintain.

There were, according to the bank, ‘limits to the extent to which above-target inflation could be tolerated‘ (a message that they had originally conveyed a year before raising rates). Those limits were dependent on the ‘degree of spare capacity in the economy.’ Considerations outside of these boundaries were therefore not paramount in their thinking.

At this stage it is prudent to recall that the Bank of England are not alone in having a target for inflation. For instance, the Federal Reserve and the European Central Bank both employ the same objective of 2%. Rather than acting alone, the BOE are instead part of a broad, global network of central banks that are working in synchrony to implement the gradual removal of stimulus measures. The only difference is in how they undertake the task.

Returning to Broadbent, he went on to emphasise some other key points. Firstly, that the rise in inflation was overwhelmingly due to the aftermath of the EU referendum, which was precipitated by the depreciation of sterling. Secondly, that the consensus amongst economists that EU withdrawal would mean maintaining record low interest rates was in fact a false belief:

There’s been a persistent strain of opinion that EU withdrawal is something that necessarily means lower interest rates, or at least that it’s a reason to avoid putting them up.

If so, then I think the belief has been overdone.

This chimes with Broadbent’s colleague, Ian McCafferty, who back in October 2017 said that markets had wrongly assumed that Brexit would be a hindrance to tightening policy.

Contributing to the BOE’s case for raising rates was the apparent global economic recovery, for which Broadbent asserted had helped ‘sustain the UK economy over the past year or so‘. The problem, though, is that this ‘recovery‘ has been measured in no small part by the performance of equity markets (the same markets that took receipt of trillions of dollars in stimulus). In particular, the general population have been taught to associate an improved economy with a rising stock market, making it easier for central banks to build up the rationale for the gradual removal of accommodative monetary policies.

Broadbent’s other notable observation was to opine that there was ‘very little correspondence‘ between the economic impact of Brexit and the consumption plans of the general public. As a result, the decline in the value of sterling along with maintained consumer demand had worked to push up the rate of inflation, prompting the conditions necessary for the Bank of England to justify raising rates. If Broadbent is to be trusted, then what we are witnessing today is a populace that is either disbelieving or ignorant to the possibility that a ‘bad‘ Brexit will affect them on an individual level. Broadbent reinforced this theory by stating that the household savings rate in the UK had fallen since the referendum.

In the first quarter of 2016, the savings rate was 8.2%. By the end of the fourth quarter it had dropped to 5.4%. At the time of the MPC meeting in November 2017, it had climbed back up slightly to 6.2% but remained lower than pre-referendum levels. The latest figures, representing the third quarter of 2017, showed the ratio as having fallen again to 5.5%. Whilst this may suggest that people are dipping into savings to maintain their spending habits, it could also be ventured that the rise in the cost of living due to higher inflation (coupled with stagnant wage growth) has contributed to the fall in household savings.

Inflation, Broadbent said, would be lower than the 3% at the time of the MPC meeting had expectations of the implications of Brexit been more uniform between consumers and currency markets. That is, if currency markets had proved as sanguine as households in response to the referendum, then inflation would have been far more subdued. On the other hand, stressed Broadbent, had consumers proved as volatile as currency markets, this also would have suppressed inflation due to weaker demand. The enticement of materialism, and wanting to spend money on superfluous goods, has, according to Broadbent’s logic, contributed heavily to where we find ourselves today.

Broadbent concluded his speech by declaring that the MPC had ‘little choice but to take the economic data at face value‘.

To adapt the football manager’s cliché, we can only play the economy that’s in front of us. What’s been in front of us for several months is an economy with above-target inflation and dwindling spare capacity. That’s why I think it was the right thing to remove a degree of monetary accommodation.

***

Conclusion

Ben Broadbent’s analysis confirms what has steadily become more apparent throughout this series. For the Bank of England to build a case for raising interest rates (one that markets would buy into), they required not only a falling unemployment rate but also an uptake in inflation. The two came hand in hand. The depreciation of sterling after the EU referendum provided the vehicle for heightened inflation. Therefore, it can be argued that without Brexit, inflation would have remained comfortably below the bank’s 2% target. The BOE themselves have attributed no other cause for its rise. That is because there has been no other discernible inflationary pressures in the economy.

Mark Carney’s position of needing to have the ‘discipline of the target‘ on inflation has not been a consistent objective of the BOE. The bank either has the discipline of a 2% target or it does not. In the years prior to the referendum, there was no discipline. This is borne out by the timeline of events explored in parts one and two.

