Posts tagged ‘interest rates’
A speech to the G20 summit in Shanghai from the Governor of the Bank of England has drawn some media interest today. Mark Carney’s words of caution to his fellow central bankers on the subject of negative interest rates centred on the “zero sum game” of seeking export-led recovery. He noted, quite rightly, that “beggar-thy-neighbour” policies at the country level would do nothing to address the sluggishness of global demand. And only on Tuesday he told the Treasury Select Committee that Britain’s policy rate would not go negative.
He did, however, say that it might be cut.
Sterling hit a new trade-weighted low on Wednesday and has now fallen by more than 10% from its August peak to a level last seen two years ago. Now the downward trend started back in November and has also received a helping hand from David Cameron’s successful reform of the European Union last Friday. But Governor Carney’s words, and those of his colleagues on the MPC this week, do undermine the credibility of his Chinese lecture at least a little.
This is especially the case since the pound’s impact on inflation has long been singled out in the Bank’s quarterly reports on the subject. A bout of moderate currency weakness could give a nice boost to CPI, if only on a forecast basis, bringing it closer to the target rate of 2% per annum without the MPC having to resort to any further loosening of policy over the coming months. And the side effect of a positive impact on British exports is just something the Bank would, regrettably of course, have to live with.
Look at the last Inflation Report and the underlying data, however, and even sterling is a side-show. As so often over the past 18 months the big news is oil.
This blog wrote about the impact of energy prices on the Bank’s assumptions for inflation back in November. Since then the effect has grown. Oil price assumptions for this year and next are down by 34% and 29% respectively; forecasts for gas prices down by 24% and 21%. On the MPC’s arithmetic this is in the process of translating into added deflationary pressure in 2016 of 0.4% p.a. by way of petrol prices and gas bills alone, with additional effects via the pass through of lower production costs (this being more difficult to time as well as to quantify).
It is, then, unsurprising that it has been oil, not sterling, which has exerted the more powerful pressure on interest rate expectations. These were already very benign, with UK rates only expected to rise late this year or some time into next. Look at futures markets today, however, and they are not pricing in any chance of policy tightening until the second half of 2018, with the base rate remaining under 1% until at least the end of the following year. As with the pound this change has been quite rapid. The 3-month LIBOR future for December 2019, which now prices at 1.02%, was priced at 2% on New Year’s Eve.
While the press looks to the pound, therefore, the rates market has been looking at the oil price.
And yet even the February Inflation Report is rightly cautious on this subject. It notes that the drag from lower energy prices will unwind over time, and that its CPI forecast on a three year view is broadly unchanged. Elsewhere it further notes that the labour market has strengthened more rapidly than expected back in the autumn: in fact it now forecasts UK unemployment of 4.8% both this year and next, revised down from 5.2% and 5.0% respectively. This is nothing less than a prediction of full employment, if the history of the last forty years is any guide. And at the same time the ratio of vacancies to the total labour force has risen again. This measure averaged 1.5x over the period 2010-12, when the UK labour market stagnated around an 8% level. Then it rose to 1.7x in 2013 and 2.0x in 2014, a time of rapid jobs growth which saw unemployment reduce to 5.7%. For 2015 the ratio hit 2.3x and unemployment already stood as low as 5.1% come December.
Under normal circumstances this would ignite at least an amber warning of cost pressures by way of wage increases. At present, however, this pressure is contained by the current low level of headline CPI, as the Bank also notes. (What the Bank doesn’t note but is nonetheless equally material is that low inflation has a direct impact on wage settlements in the public sector – about one in every six jobs in Britain – together with pensions and other welfare payments.)
The UK is close to full employment, the deflationary impact of a strong pound has fallen away in short order and price pressures are being contained only by the continued weakness of a commodity whose average annual price change in either direction over the last ten calendar years has been 30%. Interest rate markets are expecting this happy circumstance to persist for at least the next two to three years. From some perspectives – that of the property market, for instance – it would be lovely if they were right. But the more prudent thing to do, surely, is to think about what might happen if they are not.
Let us leave the last word to the Bank of England:
“At its meeting ending on 3 February, the MPC judged it appropriate to leave the stance of monetary policy unchanged . . . All members agree that, given the likely persistence of the headwinds weighing on the economy, when Bank Rate does begin to rise, it is expected to do so more gradually and to a lower level than in recent cycles.
This guidance is an expectation, not a promise. The actual path Bank Rate will follow over the next few years will depend on the economic circumstances.“
So another Autumn Statement has been and gone. As is now traditional the Chancellor tried to lift the mood by repeating some of the more substantial announcements made in his previous set-piece appearances. But there were changes too. Most significant among these was the U-turn on tax credit reform, which would have hit the incomes of low earners hard (for those who have not yet seen the headlines the BBC’s “key points” summary is as good a place to look as any). It was widely and accurately reported that this had become affordable due to improvements in the OBR’s forecasts for the British economy, delivering £27bn of extra pie in the fiscal sky between now and the end of the current parliament.
