A New BoE Mandate?

Summary

• The BoE is under growing pressure from politicians. It is blamed for being asleep at the wheel into the current crisis.
• We find, however, that a nominal growth target or a money supply target would have likely meant looser policy into the crisis.
• Ceasing paying interest on bank reserves would require a change in how the BoE controls short-term interest rates. It would be a tax on banks, which would hurt Truss’ pro-business credentials.
• As QT gets underway this issue will begin to resolve itself anyway.

A Lonely Time to Be a Central Banker

The BoE is in a bind. Their medium-term forecasts suggest loosening policy, but a near-term inflation spike makes that impossible to deliver. The economics may suggest one thing, but right now politics is dominating.

The Conservative Party (Tories) have been loudly critical of the BoE’s lack of tightening action prior to the inflation spike. They believe the MPC was asleep at the wheel, and that they should have begun tightening policy in early 2021. Among the criticisms is that the BoE’s mandate (2% inflation) tied their hands. Meanwhile, rising rates are costing HMT more money as QE has shortened the duration of its liabilities.

Consequently, there has been a number of suggestions on how the BoE may change its approach. Some of them appear to have sound economic justification, others do not. Regardless, the very fact this is being discussed points to the dawning of a new period in which political pressure (particularly from the more populist side) increasingly weighs on monetary policy. This comes even though, prior to 2021, CB performance over the longer-term had been relatively good (Chart 1).

Two suggestions for a change in mandate have been attributed to likely-next PM Liz Truss. One is a nominal growth target (NGT), the other a money supply target. We find that neither would have made the BoE any more inclined to tighten earlier. In fact, both metrics suggest increasing dovishness.

Separately, we look at the proposal to save HMT money by ceasing interest payments on bank reserves. There, we find: (1) the proposal would risk the BoE losing control of rates, (2) the problem is less pressing than first appears, and (3) the situation may end up resolving itself through QT.

NGT Would Have Meant Looser Policy

The logic for an NGT would be that it would allow the BoE to focus more directly on the demand side of the equation. This means using monetary policy to lower real growth when the economy runs hot and raise it when the economy undershoots. There are various arguments for and against it, but what we will focus on is the claim that it would have allowed the BoE to tighten more in 2021.

If we assume a medium-term horizon is retained (logical given the lag in interest rate policy effect), we actually find it would have meant the opposite – less tightening.

We can only guess how such a target might be set. We take two simple scenarios to show that it would be unlikely to have improved matters either way. In one scenario, the BoE targets period-end NG (the way it currently targets period-end inflation), in the other it targets average annual NG (across forecast years 1, 2 and 3).

It is worth considering both scenarios as the BoE have recently been much more reactive to the average forecast CPI rate than the end-horizon CPI (Chart 3). There is a logic to this – they may target the end-horizon, but they get held to account on what CPI is now.

Assuming an NG target of 4.5% (Truss’s 2.5% real growth target plus 2% inflation), we find that end-horizon NG deviation from target moves similar to CPI’s. And it would have suggested looser policy through 2021 and 2022 (Chart 2). Meanwhile, targeting average NG over the horizon would have meant tightening end-2020 (a risky move given COVID), and (again) loosening through 2022.

In short, neither situation would have credibly capped the current inflation situation.

Money Supply Targeting Would Also Mean Looser Policy

Truss has explicitly set out monetary easiness as a cause of inflation, and her approach to ‘getting tough on inflation’ have also touched on the prospect for targeting money supply. However, again such a mandate does not necessarily suggest tighter policy. In actuality, M4 money supply growth has been trending downwards since the end of 2020 despite the rising inflation and lack of CB tightening. At its most recent reading it fell MoM (Chart 4).

Furthermore, when Margaret Thatcher targeted money supply it meant fiscal tightening too. But this is the opposite of what Truss is proposing. There are other issues with the target also. Money supply has tended to be volatile in the past and has a relatively inconsistent relationship to inflation. Its historical record is not spectacular, and consequently is likely to receive pushback from mainstream economists.

Ceasing Interest on Reserves Creates More Problems Than It’s Worth

Another suggestion that has been made in the interest of saving a few HMT bucks is to cease paying interest on bank reserves. The cost of interest on bank reserves has received increased attention in the light of the recent rises in interest rates. The APF, for all intents and purposes, has been an asset swap from long-end gilts to short-term reserves. That has meant a strong net-saving for HMT while interest rates were low (basically paying bank rate instead of gilt interest), but will become more costly as interest rates rise beyond coupon rates (Chart 5). This is not a new issue. It is one that has been known and understood since the start of the APF. Furthermore, despite the APF holdings suppressing the weighted average maturity of UK debt, the WAM remains considerably above most DM countries (Chart 6).

The questions to ask then are: (1) would it be worth it, and (2) would it be attractive to the new PM?

On the first question, stopping interest payments would mechanically save HMT money – reportedly to the tune of £1.5bn pm to the end of 2027. The cost would fall on the UK banking system, as well as the BoE’s (and HMT’s) reputation and its ability to control short-term interest rates.

In terms of the structure of monetary policy, unless changes are made, the effect it would have is that the BoE would lose control of short-term rates. Since the rise of QE (and hence bank reserves), the BoE has operated monetary policy via a system of excess reserves. The excess reserves in the market depress O/N market rates greatly. By paying bank rate on these reserves, the BoE establishes a floor for short-term rates. Consequently, the BoE is able to move short-term rates directly by moving the bank rate. If the BoE stopped paying bank rate on reserves it would remove the floor, forcing the short-term rates rapidly down.

That is not to say that the system cannot be changed. Banks could be forced to hold specific quantities of reserves, which would absorb a portion of the excess reserves and lessen the effect. With QT now under way, the BoE will have to change tact eventually anyway as at some point the excess will shrink too small to keep rates pinned to bank rate. BoE estimates suggest this is some years off at current rates of QT (based on 2019 estimates of 12-18% GDP, it would take until 2026 at least).

So, would PM Truss want to pursue this? As the OBR has set out, no matter how it is cut, it would, in effect, be a tax on bank reserves (and hence banks). While banks have been a popular political punching-bag since the GFC, such a move would hurt Truss’ business friendly credentials (recall she still opposes windfall taxes on energy companies).

The situation as a whole may ultimately resolve itself. The flatness in the gilts curve may look attractive now, but this may not last. The new PM is likely to expand deficits (and gilt issuance), while BoE active gilts sales begin in September. In such a market, borrowing at even a higher-than-current bank rate may look comparatively attractive.

Henry Occleston is a Strategist, who focuses on European markets. Formerly, he worked in European credit and rates strategy at Mizuho Bank, and market strategy at Lloyds Bank.

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)