As proven by the words of policymaker Ian McCafferty, Brexit is in no way an impediment to the Bank of England’s agenda of gradually removing monetary accommodation. Given that it was Mark Carney who described Brexit as ‘inflationary‘, with inflation having been the key missing ingredient to begin raising rates, it becomes clear how the process of leaving the European Union (and the uncertainty it generates) assists the bank in its endeavour to ‘normalise‘ policy.

Were the Bank of England acting independently on monetary policy, we might feasibly look upon Brexit as a singular event that had nothing in common with other nations. Look beyond British shores, however, and the trend of central banks engaging in their own examples of stimulus withdrawal is undeniable.

It was in December 2013, under Barack Obama, that the Federal Reserve first announced the tapering of its quantitative easing programme. Ten months later bond purchases came to an end. Exactly two years after tapering began, the Fed raised interest rates for the first time since June 2006. This spawned a negative reaction in equity markets, with the next rise not until after Donald Trump’s presidency was confirmed.

We can say with clarity that before the geopolitical stress points of Brexit and Donald Trump became manifest, banks had yet to begin a sustained programme of ‘normalisation‘. The Federal Reserve have now taken this a step further by beginning the process of reducing their balance sheet. The European Central Bank, meanwhile, announced the tapering of asset purchases in December 2016 and extended this programme a year later.

Geopolitical uncertainty has risen considerably over the last few years, directly coinciding with the change in direction of central banks. Increased rhetoric from global economic institutions (namely from the IMF, the World Bank and the Bank for International Settlements) is warning of complacency in financial markets and faster than expected rate hikes due to rising inflation. Both these concerns are allied to the repeated warnings of protectionism and populism. Ultimately, this is serving one instrumental purpose. The attribution of responsibility, of holding someone or something to account whilst support is withdrawn from markets, is deflecting attention away from the actions of central banks.

From a UK perspective, Brexit has been carefully positioned as a scapegoat for economic uncertainty, meaning the focus of attention has been directed away from the Bank of England and the decisions they administer. Decisions which they will say are in response to ‘economic circumstances‘ originating because of Brexit.

The environment of record low interest rates and the accumulation of over $20 trillion in assets by central banks since 2008 has corresponded with an exponential rise in global debt (now at over $230 trillion). Integral to the ‘recovery‘ has been the ability to borrow money at near 0% interest and having central banks act as a backstop for what we are led to believe are ‘free markets‘. This is now being actively reversed. Is it a coincidence that as monetary policy has sought to tighten, the geopolitical environment has grown more volatile?

Important to appreciate here is that the actions of central banks are not originating inside a vacuum. Consider that without the avenue of Brexit, and with no discernible political or geopolitical unrest, the decisions of the Bank of England would likely come under heavier scrutiny and leave them exposed as the culprits of any ensuing downturn. The same logic applies globally.

In closing, we return to Mark Carney’s position that in the event of a ‘bad deal‘ with the EU, the BOE would not be able to respond with accommodative measures due to the ensuing inflationary pressure. This is potentially significant because the trend over the past twelve months has consistently been towards monetary tightening. If we look at the value of sterling in January 2018, it had risen to as high as 1.43 (just a few digits short of pre-referendum levels). Should this prove sustainable, then the leading cause for inflation in the UK – a depreciated currency – will have receded. The question then arises as to how the Bank of England would continue to justify further rate hikes if inflation begins to dissipate. Volatility in sterling has aided the bank in being able to raise rates, for that there is no doubt. Does it not stand to reason that a ‘no deal‘ scenario over Brexit would in fact work in the bank’s favour? The response in currency markets to such an eventuality would inevitably be negative and to a greater severity than seen back in June 2016. Remember that the BOE are expecting the effects of sterling’s decline to diminish over the current forecast period. But this expectation is contingent on Brexit negotiations proving successful.

Meanwhile, the global trinity of economic power – they being the IMF, the World Bank and the Bank for International Settlements – continue to call for the implementation of new reforms and regulations for what they claim will reinforce the global economy. To achieve this they must further centralise the economic system, with power being further concentrated within international treaties and obligations. The United Nations have also been calling for reforms in the name of ‘peacekeeping, peace-building and development‘. World leaders such as Emmanuel Macron have taken the baton from these institutions and begun pushing this narrative onto their electorates.

As history has taught us, however, wide sweeping reforms generally come to fruition out of crisis. They do not manifest during times of relative peace. With Brexit now an ever present symbol of volatility on the international stage, the possibility of it being used as a straw man for building consensus towards reform is a danger that we should not be underestimating.

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