As usual, there was a gap between spin and reality on the matter. In his speech to the Commons, Mr Osborne attributed his windfall as follows:
“This improvement in the nation’s finances is due to two things. First, the OBR expects tax receipts to be stronger. A sign that our economy is healthier than thought. Second, debt interest payments are expected to be lower – reflecting the further fall in the rates we pay to our creditors.”
Higher tax receipts can indeed signify economic growth. The OBR’s growth forecasts, however, haven’t changed much. In a rather lower-profile address given by Robert Chote, OBR Chairman, he gave the following additional information on this topic:
“[T]he underlying fiscal position looks somewhat stronger over the medium term than it did in July, before you take into account the Autumn Statement measures. This in part reflects the recent strength of income tax and corporation tax. But it also reflects better modelling of National Insurance Contributions and a correction to the modelling of VAT deductions.”
In fact, looking at the data presented at Mr Chote’s press conference, the impact of these modelling changes tots up to +£12.6bn over the five fiscal years to 2019-20.
Now let’s look at the rates demanded by those creditors. Here is how the forecasts for the UK’s central government gross debt interest have changed since the summer:
|Summer Budget||Autumn Statement|
£4.7bn out of such large totals is not a huge amount (less than 2% in fact), but in policy terms it is material, equivalent to the entire cost between now and 2020 of increasing the personal allowance to £11,000, the single biggest giveaway of the last Budget.
Underlying the relatively modest reduction in the projected cost of debt interest is a similarly modest reduction in projected gilt yields. The OBR data for these is scrambled between different documents for the Budget and Autumn Statement, which possibly explains why no media source appears to have covered it. But the point is that the average market interest rate assumption for the next five years has fallen all of 0.4% since July, from 2.7% to 2.3%. It is on such details that material elements of this country’s fiscal policy now have to be based.
Of course movements in gilt yields have not always been modest. And what ought to concern us is the extent to which they will impact the exchequer should they begin to rise again over coming quarters. Two short years ago – before cheap oil abolished inflation – the ten year gilt yield stood a full 1% higher at 2.8% as against 1.8% today. The Autumn Statement of 2013 put average interest rates for 2015-2019 at 3.8%. What would a forecast change of +100bp do the £4.7bn bonanza secured by a change of -40bp? A proportionate adjustment would wipe out £12bn at a stroke – exactly the amount of the extra spending on defence announced by the Prime Minister on Monday (to be spread over the next ten years.)
Look further back and the message is equally clear. The first half of 2011 was not exactly the cheeriest of times: Greece was collapsing, emergency monetary measures were in full swing and panic was pushing gold to record highs. Still the ten year gilt yielded more than 3.8% for much of the time. And in the years before the credit crunch began to bite the average was about 4.5%.
Neither is the cost of debt linked entirely to interest rates: there is inflation to consider as well. Of the UK’s £1.5trn nominal value of outstanding debt, over £300bn nominal is index-linked to RPI. Since July the OBR’s RPI inflation assumption has been cut by 0.2%; the average for the next five years is down to 2.4% from 3.1% a year ago. And talking of inflation, the CPI measure – which now governs increases to pensions and other benefits – has also seen forecast falls since the summer. The OBR’s average for the next five years is 0.5% lower now than it was last year, 1.3% versus 1.8%.
But then again, who really is talking of inflation? Not the Chancellor. Neither the word nor the concept made a single appearance in his speech on Wednesday. Still, Mr Chote had something to say:
“[W]e still expect inflation to kick up over the coming year as favourable base effects drop out. We expect it to rise slightly more quickly than in July thanks to greater pressure from unit labour costs.”
Something to think about there, possibly.
In summary the Autumn Statement carried an element of political drama but the macroeconomic substance remained hidden away – when it was not being positively spun, that is. Mr Osborne seems to have a rare knack for making political capital from fiscal policy, rather like his predecessor Mr Brown. But the evolution of the country’s debt position and the official forecasts on which policy is based have relatively little to do with him and much more to do with interest rates (and inflation).
That is how one London-based analyst described Mario Draghi, ECB President, in an interview with Bloomberg this morning. Markets had been waiting to see what the ECB would do about the threat of deflation and this week their patience was rewarded: Mr Draghi announced an eye-catching €400bn package to stimulate bank lending and a headline-grabbing negative interest rate.
His announcement had some remarkable results. Peripheral bond yields in Europe fell still further: the ten-year Greek bond yields comfortably less than 6% again, the spread between Italian and German government bonds fell to another three-year low, and at the time of writing the yield on Spain’s ten-year benchmark remains below that of the ten-year gilt. The so-called “crossover index” of low-grade European credit spreads reached another pre-crunch low, and is within sight of where it closed 2006. The eurozone blue-chip Stoxx 50 index reached new highs. After an initial dip down the euro closed up more than half a cent against the dollar.
