Sunday Supplement – “Rather than love, than money, than fame, give me truth.” – Henry David Thoreau.

by Feb 20, 2022

“Rather than love, than money, than fame, give me truth.” Henry David Thoreau.
Want to understand a little more about the likely direction of the interest rate, and the economy – which is about as uncertain as I can remember in the past fifteen years or so? Read on…..
This week takes a longer look and follows an explainer-style format of some of the wider implications of the macroeconomic picture right now, and the potential and most likely direction of travel of the big economic indicators over the course of this year.
I was helped in forming these views by attending one of the Bank of England’s regional breakfast briefings this week with the regional representative in the West Midlands, my home county. These are valuable for a number of reasons but there are three reasons that I attend, primarily. Firstly, I get to ask a question or two to the regional rep, who is a strong economist of course. I tend to split my questions into online (i.e. I will ask in front of everyone in the room) and offline (i.e. I will ask him one-to-one afterwards). While I’m listening to the presentation (and I’ve already read the report, and listened to the national briefing which will have one of the members of the main committee on it, often the chief economist), I’m taking notes about the 5 or 6 questions that I’d like to ask. The regional rep is very honest, and one-to-one is also willing to give a view and an opinion that you wouldn’t get from the more senior members of the committee who are clearly highly politically skilled in what they do and say (and hence there is an element of skepticism in the listener, of course, of what they say – and rightly so)
Secondly, I get to hear his take on the presentation – this is subtle but cannot be avoided. You can present 100 people with the same slides and information, and you will hear 100 presentations (assuming they are not reading off notes, which they are not in this case). As I’ve said I very much respect his economic views and so his take is valuable.
Thirdly, it is rooted in data and modelling. Opinion can take you so far, and voices inside your head 99% of the time do more damage than good. There’s still some inherent volatility in the economy and a need to parse that out and get on with business in the short, medium and long term, so a very data-heavy approach can be useful either for calming fears, or providing a slap around the face, or a blend of both which is likely the most valuable.
A quick recap of the calendar – the monetary policy committee of the Bank meets every 6 weeks, primarily to decide whether to change the base interest rate, and then beyond that if they want to tweak any other monetary policy measures that are currently deployed. The secondary measure that has been deployed in the past decade and a little longer than that is quantitative easing – basically, when the interest rate is so low that changing it doesn’t really affect much any more, providing very little incentive to save any money, or for banks to have any money on deposit, it makes them want to spend (people) and lend (banks) – that situation leads to needing to use other policy levers to try and influence behaviour as the interest rate becomes somewhat “impotent” for want of a better word.
Quantitative Easing is the Bank printing money, and using that money to pump liquidity into a chosen part or parts of the economy. Around the world, it has been used since the Great Financial Crisis of 2008-9 to do different things – buy Government Bonds (if this seems a little convoluted – it is – yes, the Bank just creates the money then lends it to the Government), or buy Corporate Bonds – so, term loan notes issued by companies large enough to be listed on the FTSE stock market. It has also been used to buy shares in companies sometimes – similar to the situation with the shares of Lloyds Bank and also RBS (similar but not the same, because the Government effectively forced Lloyds to take over HBOS – Halifax and the Bank of Scotland – in January 2009, so the Government provided liquidity in order to do that, and so the Government owned the shares, not the Bank).
There is and has been a level beyond this that has been used in one way or another, although again it has not tended to be used by the Central Banks around the world – and that is “helicopter money”. This analogy is used because the image you are supposed to conjure up in your head is a helicopter dropping money from the skies! In reality, when it came to direct stimulus during the pandemic, what happened in reality was that money coming from Government via fiscal policy for a number of reasons, rather than having the Bank in control of it. This is just one example of where monetary and fiscal policy meet and can potentially have the same effect – it won’t surprise many readers to hear that the Government wanted to stay as much in control of that as possible during the pandemic, just as they wanted to try and stay in control of pretty much everything!
So – where are these monetary policy tools at, at at the moment. Helicopter money, from being a distinct possibility in 2020, is a long way from the agenda right now. Quantitative easing – a quick bit of information on the trend – first introduced at £200bn of Government bonds in 2009, the amount has steadily crept up, in fairly chunky amounts, in 2012, 2016 (post referendum) and then 2020 (pandemic). It now stands at £895bn, which is £875bn of Government debt and £20bn of corporate debt.
