Since the global financial crisis of 2008, we have become accustomed to cheap money with low interest rates and quantitative easing (QE). The latter has prompted the Bank of England to print money to buy government bonds known as gilts. Last year QE had reached £895 billion and the bank owned almost a third of the national debt.
The problem is that 14 years of cheap money has created big problems. And we have relied on it as a way out of our economic woes.
First, it has led to rampant asset price inflation. With interest rates at record lows, not only did the stock and bond markets do well, but also the housing market. Of course, a low supply of new living space and strong population growth played a role. But at its core, cheap money kept mortgage rates down and encouraged people to take out huge loans.
Second, it has caused financial markets to misprice risk. When the cost of borrowing is near zero, all assets – including risky ones – are cheaper than they should be.
Third, it has allowed zombie companies to survive. This has played a part in our history of low productivity, although there are many other, more important issues, such as: B. low investment and a lack of education and skills.
Eventually, this created an environment where inflation could take hold — as it has for the past year or so.
The bank is belatedly trying to fix these problems by ending its own easy-money policy. However, this will create problems of its own, which will then be exacerbated in global financial markets as many other central banks do the same.
Markets want higher interest rates, but the economy may not be able to handle it. This means that while it is imperative that we wean ourselves off cheap money, the pace, scale and sequencing of monetary tightening must be gradual. It must react sensitively to the development of the financial markets and the economy.
Last year, the bank should have tightened monetary policy. Instead it was relaxed.
At the beginning of 2021, it was clear that inflation would rise: Annual inflation was 0.4 percent in February and had stopped falling. 18 months ago, the economy would have coped with higher interest rates. Eventually, it should bounce back when pandemic restrictions were lifted. Instead, the bank left interest rates on hold at 0.1 percent, urged banks and businesses across the city to prepare for negative interest rates, and committed to further quantitative easing.
This catastrophic error was due to the misreading of inflation. At the time, I asked the question, which “P” would the rise in inflation be? Would it pass, stay or become permanent? I thought inflation would continue. The bank felt it would happen quickly. It has held up.
Our current inflation problem is being triggered by supply-side factors, including shortages from the pandemic and the war in Ukraine, and has been exacerbated by poor monetary policy. It was not triggered by an overheated domestic economy. In fact, domestic demand is weak. Consumer price inflation is 9.9 percent. The bank’s inflation target is 2 percent. After the energy price cap, inflation is likely to peak at around 13 percent this fall and slow down next year.
There is clearly a need to escape the easy money trap. But there is no easy way to do this now.
Even before the mini-budget, markets were expecting interest rates to peak at 4.5 percent and stay high. After the mini-budget, rates are expected to rise further and sooner, peaking at over 6 percent. A large rate hike is expected at the next monetary policy meeting.
The chancellor failed to calm the markets before or after the mini-budget. But the day before, markets were already unsettled by the bank’s decision to hike rates by 0.5 percent to 2.25 percent as many waited and hoped for a bigger move, and by its announcement that Gilts would be part of 80 Billions of pounds to sell quantitative tightening (QT).
In addition to the necessary issuance of gilts and the new issues expected from the mini-budget, this meant additional selling from the Bank of England. The bank should stop this QT. It doesn’t have to sell gilts now.
Since then, the picture has become more unclear, with markets calling it “quantitative confusion”. The bank has now suspended its QT until the end of October, when it will resume for policy reasons.
Then last week it announced it would temporarily buy £65bn worth of gilts on financial stability grounds. A number of pension funds — not all — had taken leveraged positions in risky moves by buying derivatives from investment banks.
As interest rates rose, collateral requirements for these derivatives transactions increased, forcing the Funds to sell gilts in a falling market and pushing down the price of gilts. It was good that the bank stepped in to help and stop a doom loop. But it has now emerged that regulators and the bank were aware of this risky practice. Surely they should have tried to ban it in the first place?
It seems that too many parts of the system and economy have become dependent on low interest rates and easy money. As Warren Buffett famously said during the financial crisis, it’s only when the tide is out that you see who’s swimming naked.
dr Gerard Lyons is Chief Economic Strategist at Netwealth
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