Claudio Borio, head of the monetary and economic department at the Bank of International Settlements: “I see some of the tensions with politicians less as a threat to independence than as proof that independence is working. But of course independence cannot be taken for granted. It must be earned, retaining trust and legitimacy in the eyes of the public. From my point of view, there is no doubt about the importance of independence. When defending it, one must address the growing gap between what central banks are expected to deliver and what they can actually deliver. I’m very worried about this expectations gap. The expectations on central banks are simply too great.”
What does 54% mean to us all this week? The events of this past week have a feel of the choppy seas that I’ve been referring to in weeks gone by – so I’ve set aside the planned topics to take the time to really do a deep dive into the outcome of the Bank of England monetary policy committee meeting this week, and make some sense of it all to hopefully reassure everyone reading of the likely outcome and the real results we are going to see over the coming months and years. What might interest you about this week’s quote is that it came from B.C. i.e. Before Covid……
Firstly, inspired by some talk radio that I was listening to in the past week, it is worth revising what the scope of the Bank’s authority and firepower truly is. The Bank of England is independent – certainly by name and mostly by nature, although there are times when collusion with the Treasury is not only sensible but effectively mandatory (normally times of crisis). Some might blame the Government for everything – that’s a popular view at the moment – but the Bank controls the base rate of interest (the Base Rate) – their toolkit also includes Quantitative Easing which is the ability to buy government bonds (or other securities) as they see fit by printing the money to do so, and then investing that money in those securities. They have, of course, used that ability extensively over the past 13 years or so. They are concerned primarily with inflation and have set a target (or have a target set by the Government, more accurately) which is currently 2%. It was 2.5% when first set in 1992, but revised to 2% more than a decade ago now.
So – they have control of the monetary policy tools – but still need to dance to the Government’s tune. I speculated last week about whether that 2% target could move upwards – but that’s not been the matter of any airtime this week. Instead that is seen as set in stone, and therefore there is only one real tool available when inflation is operating well above that target – and that is to raise the interest rate. This under normal conditions makes sense – under cost push inflation conditions, caused by supply chain issues, skills mismatches, changes in demand and expectations (which is what we are seeing and living right now) – it has less of an impact but it still gives the appearance of monetary responsibility which the institutions want to see (as do the credit rating agencies).
Inflation and the interest rate is not their only concern. They are also interested in unemployment, GDP growth and the overall health of the economy, and also lending in general – seeking to avoid bubbles in various debt markets, involving both consumers and corporate entities, and seeking to discourage speculators where they deem that to be necessary – indeed they pushed this back in 2016-7 when they felt there were too many investors in the Buy-to-let market and they feared that in the event of a crash, the investors would be the first ones to dump stock and therefore added potential volatility to the marketplace.
So – a broad remit with a limited number of tools at their disposal. It is worth reminding everyone also exactly what the base rate is – it is the rate at which the Bank of England rewards any commercial banks that hold money with the Bank at. While it is very low it should be clear to everyone that the reward for doing this is tiny – and therefore the incentive is to lend it out, which is just what is wanted after a recession or a crash. The problem is, this low rate has been there since March 2009 now, so it is nearly 13 years old. That’s some time for something that was described at the time as a temporary measure.
Those interested in property investment, or indeed those who have any interest in significant gearing for other business interests, or on a personal level, are not just beholden to the base rate. It is quite common for commercial banks to offer loans at base rate plus a margin, that margin representing their profit plus their commercial operating expenses. Smaller “challenger” banks have traditionally offered more commercial loans on terms at LIBOR (as it was, the old London Inter-Bank Offer rate, now retired thanks to its famous manipulation from the 90s, through the 00s to 2012) or now SONIA (the Sterling Overnight Interest Average) which is administrated by the Bank of England, rather than a small number of parties with a conflict of interest as LIBOR used to be administrated pre-2014.
For those who focus more exclusively on the very competitive cheap debt that is provided by the smaller banks, lenders and packagers, it can be more useful to property investors specifically to keep a close eye on the 5-year government bonds, and the 10-year government bonds. These are running at around 1.31% and 1.41% respectively at the moment – so this tells you there are not major ructions expected just as yet. They are on the rise – yes, that’s true – but are still well below the US 5 and 10 years right now (who are battling even higher inflation than we in the UK are, although without the same energy constraints that we are facing).
