In what turned out to be a unanimous decision, the Bank of England raised interest rates to 0.75% last week – the highest they have been since 2009. In a recent economic update I suggested that the BOE may raise rates in spite of growing household debt and Brexit uncertainty being at its most pronounced. With this proving the case, let’s take a brief look at Mark Carney’s latest press conference and question the bank’s next potential move as the UK’s exit from the European Union draws near.
As on previous occasions, Carney reaffirmed that heightened inflation since the EU referendum was ‘entirely‘ a consequence of the sharp devaluation of sterling. This line is nothing new, but it is worth repeating as over the past three and a half months the currency has fallen over 9% from a post referendum high of $1.43 set in April. The relationship between Brexit and sterling is a prominent factor given that the drop in the pound has been blamed for a rise in inflation. Most importantly, it is inflation above the BOE’s target of 2% that the bank have used as a primary excuse to begin raising interest rates.
The depreciation in sterling since April worked to assist the Bank of England in raising its inflation projections in the bank’s latest report. They are expecting inflation to rise in the near term as a result. Carney used this as justification to say that ‘ongoing limited and gradual tightening of policy is likely to be required to return inflation sustainably to target.’ More specifically, the bank are signalling three rate hikes over the next three years, with inflation expected to remain above the 2% target until around 2020 if rates remain at the current level of 0.75%.
Next came the issue of Brexit. It was revealed some time ago that the BOE have yet to devise specific forecasts for a no deal scenario. The model they are working to is based on a ‘relatively smooth transition‘ to some form of post Brexit relationship with the EU. Carney emphasised that this did not amount to a prediction. Rather, it was a ‘simplified assumption based on business and household behaviour.’ The bank’s perspective up to this point is that households are proving resilient to the Brexit process, and are therefore able to withstand interest rates rising.
Concluding his prepared statement, Carney said the BOE would respond to changes in the economic outlook to bring inflation back to 2%. ‘That’s how we set policy two years ago, that’s how we’re setting it today and that’s how we’ll do so in the future,‘ he declared.
On reflection, this comment is not as straightforward as it first appears.
Whilst answering questions from the floor of journalists, Carney stressed that there were a ‘wide range of potential outcomes‘ to Brexit negotiations. It was at this moment where the governor lowered his defences somewhat, offering a much more detailed impression of how the bank could proceed in the future:
In a number of those potential outcomes and transitions to them, rates need to be higher. A relatively smooth transition to some sort of average relationship, we’d need a gentle increase in rates over the next few years. We can’t be handicapped or tied by the range of Brexit possibilities. If there is a major shift as a consequence of the Brexit negotiations that is dis-inflationary – has to be dis-inflationary – or creates extreme trade offs such as the one we saw post referendum, then that could have consequences for monetary policy. It is not as simple as saying that Brexit equals a reduction in interest rates.
What makes this passage in particular stand out? Back in May the media latched onto comments made by Carney during a speech in London, interpreting his stance on a potentially ‘disorderly‘ Brexit as an indication that the bank would cut interest rates in response. At no stage, however, has Carney made any specific promise that this would happen. This is especially important for the public to realise, and should encourage people to look at Brexit in a wider context.
In remarks made three weeks ago, Carney spoke of how the UK dropping out of the EU with no trade deal would be a ‘material event‘ for interest rates, one that he would not wish to prejudge in either direction. Measure this against his comment at the press conference about how ‘it’s not as simple as saying that Brexit equals a reduction in interests rates‘. The idea of rates declining in the aftermath of a chaotic Brexit is no longer a given.
If we go back to 2017, Carney warned that without a transition deal in place with the EU, a leading consequence would likely be higher inflation.
Here is the crux of it:
When the bank lowered interest rates and expanded quantitative easing by £60 billion two years ago (six weeks after the referendum), inflation was 0.5%. Prior to the referendum taking place, it was even lower at 0.3%. In other words, the UK was already closer to deflation than it was to overshooting the bank’s 2% target. The referendum result was not a dis-inflationary event, despite the Bank of England attempting to convey that perception by cutting rates.
