Posts tagged ‘Brexit’
Tomorrow’s election in the Netherlands may not be very exciting after all. Until recently it looked as though the nationalist PVV would emerge the clear winner, to the extent that keeping its leader from the Prime Ministership would be very difficult. (PVV wishes the Netherlands to leave the European Union among its other policies.) But then the party’s leader, Geert Wilders, was convicted for inciting discrimination before Christmas, and as the campaign got underway the incumbent PM, Mark Rutte, deployed much hard rhetoric and advertising on PVV’s key issue, immigration. The current polling is finely balanced. Mr Rutte has repeatedly ruled out coalition with Mr Wilders. Dutch politics may remain an earthquake-free zone; we will soon know either way.
Eurozone asset markets are priced rather sanguinely in any case. Back in 2011 it was the bond market, and specifically the Italian bond market, which threatened to ignite a wholesale global banking collapse with an internationally unaffordable sovereign default. Back then, the credit default swaps which can be bought to hedge against Italian credit risk cost almost 6% over LIBOR, as against 6bp in mid-2007. Today the rate is 192bp: higher than the pre-credit crunch levels, but then Italy has been downgraded from AA to borderline junk since then. Even the end of the country’s government last December at the hands of a referendum seen as a valve for anti-Establishment sentiment did relatively little to move the price.
Elsewhere in the euro area the story is similar. The exception, which is worth dealing with separately, is Greece. Here the debt burden, which has of course already been restructured once, has reached over 180% of GDP. The IMF – one of the “troika” of creditors dictating Greek fiscal policy – has said that it has again become unsustainable. Fraught negotiations with the Greek government have continued. But none of this is news. Furthermore the Bank of Greece’s November estimate for the country’s budget was of a “primary surplus” (budget balance before debt interest) of +4% of GDP, indicating both a sustainable underlying spending pattern and compliance with creditor demands. There are those who expect the contradiction between monetary union and fiscal autonomy to upend the single currency at some point, but then at the zone-wide level debt to GDP peaked back in 2014 and again, this is hardly news.
Another recent source of concern over Europe was the banking system – or, to be more accurate, the solvency (or otherwise) of various European banks. Deutsche Bank caused consternation for a time, but then the German government has been cutting its debt burden since 2010 and if anyone can afford a major bailout, it is surely them. In any case, no bailout was necessary; DB shares have risen by more than 70% from their lows. Where restructuring has been needed, at Banca Monte dei Paschi di Siena, it has not been anything like sufficiently material to threaten the whole Continent. And where banks are daily dependent on emergency central bank facilities (Athens), this is, once again, not news. Their shares have been available for a handful of cents for years.
There is only one moving part that has shown real signs of weakness: the euro itself. This has fallen by 23% over the last three years. Its low against the dollar of $1.0388 back in December was the weakest level it had reached since the opening sessions of 2003. However, even this is not a credible sign of structural malaise. The currency has been much lower still in the past, hitting an all-time record of $0.8272 in late 2000. And while the ECB has been loosening policy in a range of ways, the Fed has embarked on a tightening cycle. Like the Italian credit spread the euro’s weakness can be interpreted as nothing more than a rational response to changed circumstances.
In other words, there appears to be nothing to see here. Political risk remains, yet seems not to be priced in.
This blog argued at the time that the support of the stronger eurozone economies for the weaker ones in 2010 answered a key existential question for the single currency. In theory, (a) there is no debt mutualisation in Euroland and (b) its members enjoy complete fiscal autonomy. In practice, when the going got tough, there was a very EU-esque “pooling of sovereignty” over debt via the European Financial Stability Facility / European Stability Mechanism. And bailout nations have had to comply with the rules of their emergency lending regimes.
There is another factor to consider, however, and that is Brexit. Attention in the UK tends quite understandably to focus on the consequences for ourselves, but there will also be consequences for the rest of the EU.
A harsh deal, or no deal, with Britain, and some businesses and industries will suffer. It was interesting that a senior executive at global food giant Mars Incorporated spoke about this a few days ago. Agriculture has managed to remain immune to the GATT / WTO decades of compromise on tariff reduction and quota control. Look at the WTO tariff tables and food, drink and tobacco are about the last redoubts of punitive import duties. From the BBC last Friday:
Fiona Dawson . . . said the absence of a deal with EU member states would see tariffs of up to 30% for the industry.