The Bank’s current position is that this will be unwound when these bonds expire. So, so far they have re-bought more bonds to maintain these levels, as they’ve gone along. A couple of points on this:
Firstly, it was supposed to be a temporary measure – so we should be supportive of this tapering philosophy. However, arguably, the economy has been in better places (it is simply reflating at the moment after the pandemic, you can ignore year-on-year growth figures for the moment) – productivity is still a large issue and will continue to be one with massive pressures on minimum wage, and there are plenty of other concerning signs which make me feel now is not the time. Another one is that the yield curves are flattening/are flat at this time and there are even inversions (so, a 3 year bond currently returns a better yield than a 4 year bond i.e. you can commit for less time and get better returns).
So this takes us on to the second point – What do inversions mean? They are a notoriously good predictor of recessions. The current inversions are quite mild and have been sponsored by tensions in Russia and Ukraine, apart from anything else, but they get lots of influential people very concerned. What’s been the typical Central Bank response to this over the past 13 years? Quantitative easing going up, not down, pumping in more liquidity to control the bond market response and settle fears in the stock market.
Indeed, that was the subject of my “open” question this time to the regional rep. Why are we unwinding when the yield curves are in the shape they are in? He gave a wonderful but sidestepping answer to that – basically, “That is the current policy at this time, and if something changes we may change our mind” – so I would read into that that there is a loose commitment to unwinding that may or may not materialise, especially subject to the contents of the rest of this article…..
So then we move back to the interest rate, the Bank’s primary tool. The markets currently expect several more rate rises this year. This is based on the last meeting and the 5-4 vote that I referred to a couple of weeks ago, probably the most exciting or perhaps I should say eventful vote of recent times, because the 4 dissenters actually wanted to put the rates up by 0.5 bps rather than 0.25 bps which was the choice of the 5.
The layman’s interpretation of this would be that rates are highly likely to go up at the next meeting. I am inclined to agree without awarding it “penalty kick” status. It does look highly likely those 4 people will again vote to raise the rate, but the other 5 might decide discretion is the better part of valour. There are issues with Central Banks acting quickly, although when they need to (e.g. the day of a referendum result that creates an economic shock) they will act on the day and rightly so.
There are a number of issues here and there has been some “leaked” insight this week from a member of the Monetary Policy Committee, which is always deliberate, and also the regional rep’s view to consider. So let’s address those in turn.
Firstly – the cause of this inflation. Is it because of a roaring economy? It looks like it, but not really. We are just in the “long V” shaped recovery here. All sensible models expect economic growth to slow, indeed to a fairly anaemic and problematic level, within the next year or even sooner. Traditionally, raising rates if the economy is roaring forwards is a good thing to do, to stop credit bubbles from inflating too quickly – and indeed the Bank spends a lot of time monitoring these potential credit bubbles. They have no concerns over a credit-induced bubble in the housing market at the moment, there were only a couple of lines in the official report, and the regional rep added some colour to this by saying that in the part of his role which is speaking to local businesses (which is a large part of what he does, and then reports back to the Bank), estate and letting agents are still concerned over the lack of stock and are not seeing much or any respite on the supply side of the fence at the moment. They know that the price of credit is a potential issue but still believe that the major blocker is the saving of the deposit rather than the price of the mortgage, and so are not too worried about the price of the mortgage nudging upwards at this time.
If it isn’t a symptom of a roaring economy, then controlling it via raising rates is likely not going to have the desired effect. And this is where it gets really interesting. I am very grateful to one of our Partners in Property long-standing members who shared with me that when he attended a different briefing, with the same regional rep, that the rep basically said to him when he asked the question that the Bank needs to be seen to be doing something to control inflation, to look prudent from an international policy perspective, even though they have exactly these concerns.
This very much ties in with some of the “between the lines” analysis that I’ve shared in this article in the past 4-5 months. The Bank does not really think it is time to raise the rates. It is having its hand forced. Of course, its hand may continue to be forced over the next several months – that is entirely possible. The Bank now sees inflation at 7.25% in April and I think we can go higher. The Bank also, interestingly, sees the inflation taking 2-3 years to work its way through the system (so, that’s the current definition of “transitory” it seems – again, I see it being longer and more secular than transitory, with 3% a much more realistic longer term target than 2%. This in itself has implications including rates having to rise in the more medium term, but this is by definition potentially 2-3 years away while that’s the current “transitory” narrative and time frame defined by the Bank).
So – interest rates vs inflation isn’t really the battleground at the moment – but it is being painted as the battleground and seems to have calmed the bond markets. There was one question which was fairly aggressive in its tone by an audience participant who clearly believed the bank was not doing enough to control this secular inflation potential and should have raised rates earlier – he was answered by a calm point that hindsight is everything, and, for example, end of furlough was expected by the Bank to have a larger effect in November 2021 and therefore they could not raise rates in say September or even November 2021, until they knew the true impact of that. Some commentators (including myself) had indeed predicted this, but this was not in line with the Bank’s models and I dare say if I picked 100 fights with them I would only win a handful!