In the ensuing months inflation began to rise, and surpassed 2% by February 2017. The sharp devaluation of sterling since the referendum result was held up as responsible. Ever since then inflation has remained above target. Nine months later in November, the bank raised rates for the first time in a decade. With inflation still comfortably above 2%, they moved again this month under the pretext of ‘returning inflation sustainably back to target.’
The connection to rates increasing has been a heightened rate of inflation, whereas when the bank cut rates after the referendum inflation was running at half a percent and had been below the 2% target since February 2014.
In the passage above, Carney affirmed three things. Firstly, that many of the potential outcomes from Brexit will result in rates rising further. Secondly, that even a smooth transition to a new trade arrangement with the EU would mean rates continuing to rise. Thirdly, that the only scenario in which rates would be cut and quantitative easing reenacted would be if the fallout from Brexit was dis-inflationary.
The likelihood of the third scenario is low when you factor in that even with a trade deal agreed between the UK and the EU, the Bank of England are still signalling further rate hikes ahead and inflation above target until 2020.
Over the past few weeks the overriding narrative within the media has been the growing threat of the UK leaving the EU without a deal. One day after the BOE raised rates, Mark Carney appeared on the BBC Today programme and stated how the prospect of no deal was now ‘uncomfortably high‘ and would be a ‘highly undesirable‘ outcome.
Exactly how undesirable for the BOE would a no deal be, though? As I have detailed consistently over the past year, the Bank of England are just one strand of what is a global assembly of central banks (all of whom are at the behest of the Bank for International Settlements). The BIS have a proven record of foreshadowing the onset of a financial crisis many months before it breaches the mainstream. Their latest warnings pitch protectionism and a rise in global debt as the leading risks to the world economy.
As for monetary policy, the BOE and the Fed in particular tend to move in cycles. Prior to the 2008 ‘Great Financial Crisis‘, the Fed were still raising rates as late as June 2006. The BOE carried on until July 2007, only two months before Northern Rock collapsed.
Today, the Fed are raising rates and rolling off assets from their balance sheet as the Trump administration issues record amounts of new debt to service its expenditure, and also as Trump’s trade tariffs begin to take effect. Across the Atlantic, the BOE continue to gradually ‘normalise‘ policy in the face of a no deal Brexit becoming an increasing possibility.
As CNBC’s Steve Liesman pointed out recently, the language used by the Bank of England after raising rates was ‘almost the same language the Fed used‘ the day before when they kept rates on hold. I would venture that this is not a coincidence. Central bank behaviour is highly coordinated, and in this case a clear trend has developed of rising geopolitical tensions that provide both institutions with an avenue to retreat from a decade of loose monetary policy.
For the UK, the spectre of a no deal Brexit is maintaining pressure on sterling, and the longer this carries on the greater the chances of inflation working its way back up towards the 3% level as negotiations reach a climax and the exit day of March 29th 2019 edges closer.
As the Bank of England noted in the minutes from last week’s MPC meeting, the ‘peak impact of the referendum related fall in sterling is now behind us‘. The sustained fall we have seen since April could well mark the beginning of a second phase in which volatility in currency markets transpires into rising inflation.
Those who persist in believing that a no deal scenario would automatically result in the BOE backstopping the economy – effectively taking ownership of the fallout – are discounting the inflationary aspect. Yes, the bank did cut rates after the referendum. Yes, they did tolerate inflation above target whilst engaging in quantitative easing back in 2011 (on the pretext that the economic recovery had yet to be secured). But by Mark Carney’s own judgement, policy post referendum is focused on having the ‘discipline of the target‘.
As demonstrated in this article and others, the direction of global monetary policy is geared towards tightening. Nothing in the communications of central banks contradicts this fact.
With inflation currently above target at 2.4%, a no deal Brexit would probably occur with inflation still running above target. Based on the evidence so far, the Bank of England’s response would not be to cut rates but to raise them. Rates rising faster and more aggressively than markets and the public currently anticipate is a very real danger, one that is not being given due consideration.
Would this precipitate a ‘Brexit recession‘, or perhaps a more sustained economic crisis? In one of my next posts I will examine how a downturn of the global economy – off the back of nationalist / protectionist sentiment – is potentially going to be used to galvanise support for what Mark Carney himself has described as a ‘new world order‘ in international finance.