Speaking at the American Chamber of Commerce to the EU, she warned this would “threaten [the] supply chain and the jobs that come with it.”
“The absence of hard borders (in Europe) with all their attendant tariff, customs and non-tariff barriers allows for this integrated supply chain, which helps to keep costs down,” she said. “The return of those barriers would create higher costs which would threaten that supply chain and the jobs that come with it.” Ms Dawson said those costs could not be absorbed by confectionery companies, meaning consumers would have to pay more for their products . . .
Companies in the automotive and the financial sector have been the focus since the vote, according to Ms Dawson. But with food and drink the largest manufacturing sector in the UK, accounting for 16% of turnover, she said she wanted a new focus, and called for EU leaders to look at the bigger picture when negotiating. “There can be no economic advantage either side restricting trade with a large market situated on its doorstep,” she said.
“In simple terms, if the UK and the EU fail to agree on a new preferential deal, it will be to the detriment of all. Other member states should remember this is not about ‘punishing’ Britain for her decision to withdraw, but rather about finding the best solution for European and UK workers and consumers.“
The emphasis at the end there is my own. And it is not just manufacturers who could, in theory, be walloped in this sector. Pity the poor farmers, logistics firms, supermarkets, restaurauteurs who would be crippled by the reimposition of border controls. (The EU’s “Border Inspection Post” system is, to put it mildly, neither rapid nor straightforward. Our own government has helpfully printed the details here.)
A no-deal Brexit, then, would entail potentially disastrous consequences for certain sectors.
This is not priced in. Does this mean that Britain will leave with many of the customs union’s features still in place? That we will, as Ms Dawson clearly desires, not be “punished”?
That is a possibility but it could spell the end of the EU, which appears not to be priced in either . . .
Just imagine. An economically benign Brexit would mean Britain securing a free trade deal that goes way beyond current WTO rules in the key areas of agriculture and fish, while maintaining border control-free access in these and related markets. At the same time we would be regaining complete control of our immigration, lawmaking and judicial processes – and saving part, if not all, of our contributions to the Brussels budget.
A core of true believers – Luxembourg, for instance – might want to stay in the bloc and accelerate the move towards political federation. But surely, plenty of other “member states” would want to follow such an example.
This year’s electoral cycles across the Channel may not threaten the euro, then. But Brexit seemingly has to threaten either some sector-specific but nonetheless material economic damage, or the continued existence, to some extent, of the EU. If a eurozone country wanted to leave the EU, it could in theory continue to use the single currency. But might financial market pricing, by that point, not have begun to look rather different . . ?
So much of the focus has been on Article 50 and the possibility that Brexit might be somehow derailed that thinking has yet to turn to this apparently logical conclusion. The question for investors is: what are the euro assets which are so compellingly attractive that one should wait until it does so?
The gilt market has staged a modest rally over the past couple of weeks though this should not fool us: there remains a good deal of attention focused on the inflationary outlook. Data for January, out earlier this month, was entirely unsurprising on this front. Input prices were up by more than 20%, eclipsing the prior peak of +17.6% reached in 2011, CPI is almost back on target and RPI ex mortgage interest payments came in just shy of +3%. The ONS quite predictably singled out currency weakness and fuel costs as the main culprits.
But the weak currency is not all bad news as we were reminded with the publication of GDP figures for the UK this Wednesday. Export growth of over 4% on the final quarter of last year was celebrated by some of those on the Leave side of the Brexit vote; though there is considerable quarter-to-quarter volatility in this data it was, undeniably, positive.
In fact there was already evidence of this effect from industrial production numbers out for December a couple of weeks ago. The yearly IP increase of +4.3% was the highest posted since the country’s recovery from the Great Recession and smashed expectations. Looking beyond exports too there was good news from the personal consumption component of GDP, which hit a solid +0.7% for Q4 while the Q3 estimate was revised up to +0.9%, suggesting a Brexit bounce. Business investment – as highlighted by the Remain side – flattened off into the end of the year but the picture is unequivocally of an economy ticking along rather nicely and enjoying a boost from its currency-enhanced competitiveness.
Returning to the theme of inflation, there has been some coverage of the oncoming squeeze on real wages and that is a perfectly valid concern. However this cloud may not be quite as dark as all that. As of December both headline RPI and average earnings growth hit +2.6%, meaning that real wage growth was zero – not a supportive situation for the economy. But throughout the period from 2010-2014 real wage growth was negative, on several occasions falling below -3% (and hitting a nadir of -3.8% at one point). Over the same horizon annual growth in household consumption averaged 1% and broad GDP growth +2%. Today, RPI inflation would have to hit 5.6% plus to achieve the same depressive force on real wages. That is a risk and by coincidence exactly the peak reached in the autumn of 2011, but we are not there yet.