If Mr Draghi is a rock star, then, the crowd love him. But how radical are the changes he has actually put forward?
Having a negative deposit rate seems like a significant move. But the reduction is all of 10bp, from 0.0% to -0.1%. The impact on bank margins is therefore of mostly presentational significance. Nor are negative rates – even in Europe – as much of an innovation as all that: Sweden ran a deposit rate of -0.25% for a year from mid-2009, and the Danish Central Bank’s offered rate on certificates of deposit was set at -0.2% in mid-2012, only turning positive again this April. Longer rates have been negative too, with one-year German government paper dropping below a zero yield several times as fears over the sovereign debt crisis persisted over 2012. Consider the level of rates in real terms, of course, and this becomes even plainer, with reference interest rates well below inflation over much of the developed world now, including Japan.
The €400bn bank liquidity programme, in practice, is even less dramatic. It is limited to 7% of the value of lending to non-financial corporates and household borrowers by bank, will not kick in until September and then will only be phased in on a quarterly basis. Another programme, designed to cover net corporate lending with centrally-borrowed cash, is not scheduled to start until next March; and in terms of outright quantitative easing, all the ECB said is that it will “intensify preparatory work related to outright purchases of asset-backed securities”, which hardly sounds exciting.
The real benefit of this week’s announcement, therefore, has been the market reaction. The same goes for the ECB’s last big programme announcement back in September 2012: outright monetary operations, enabling the bank to purchase an unlimited quantity of short-dated government bonds in the event of emergency, billed in advance over the summer as doing “whatever it takes” to save the euro. It drove markets wild with relief. The number of times it has actually been used since? Precisely none: the market response was outcome enough.
This is not to dismiss the importance of “open mouth operations”. While its policy response to the credit crunch itself was exemplary, for instance, the Federal Reserve caused major carnage on two occasions further down the line: its botched announcement of “Operation Twist” in the autumn of 2011 undermined a sensible policy by heaping further panic on already fearful markets, and the announcement of QE “tapering” a year ago caused some of the most significant market dislocations in recent history. Having seen what can happen when central bankers get their delivery wrong we should be pleased that Mr Draghi, so far, has been getting his right.
There is a fundamental point worth raising too. Further emergency action from the ECB – received wisdom aside – is not necessary.
Lots of people “know”, for instance, that deflation caused a lost decade in Japan. These people agonize that the same may happen on the Continent. But what about deflation in … Switzerland? CPI inflation was at or below zero there for two years from October 2011, fell to a low before that of -1.2% in mid-2009 and has averaged -0.1% and +0.6% over the last five and ten years respectively. Yet the Swiss economy experienced one of the shortest and shallowest downturns of the Great Recession, and unlike the eurozone did not experience a double dip. It might just be, therefore, that deflation is at least as much a symptom as a cause of economic malaise.
On a similar note, there is a widespread assumption that the ECB needs a weaker euro. But is this true? If low inflation is a symptom of high unemployment and slack growth, what more would a weak currency deliver when the current account surplus has already been reaching record highs? On the other side of the coin, over the year to May – when eurozone CPI inflation fell to 0.5% on the year – the euro had only strengthened by 1.3%. Most of the currency’s appreciation came much earlier: from May 2012 to May 2013, for example, it was up over 8% on a trade-weighted basis. And in May last year CPI inflation was running at 1.4%. This should make it rather difficult to believe that Europe has been importing deflation.
We shouldn’t get carried away with the eurozone’s economic situation to anything like the point of jealousy. Remember disappointing growth and regional disparity. And it would be great to see some credit growth there along with other recent signs of recovery, such as the peak in unemployment and the strongest retail sales growth in more than seven years.
However, a proper analysis suggests that Mr Draghi has indeed been playing to the crowd as much as anything this week. Why not, when this can be as important to a central banker as a rock star?
The next time he puts on a big performance, let’s hope that too is a hit.
The most significant UK event this week was the release of the Bank of England’s latest Inflation Report and accompanying press conference. Mr Carney’s “forward guidance” on interest rates, introduced last year, came under particular scrutiny with unemployment now within sight of the 7% level originally identified as a precondition to tightening policy. This guidance – “open mouth operations” in City slang – has been broadened. In line with statements from the Fed, the Bank is making quite a strong effort as the recovery strengthens to contain expectations that its base rate will rise. From the introduction to the Report:
“The UK recovery has gained momentum and inflation has returned to the 2% target … employment gains have been exceptionally strong and unemployment … is likely to reach the MPC’s 7% threshold by the spring of this year. Even so, the Committee judges that there remains spare capacity, concentrated in the labour market.