I like to also watch the 30 and 50 year, to see where the really long term expectations are at – currently these are at 1.48% and 1.24% respectively, indicating that in the very long run, interest rewards on government debt are still acceptable at a very low real rate of return (well, a negative rate of return if you projected the inflation target of 2% onto those yields, of course). This is, therefore, unlikely to see a massive increase in the cost of this packaged debt as yet. It also needs noting that this has moved down from mid 3s to below 3% in the past 6-12 months, and so has some going to get back to mid 3s before it heads up to more like 3.75-4% at some point later this year, you would think, based on current expectations.
With expectations in mind, it is worth mentioning that the markets now predict that base rate will be at around 1.4% in the middle of 2023. Thus, they are pricing about 3-4 more hikes in the rate in that time. It’s a good time to mention that the committee, unlike in December, were in no way unanimous in their decision this month. The biggest split that is possible – 5-4 in the voting, because there are 9 members on the committee – was the outcome. What’s worth knowing here though is that the 4 dissenters were united – each of them thought the rate should go straight up to 0.75% rather than to 0.5%. A little internal politics is perhaps at play here, because to do that would have effectively admitted a mistake in November 2021 particularly, when the markets expected an increase but the MPC did not deliver one, voting 7-2 in favour of keeping rates the same. In hindsight that now looks like a mistake, but the public admission of that mistake by moving up 50 basis points might have been too much.
There is also the overall penchant of central bankers to move slowly, and there is also some method behind all of that. The economy remains fragile – particularly to significant shocks – and this and the UK’s uniquely poor strategic gas position, with pathetic reserves after some poor quality decisions from the Coalition government of 2010-15, means that there is more skin in the game in the Ukraine-Russia conflict for the UK than for many of its NATO allies. That situation has calmed somewhat and expectations are for a diplomatic solution right now; but I would rather not underestimate Vladimir Putin.
So – the base rate and the price of the 5, 10, 30, 50 year and other length bonds have a clear correlation, but they are not the same thing. You can see quite a difference there between an expectation that the base rate will be close to 1.5% in around 18 months time and an expectation that over 50 years, the average will be 1.25% for a return on a government bond. This anomaly is leading to a flattening of the yield curve, which has a number of analysts quite nervy when it does happen. The inversion of the curve – to be clear, when the short term bond yields are higher than the longer term bond yields – is a notoriously good prediction of a recession.
I need to be careful as I have floating rate exposure, so I need to question whether I can be truly independent here – but I still see plenty of problems on the horizon if we do race away like this towards the highest base rate for 13 years. There are a multitude of fragilities that will be exposed as the expectations continue to rise upwards. I don’t want to be overly hopeful – but there is an element to which the bank agreed with me this week.
The medium-term forecast is always how the Bank finishes its briefings after a Monetary Policy Committee meeting. The graphical representations at the end of this month’s efforts were saying GDP growth in 2024 and 2025 down at 1-1.25%, and unemployment up to 5% (from around 4.1% today on the most recent data, 3 months ending November 2021).
Once again – and you see the theme here – on the face of it the unemployment issue does not cause a problem (the growth rate does – and as usual the answer out of that is productivity, but that’s a puzzle that’s remained unsolved in the UK since the financial crisis). 5% is a perfectly healthy post-WW2 long-term unemployment rate. Indeed, last decade, that number was considered to be absolutely fine if it was below 6%. But politics knocks at the door and rears its head. To go from 4% to 5%, over the next couple of years, is a dangerous direction of travel. It looks like a trend, and that part of the Conservative party value proposition, the party of jobs and business, does not look like it is being delivered if that is the direction of travel.
The growth rate at an anaemic 1% looks even worse than the forecasts in the 2010s (and indeed some of the results!). This, I would say, is a relative shot across the bow to put the ball firmly in the court of the Government and expect fiscal policy to make a difference to those forecasts. There’s a problem here and something has to give – and the highly likely general election in mid-2024 (because whether he stays after this year – 33% likelihood in the betting markets – or goes this year, 67% likelihood) looks horrifically timed at this time.