Some have turned to the second consecutive month of contracting retail sales as evidence of consumer weakness but again the short-term data here is incredibly volatile. The six month running mean for annual growth in retail sales was +4.9% as of January, a little less than double the average rate over the past 20 years. Might there be a sustained reversal in consumer behaviour? It’s possible – but the GfK consumer confidence survey actually rose for two consecutive months into January.
For investors, the big picture is therefore as follows. The UK economy is growing at a healthy rate, “despite Brexit”. This is in part due to the weak pound; a currency depreciation is a straightforward monetary expansion and this seems to have been forgotten. There is presently a risk that rising inflation will take some of the edge off the growth rate but on the basis of current data and recent history we ought not to be too anxious. Markets in some respects do appear complacent about the risk of more seriously damaging price behaviour – but that is another story.
Let’s start with the facts.
- Yesterday saw the release of the Bank of England’s latest quarterly Inflation Report.
- For the second time, its growth forecast for 2017 was revised up. This now stands at 2% as against the 0.8% forecast in the wake of the EU referendum result, which the Bank officially and Mark Carney personally expected to usher in immediate economic disaster.
- Projected unemployment now stands at 5.0%, up from a 2017 forecast of 5.5% last August.
- Despite this the CPI forecast for this year has been trimmed back: to 2.7% down from 2.8% back in November.
- The “equilibrium unemployment rate” [a.k.a. the “natural unemployment rate”, a.k.a. the “non accelerating inflation rate of unemployment” (NAIRU)] has been revised down from 5% to “around” 4.5%.
- Despite its lower CPI forecast the Bank’s sub-trend growth forecast for the years following this one (+1.6% for both 2018 and 2019) is predicated on squeezed real wages under pressure from higher inflation.
Governor Carney took considerable pains to wipe the egg off his face by way of his opening remarks to the press conference yesterday. He admitted, obliquely, that consumer behaviour has not remotely suffered in the way which the Bank assumed it would last summer. But this was dismissed as the least important reason for the higher growth outlook, behind the Autumn Statement, improvements in economic confidence abroad and supportive financial conditions. Be that as it may, Mr Carney’s insouciant defence of his institution’s forecasting record does speak of a certain strength of character and for that at least he may perhaps be applauded.
The fact remains, however, that monetary conditions are still set firmly in emergency mode at a time when inflation is projected to exceed the notional target, the economy is close to full employment and growth is nudging trend. From its rhetoric, however, the Bank is wedded to accommodating unspecified and unquantifiable risks surrounding Brexit and seems intent on keeping policy unchanged for the foreseeable future.
This already looked curious last summer. Today it seems downright insane.
Now to the conspiracy.
Britain is no stranger to having her financial affairs managed on the basis of seeming insanity. Back in 1999 Gordon Brown infamously sold a large amount of the country’s gold reserves in an auction process which he announced publicly in advance. This secured him a bargain basement price for the sale. Gold subsequently multiplied in value and the period was dubbed the “Brown bottom” as a result.
The official explanation for the sale was that it would rebalance the country’s foreign exchange reserves away from a volatile commodity and into thrusting new assets such as euros. Gossip emerged later, however, that at least one major bank, likely JP Morgan, had been shorting gold to fund asset purchases in some size – a classic “carry trade” – and was threatened with serious difficulties should the price rise. Brown’s actions were therefore explicable as being for the greater good of the financial sector: there was method in the madness.
A similar case could be made today. The Brexit vote set sterling on a downward trend which persisted into the autumn. Last year’s foreign asset returns, in sterling terms, were astronomically higher than long run expected rates. And with interest rates near zero the pound is very cheap to borrow. (Remember too that it is one of the world’s reserve currencies and extremely liquid.)
Last year, then, the sterling carry trade was one of the deals of the century. As with the gold carry trade in the 90s, however, if the price of the borrowed asset goes up it doesn’t look very good for the borrowers. A rise in the value of the pound due to changing expectations for interest rates could well pose a risk to one or more banks assessable by a Bank of England Governor as systemic.
