Old Lady Off Limits

Perhaps it was inevitable that the Brexit vote would herald the end of more than one era.

Yesterday the Bank of England took a series of eye-catching expansionary measures in response to the vote, as expected. One of the consequences of this was the explicit abandonment of its two-year inflation target. CPI inflation is projected to exceed its 2% target by the end of next year and stabilize at 2.4% from 2018 into 2019. For the first time since the “Ken and Eddie show” began in 1993 the Old Lady is wandering quite happily away from her inflation mandate. The justification for this is labour market weakness and slower growth supposedly arising from Brexit and surrounding uncertainty, which is perfectly understandable. In previous Inflation Reports, however, such justification has always underpinned monetary shifts which were to result in the path of UK inflation reaching 2% in two years’ time – growth and employment objectives being officially “subject to that”.

Not any more.

In fact this month’s Inflation Report might as well have been called the Brexit Guesstimate Report, as that was the gist of nearly all of it. On what the Bank itself admits is incomplete evidence, much of which conflicts, it has taken the most dramatic series of monetary steps since the financial crisis. They are:

• Cutting the base rate to 0.25%
• Increasing QE by £60bn (gilts) and £10bn (corporate bonds)
• Introducing an emergency bank lending programme called the Term Funding Scheme (TFS), supported by a change to the regulatory capital framework

The base rate cut was as almost universally expected, and clear signals have been given that a further cut to “close to, but a little above, zero” is on the cards for later in the year. This is thought likely to be at the November meeting so that it coincides with another so-called Inflation Report (the MPC’s preference this time). Who knows?

The British “QE3” was not quite so widely expected, with just over half of the 44 economic estimates compiled by Bloomberg pointing to no change. With government borrowing running at well over QE target levels the conceptual efficacy of a “helicopter drop” has always been suspect and the practical impact of its own programme on the US economy has been estimated by the Fed to be almost zero. The announcement has, however, already pulled gilt yields even lower, which will give Chancellor Hammond, on paper, much improved budgetary arithmetic for his Autumn Statement in due course. (It is notable that the very first QE target was for £75bn of purchases so Mr Carney thinks that about as much bond market intervention is warranted amid today’s uncertainty as his predecessor did in the teeth of the most vicious global recession since the last world war.)

The TFS “element” is especially significant. We know that low interest rates have hurt bank profits – along with much else (have YOU been mis-sold PPI?). So the TFS encourages the banks and other lenders to take advantage of this week’s rate cut by offering them access to £100bn worth of borrowing direct from central bank reserves at base rate. The condition is that they use it to increase their net lending. To facilitate this, the rules have been changed so that central bank deposits do not have to be covered by capital reserves. On the Bank of England’s maths the direct access to base rate financing will represent an interest rate cut of 75bp to the extent this facility is used by the banking system, not the headline 25bp. Again, by way of comparison: the Special Liquidity Scheme operated by the Bank as the credit crunch reached its most crushing in 2008 peaked at the exchange of £185bn worth of government paper for illiquid assets. And of course the TFS is expandable from here.

To reiterate: the evidence we have to support all this drama is incomplete and, in part, conflicting. As the Bank itself notes, the Markit UK PMI output measure dipped below 50 in July (neutral activity) but the lower-profile Lloyds Business Barometer recovered to its pre-referendum level. In both cases we have only a single month to go on. Then there is the property market. While there is clear evidence of short term demand loss in the commercial property market the accompanying weakness in residential property, a supposed outcome which is cited as a key factor in the MPC’s judgement, is predicated on labour market developments which remain unclear. The Inflation Report points out, correctly, that available survey data (including from the Bank’s own agents) has indicated that those businesses who do expect there to be a referendum impact on their hiring decisions – very far from all of them – expect to respond by reducing recruitment, not by laying staff off. This sits oddly with the projection for a rise in unemployment from 4.9% as of May to 5.5% by the end of next year.

It is, of course, possible that events will turn out as the MPC seems to feel in its collective gut might be the case. But it is largely on the basis of such a gut feeling that it has chosen to enact a series of monetary measures comparable in their scale and ambition with the emergency steps taken during the worst of the credit crunch and Great Recession. Should this feeling be characterized as expert intuition? Or panic?

Even if it is the former, throwing out the inflation target is a huge move, and one which has not yet attracted the attention it merits.