The traditional tax cut comes in around a year before, so the early 2023 budget might be one to give a bit back – but the issue here is that on current numbers it looks like there will be relatively little to give. The expectation for 2022 GDP growth is between 3.5% and 8.1%, with the private sector forecast settling at 4.7%. I am a seller at these numbers, expecting the lower end of the range; simply because the disruptions are not yet over from Covid supply chain issues (although they are lessening) but also these interest rate hikes, if they do come like London buses, will unsettle this fragile economy. If we don’t exceed those expectations, treasury receipts will not be where the government expects, and there will be difficulty in paying for tax rises. If we extend our speculation a little further – IF Sunak is the next in line, then his attitude towards austerity is much warmer than Johnson’s – and, whilst it pains me to say it, Johnson’s approach is likely better for the country (once again – the right thing for the wrong reasons, which seems the best you can hope for under Boris). Sunak will be left robbing from the poor to give to the rich, which will blow the “Red Wall” right back open.
Two mitigating factors to remember here however; firstly, 2020 saw a massive transfer of wealth to households (and of course, a disproportionate one where those with assets in place saw significant appreciation on those assets), leaving households massively better off (at least on paper) – and secondly, alongside that, unprecedented levels of savings due to many typical expenditure items being unavailable for large stretches of time (restaurant meals, holidays, etc). Plus the fear factor means that households do have savings to soak up some of this cost of living increase.
This will work for a while. Potentially. However, I’d invite you to consider the groups that will be the hardest hit. The bottom 20%, the poor, the disabled – yes, they will be. From an utterly brutal political perspective – the incumbent party won’t care. As a rule they don’t vote, and ideologically, these two groups will never like each other anyway. But consider another group hit quite hard in all of this. Rewind the clock back to mid-2021 and the Government “paused” the triple lock (offering the highest of 2.5%, inflation, or wage increases as the pension increase for the year). Now, luckily for the pensioners, the double lock that remains in place does keep inflation in mind – but it is September 2021’s inflation rate, 3.1%, that was considered. We know the Bank of England are now saying 7.25% is the top – I personally think we will top 8% at some point this year – and are looking at a likely average, in my view, of 5.5% for 2022. So – the pensioners have lost purchasing power. They feel it most, and are the group with the least opportunity to do something about it.
But there is a more important factor. They are also a) active voters and b) the most likely of the age bands to vote Conservative. This is an election problem already manifesting itself – and how this is dealt with will be interesting. We’ve seen some tinkering at a huge level this week with a quite bizarre and difficult to understand loan scheme against October’s utility bills, on the back of an eye-watering FIFTY-FOUR (54)% increase in the energy price cap (versus say France at 4% – it’s almost as though they have an election coming….) – and then council tax rebates on all properties banded A to D this year of £150 (with no payback needed). I applaud the relatively progressive nature of these tax breaks, and it should not be forgotten that the drop in the universal credit taper rate from 63p to 55p leaves about £1000 extra in the pockets of around £2m people – the same number who are potentially entering fuel poverty. So Sunak feels he is on top of all of this – to the best of his ability – but the money is not all coming from the magic money tree, with a clear propensity to squeeze local authority budgets with the £150 cashback incentive for April (as the energy prices go up, but of course as the heating likely goes off).
So – in conclusion for this week – the plot thickens. Plenty of reasons for wobbles to be occurring as we work through this spell. One message remains very clear – fix your mortgages now if you can or are in position to. If you are looking at defined benefit pension transfers – get on with it for goodness sakes because your transfer values will be being eroded (it is VERY difficult these days anyway if you are under 55). The rates trend is upwards – this will not be without incident this year and I see a possibility of rates moving upwards and then downwards again if we go too much too soon. The central bank will be aware of this but are moving into tougher territory, and Andrew Bailey, the Governor, did not look as cool, calm and collected under the microscope this week. So – watching with interest, not being too concerned, but expecting some fireworks over the next few months. Until then – see you next week, where I have a different format planned – an open letter – but I won’t say too much in case there are further incidents which in the now mean that needs to be bumped down the road a little.
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