Secondly, the Chief Economist let “slip” (yeah right) on Wednesday that he doesn’t believe that the Bank should be raising rates aggressively and quickly. Now, he’s arguably the most hawkish member of the Committee – the one most likely to want to put rates up. So to pick him to make this statement is quite a strong and bold move. The markets did not react much, if at all – they clearly feel that inflation will force the hand of the bank, and the breakevens (simply, the 5-year/5-year breakeven is the difference between the 5 year bond yields that are nominal, i.e. they pay a fixed coupon, and the 5-year inflation-linked bond yields) are expecting inflation to be at around 3.8% in between 5 and 10 years time, well above the Bank’s target. The bank see a number of deflationary effects in the next few years which makes them disagree with this and they are clearly more on the “long term deflation” side of the argument – however, this does start to become about what is transitory and how long is a transitory period, fairly quickly.
Thirdly, after the event the rep also confirmed to me in my “offline” question that the overall feeling from the Bank is that they won’t be raising rates as quickly as the market expects them to. My takeaway here would be that if there is a marginal case for raising rates, they are likely to stay the same rather than rise. That is the default position of the collective wisdom of the Monetary Policy Committee and that is what will shine through unless there is a real step change or sudden acceptance of what some of us feel may well be secular inflation.
There is a fourth point to make. This could, of course, all be a massive confidence trick. The Treasury would still be relatively delighted to see, in my view, inflation between 3 and 4 per cent in 5-10 years time. The inflationary effect on the debt would be powerful – and after all, this worked well post-WW2 (MASSIVE caveat – as long as there can be sustainable economic growth at a reasonable level). They can’t come out and say this. The Bank also understands the powerful effect inflation can have on the debt. It’s fair to say that “massive confidence trick” may be a little OTT as well – they may just see this upside risk as manageable, with a bit of a bonus. I’ve written for over 12 months about the risk of playing this game with inflation, and just one of the many dangers contained within such a strategy, if it was being played out behind closed doors, is the chance of a shock event which would impact inflation to the upside (e.g. Russia/Ukraine conflict). Another risk is the risk of stagflation.
Where we are not at, just yet, is the return of consumer confidence. People are still in an element of “fear” (e.g. selling their houses) or “ration” mentality (hoard savings, despite inflation, in case of any disaster). Indeed, interestingly, at the briefing one of the professors from Warwick Medical School was there and he was saying that endemic Covid Management still will be nowhere near perfect next winter, so there will still be scare headlines and the spectre of Covid is likely to suppress consumer confidence, potentially, for at least another 12 months. Of course, many demographics within the population will think this is a nonsense – indeed, from a personal point of view this certainly isn’t my attitude – but I thought this was an interesting insight and this is from someone actively involved in the management of the disease alongside his role at the med school.
So, my conclusions from the meeting and all of my current thoughts?
  • House prices likely to be above the consensus rise of about 4% this year, I am sticking with my 6-7% prediction
  • Inflation incredibly likely to reach 7.25% and only have upside to that, with an annual average rate in my eyes of around the 5.5% mark by the time this 12 months plays out
  • Interest rates to be at 0.75%-1% at the end of the year so I’ve had to nudge my markers up by 0.25%, but am comfortable at this position and still feel there is a shout for 0.75% being the number after the last MPC meeting of the year
  • Economy fragile and ball very much in Rishi’s court with the Budget and overall fiscal policy to ensure we don’t lose jobs, get into a stagflation trap, and have anaemic or no economic growth

 

It is important to say – at the end of the report, the Bank’s models believe there is a 33% chance of a recession in late 2023-5, based on them raising rates as the markets expect. This is what they are watching. The issue, of course, could be that their models just don’t work any more after Covid (or don’t work as well as they once did) – we don’t get to look under the bonnet of those but that’s also a live possibility. But this is exactly why they don’t want to raise rates as the markets expect. If they ARE forced to do so by even more runaway inflation (note, the peak is not the same as the ongoing premium above the 2% target, I see a higher peak but also a relatively fast abatement, hence the 5.5% average in my forecast – one is about peaks and troughs, the other is about lengths of time), then I feel that without a policy change certainly on QE we would be talking ourselves into a recession. So – watch this space closely, I will be updating on a regular basis on these subjects!