Surely it would be absurd to think that the MPC was secretly conspiring to hold down the value of sterling? Well – probably. But its official position appears no less absurd. It is also worth noting that the one key reaction to yesterday’s release and Mark Carney’s comments was a fall in the value of the pound. (Sterling had gone up as high as $1.27 in the morning, then crashed down towards $1.25 again over the course of the day.) The Bank’s forecast for the exchange rate is of near-complete stability at the current level into 2019 – or should that read, “the Bank’s target”?
It is an intriguing possibility. But this blog cannot go in for tin foil hats. So let us conclude simply by repeating the observation that the Bank’s current stance is extraordinary, and, apparently, inexplicable.
Followers of the UK’s business media will have noticed coverage of an unfamiliar subject this week. On Tuesday we discovered that the annual rate of CPI inflation had rocketed up to 1%. Last week this blog opined that it was actually input prices which would merit close attention; this did not happen so detail on those shortly. First, however, let us deal very quickly with the headline rates.
1% on the CPI is indeed “the highest rate of inflation for nearly two years”. But that is not saying terribly much for two reasons:
- Over the longer term 1% is an insignificant number. Before the recent period of energy-driven disinflation CPI hadn’t fallen as low as 1% since September 2002, when the world was still recovering from the collapse of the TMT bubble. Its average over the past 20 years has been 1.9%. Exactly five years ago it peaked at 5.2%. So it ought to be difficult to become too excited by the print on Tuesday (which was broadly in line with expectations anyway).
- The “core” CPI measure, which cuts out energy, food, alcohol and tobacco, had already hit a level of +1.5% this March. What we observed this week was the continued closure of the gap between core CPI and the headline rate. In other words, the pickup in headline inflation tells us more about the dwindling influence of cheap oil than it does about, say, the weakness of sterling.
This is not to dismiss the significance of the CPI data entirely. But if we are looking for the fingerprints of the pound we will not find them here.
And so to PPI: producer price inflation.
There has been a little more drama here. Input prices were again up by more than 7% on the prior year – not at quite as high a rate as for August but nonetheless, this measure is showing more heat now than at any other time since 2011. And this time we know sterling has something to do with it since the core measure of input price inflation, which strips out oil among other things, has also reached levels not matched in almost five years. We should expect this to be the case: with the pound down by over 20% on a trade weighted basis in the past year it is a matter of the “basic laws of economics”, as one of the better comment pieces had it this week (it always a pleasure to find that one has friends in common with people).
That piece also carried a forecast from Lord Haskins, former scion and chairman of Northern Foods, that food price inflation in particular is on track to hit about +5% in a year or so. Again, those “basic laws” do tend to repeat themselves. The last time we had a comparable fall in sterling was during the years 2007-8 when the trade weighted index shed nearly 30%. By mid-2008 that input price inflation had peaked not at +7% but at +35%. Back then the food component of the CPI hit a ceiling only at +14.5% making Lord Haskins’ prediction seem quite mild.
Of course in 2008 this didn’t last. The currency found a level and input price inflation fell away again. The domestic economy was contracting, and output would not fully recover until Q3 2013. Unemployment had already started to rise – though it would take three years to reach its peak of 8.5%. And the housing market was in a state of freefall. (It was not until mid-2014 that the average UK price would recover its 2007 high.)
Back to the present.
Should sterling hold its current level the inflationary impact on producer prices will persist, to a greater or lesser extent, into the summer of next year. And nowadays the position of the economy could hardly be more different.
GDP growth of +2.1% is precisely in line with its 20-year average rate and though such estimates are fertile grounds for analytical controversy is likely to be near or at its trend rate. Similarly unemployment of 4.9% could well be regarded as “full employment” and nationwide house price inflation is still running at over 8%.
Given that Britain’s circumstances are so very different today, what is curious is that the policy response to all this is exactly the same as it was in 2008: interest rate cuts and QE from the Bank of England, and if he can get away with it in next month’s Autumn Statement, fiscal largesse from the Chancellor (gilt yields suggest he might be able to fiddle his way to justifying it despite the lousy borrowing numbers out this morning).
Something about this is not quite right. Perhaps the Bank’s expectations that Brexit will see labour market slack and falling output will be met. But even the Bank acknowledges those Basic Laws. And in only a few months’ time, the clear signs of price inflation simmering away at the bottom of the pot could very easily have erupted into a vigorous boil.