Inflation is likely to remain close to the target over the forecast period. Given this … the MPC judges that there remains scope to absorb slack further before raising Bank Rate. Moreover, the continuation of significant headwinds — both at home and from abroad — mean that Bank Rate may need to remain at low levels for some time to come.”
The message is clear. On the one hand the Bank has partially unwound one of its emergency monetary measures by taking residential mortgages out of the scope of its Funding for Lending scheme. The economy has picked up. On the other hand the Bank mustn’t frighten the horses by allowing premature expectations for rate rises to dampen confidence. Tighter credit markets and a stronger pound could undo the work of an accommodative base rate whose work against a fragile background is not yet done.
At the same time the Bank must justify its stance with an eye on the outlook for inflation. This is something it has woefully misjudged in recent years. Yet the argument remains the same: with spare capacity in the labour market there is no upward pressure on wages (which the data shows has been true) and so an increase in rates to tamp down demand is unwarranted.
This blog noted a few months ago that inflation is not yet on the world’s list of concerns. Indeed, in Europe the annual rate of CPI inflation has come in below 1% consistently since September and there is now talk of deflation in the eurozone. But in the UK prices have been much more stubborn. Can we really expect them to remain around the CPI target level of 2% over the next two years as Mr Carney’s model expects – the first time this will have happened since 2005?
We ought to have some sympathy for the Bank. Some of the inflation since the Great Recession has been attributable to VAT hikes, fuel duty and other indirect taxes. The question is: have these effects – which have nothing much to do with capacity in the labour market – really gone away?
When it comes to utility bills, for example, are we sure that costs due to capital investment programmes and environmental measures can be kept away from consumers? And is the impact of flooding on the price of food destined to be entirely negligible? There is also housing to consider. House prices are rising at over 5% on the ONS measure: over three times the average rate for 2012. For most months in 2011 they fell.
Governor Carney’s message on Wednesday saw bond yields and expectations for shorter-dated interest rates increase, and the biggest one-day rise in trade weighted sterling since last April. The market’s horses are not frightened, but nor are they discounting the eventual policy impact of the UK’s recovery entirely.
As conditions improve and risks remain, central banks have a tightrope to walk between destabilising recovery and fanning inflation. We must all hope they have a very keen sense of balance.
The economic data released for the UK so far this month illustrates an important dilemma for British monetary policy. On the one hand, purchasing manager surveys for the manufacturing and construction sectors showed increasing strength, equivalent data for the service sector confirmed that it is still growing, industrial production posted its strongest annual gain since the recovery of the early 1990s and price rises at the factory gate reached new post-recessionary highs. On the other hand, the Nationwide, Halifax and Hometrack house price measures all saw declines on the twelve months to February, mortgage market data still looked relatively weak and so did growth in unsecured lending to consumers. It looks all too clear that any increase in the base rate would exert further downward pressure on an already vulnerable housing market, knocking confidence and halting the UK’s recovery in its tracks.
Appearances, however, are deceptive. Yes, mortgage approvals are running at about half the average monthly rate of the last ten years (45,000 plays 90,000), but they are well off the low of 26,000 reached in November 2008 – and does the approval of 45,000 home loans each month really indicate a mortgage market that is – in any absolute sense – broken?
More important, perhaps, is the fact that bank lending rates and the theoretical margins available on mortgage lending have returned to normal levels. Bank of England data shows average variable rates on mortgages running at about 4%, pretty much where they have been for the last couple of years or so. Reducing this by 3-month LIBOR plus the spread at which European banks can borrow (as measured by the credit default swap market) gives a figure of about 1.5% – exactly where it was in March 2007, just as the subprime crisis was beginning to break. In other words, the average mortgage lender should be able to generate similar profits to the pre-crunch market, when over 100,000 UK mortgages were being approved each month. The dislocations in the interbank and credit markets which prevented this from happening even when SVRs were much higher are now ancient history.
Leaving the technical stuff aside, are lower house prices really such a bad thing anyway? Do we want to return to the era of 125% mortgages, debt-powered buy-to-let empires and ubiquitous small-scale “property development”? Or would we rather see genuine value-added economic growth, more affordable housing for first time buyers and strengthening consumer balance sheets – while accepting a limited amount of pain in the form of negative equity for the unluckiest / most reckless borrowers as a price worth paying to stop everyone suffering the consequences of runaway inflation?
It might even turn out in an ideal world that the prospect of higher UK rates attracted investors to the pound, mitigating the worst effects of imported commodity price inflation without actually having to tighten policy all that much.
The banking system is not the basket case it was a few years ago, the mortgage market is arguably less broken than it was in the heyday of Northern Rock, and another 0.25% or 0.5% on the cost of borrowing is most unlikely to kill everything off again. The worst of the emergency is over, and prices are rising rather sharply now. It is time for Mervyn King to recognise all this and act accordingly.