At midnight last Thursday, the pound fell by more than 6% against the dollar. Its intraday (intranight?) low was 1.1841. Since then, cable has stabilized somewhat. It currently prices at about 1.22, up from a closing low of 1.2123 reached on Tuesday. So what does the pound’s latest “31-year low” – or even “168-year low” – signify, if anything?
First let us consider the very straightforward economic consequences, which are twofold.
On the positive side, the cost of buying British goods and services from abroad, from JCBs to tour bus tickets, falls. This is growth positive. It is also why currency devaluation is one of the most obvious and best understood forms of monetary easing.
On the negative side, the cost of buying foreign goods and services in Britain, from rice to Ritalin, increases. This is growth negative since it compresses margins for importers and makes consumers poorer. This is also why currency devaluation is a risky and unpredictable means of monetary easing.
One key question for the British economy is: which of these two effects will predominate? That depends purely on the inflationary impact. If this is relatively modest then devaluation will increase growth without hitting people’s pockets, or firms’ margins, too forcefully. If it is significant, however, then the devaluation will depress overall economic activity since domestic demand accounts for a far more substantial part of output than exports (62% versus 30% on Q2 GDP data).
It is hazardous to speculate as to which outcome Britain will face. On the one hand, supranationalist media sources are sure the export benefits will be slight and the inflationary impact severe. On the other, Brexiteering sources seem not to have considered the inflation question at all.
One thing we can do is examine the scale of the pound’s recent fall with some detached perspective.
Cable has fallen by 29% since the high of 1.7166 it reached in early July 2014. Its all-time closing low was posted on 26 February 1985 at 1.0520. However the pound has not yet broken through its December 2008 low against the euro (€1.025) or its more recent (2011) low against the yen. Looking at the Bank of England’s trade weighted index, which pits the pound against a basket of other currencies, this week’s low was barely through the previous record level reached in 2008 (73.3 versus 73.4 back then).
It is understandable that the focus of the media should be on the sterling exchange rate which has moved the most dramatically. However, again with some detachment we ought to observe that cable’s recent history has been affected by dollar strength as well as sterling weakness. The Federal Reserve’s trade weighted dollar index has risen by more than 21% since its 2014 low. Indeed, while the pound has fallen by 29% against the greenback the euro has not been far behind, dropping 21% since its own 2014 high point (from $1.39 to $1.10 today). Without wishing to overdo the point about press coverage one does not see headlines in The Economist about “votes of confidence” in the single currency.
Some sources have taken things further, with Bloomberg claiming that the pound has become an emerging market currency: “the new Mexican peso”. Now at the time of the “tequila crisis” back in 1994 the peso more than halved in value against the dollar in under three months. More recently, the Brazilian real almost halved in value as commodity markets collapsed in 2014-15. Again, a little more perspective would be nice.
This is not to downplay the risks arising from imported inflation. The UK’s next CPI and RPI prints will come out on Tuesday. PPI input prices in particular will merit close attention. Year on year they have already rocketed up from -15% to +8% in the space of 12 months. That inflation has to go somewhere: again, either into shrunken margins or consumer’s pockets (and if it persists, most likely both). Back in 2007, RPI inflation rose at around 4-5% and food prices were making tabloid headlines. Inflation also means higher pensions, higher gilt yields and higher public sector wages, all of which is bad news for Britain’s strained fiscal arithmetic.
Furthermore, Mark Carney today confirmed the Bank of England’s insouciant attitude to inflation at a “public roundtable”, saying that while he appreciated that it could cause problems he was willing to see the Bank miss its target to protect against the supposed loss of jobs into next year. (Readers of this blog will know that the MPC officially abandoned its founding mandate back in August). Markets are less complacent: expectations for a further cut in the base rate have evaporated, and the ten year gilt yield has risen to 1.1% from the record low of 0.52% it established only a couple of months ago.
Now price increases were back in the tabloids again just this week. If imported inflation does cause problems, and the Bank does nothing to stop it, then the ugly devaluation scenario may well end up playing out. Looking at the bigger picture for sterling, and not just the cable rate, we ought not perhaps to panic overmuch. But even at a princely 1.1% the gilt market is not remotely priced either for an uncomfortable patch of price behaviour or the policy normalization required to deal with it. There could be some interesting developments ahead.
Earlier this month the Bank of England took a dramatic monetary leap, largely in the dark. Since then, however, some actual economic data has emerged for July – which is of course to say, post-referendum. We do not yet have a completely clear picture of the Brexit result’s impact on the country. And we still remain part of the EU for now (and are included as such, hilariously, in an alternative analysis of the Rio medals table). So whatever impact is shown in the July figures – if any – will reflect nothing more than confidence.
What signals there are, have been mixed.
One area of concern has been the property market. So far this one is still a bit of a grey area though we do have some numbers. HBOS published their July house price index on the 5th and it showed a fall of 1% for the month – but this is a very volatile series and the smoothed year-on-year data was still running at +8.4%. (The Land Registry series, which is the most comprehensive and statistically robust overview of the residential market, will not be out until next month.)
We also had the RICS agent survey out on the 11th. Last month, a net +5% expected rising prices, down from +15% in June. This is a very volatile series which has ranged between -92% and +59% over the last ten years, with an average of zero. Furthermore the number, while reduced, remains positive so this is not perhaps as concerning as all that.
We will know more at the end of August when mortgage approvals data appear. Until then the mist over British housing has not quite cleared, but what we can discern ought not to panic us so far.
On the commercial property front, as widely expected, there was more evidence of gloom. The IPD dataset for privately-held assets posted a fall of 2.4% on the month with no new purchases made. Whether driven by sentiment or not, this may turn out to be an area where the bearish expectations for a Brexit result are borne out to one extent or another.
Turning to consumer activity, this might have been expected to drop off a bit if GfK’s confidence numbers were to be weighted with significance. But there is no evidence of this.
Firstly, new car registrations for July came in ever so slightly higher than in July last year (178.5k versus 178.4k). So there were no signs of decline on the Major Purchases front here.
Then we had retail sales data out yesterday. This was so strong it surprised everybody: +1.4% on the month, and +5.9% year-on-year, the highest annual rate since September 2015.
On the basis of consumer activity therefore one might be tempted to disregard those confidence numbers entirely, but it is early days.
On the industrial activity front we have almost nothing to report. (Production and growth data released this month pertained only to June.) On the 3rd we saw undeniably weak PMI data, pointing to a contraction: the composite indicator came out at 47.5, down from 52.5 in June, 50 being the neutral level. We will have to wait and see how this translates into the official statistics.
Arguably the most interesting data concerned price behaviour. CPI and RPI prints (out on Tuesday) showed a slight increase in headline inflation, up to +0.6% and +1.9% year-on-year respectively from +0.5% and +1.6% in June. But it was the industrial PPI data which caught the eye.
Sterling has of course weakened since the referendum and this was projected to lead to input price rises of 1.0% on the month and 2.0% on the year. In fact the outturns were +3.3% and +4.3%, materially higher than the highest individual forecast in each case.
Look below the surface and there could be more of this to come. After all, the trade weighted sterling index for July averaged 7.4% below its level for June and 14.9% below the average for July 2015. Offsetting this was the soft oil price last month, down 6.5% from June on average and 18.2% below the average for July 2015 as measured by the Brent Crude future.
Now the average price for oil in August-September last year was $48.46 per barrel, as against over $50 today. This is significant because it means the impact of the pound’s weakness on input prices is not likely to be contained by the disinflationary influence of cheap energy over coming months. And unless sterling stages a big rally the inflationary impact from the currency will persist for up to a year. That inflation – which means higher costs for industry – will need to be passed on to consumers or it will squeeze margins. The other side of the coin is more competitive exports, of course, but this aspect is bad news for the economy.
Finally, the employment data on Wednesday drew some attention from people who seem to have expected instant post-referendum trauma from this textbook lagging indicator. (In the event the ILO unemployment rate was unchanged at 4.9% with the claimant count down by a few thousand.) This says more about the level of bearishness in some quarters than anything else. Similarly, today’s numbers on government borrowing might well have been a little worse than hoped for but in the words of the Office for Budget Responsibility: “Any underlying weakness in the latest data is mainly likely to reflect pre-referendum economic activity.”
Overall there is little reason to panic as Britain’s post-referendum economic landscape has begun to reveal itself. On the bear side, commercial property is an obvious one to watch, and imported inflation could start to cause headaches into the end of the year. Elsewhere there is but little sign of any stress in the residential property market. Indeed, the UK consumer has shown clear signs of increased activity.
We shall of course have to wait and see what happens next – not least in terms of the Brexit deal which is ultimately, at some point, secured. But if we look at the numbers which have come out over the last couple of weeks it does appear that the Bank of England has sacrificed its inflation target prematurely.
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.