The vaguely bipolar Bank of England

I read a history of the Bank of England (BoE) last year. It wasn’t very exciting. Even when armed guards took up positions to protect the bank from riots and during the war, not much happened.

But one thing did shine through the book. The Old Lady of Threadneedle Street always knew what she was doing. Or pretended to know. There was certainty and continuity.

At yesterday’s press conference, governor of the BoE Mark Carney was clueless. He told the financial media he didn’t know what he’d do about interest rates in coming months. Mostly because of Brexit.

But here’s the shocking part. Even if he did know what was about to happen on Brexit, he’d still would not know what he was going to do about interest rates. That’s a whole new level of cluelessness.

Carney couldn’t even rule out any possibilities. Whether it’s hard Brexit, soft Brexit, or anything in between, rates might go up, they might go down, or they might stay the same. Everything is on the table.

Helpful, isn’t it?

But why would the BoE hike interest rates if there’s a no-deal Brexit? That was the first question of the Q&A.

Carney explained his answer carefully. And it explains the nature of his uncertainty.

The BoE is worried about three things when it comes to Brexit. The demand shock from people buying less. The supply shock from people producing and trading less. And the currency shock from a tumbling or surging pound.

The three variables make things very confusing.

If supply falls dramatically due to economic disruption and trade barriers, that could cause inflation. This is the issue when it comes to food prices. If we can’t get our hands on the European-produced food we subsidise, food prices will go up.

These sorts of supply shocks are very rare in developed economies, Carney repeated a few times. Which means he doesn’t know what to do in the face of such a shock. There’s just not enough academic theory backing him.

The demand effect is simple. Brexit could mean people buy and invest less, cutting GDP and jobs. This is a more familiar problem. It’s deflationary – a typical recession-type risk.

Because Brexit risks an inflationary supply shock and a deflationary demand shock at the same time, the BoE finds itself on a wobbly tightwire that’s about to be cut at both ends. Everything changes at once. So the appropriate policy response is not obvious.

But it’s Carney’s comments on the currency that are most fascinating. He’s worried a drop in the pound could trigger inflation by making imports expensive.

This is the more traditional concern for central bankers. Historically, the BoE played a currency manipulation role. It had to support the pound. Politicians and economists feared unstable exchange rates. Especially falling ones. Which is amusing given the modern advent of currency wars and competing devaluations.

Back in the day, the BoE would raise interest rates to protect the pound. Economic conditions were secondary to the exchange rate.

This is what happened the evening before Britain left the Exchange Rate Mechanism (ERM). Interest rates were raised from 10% to 12% to 15% within hours. But it didn’t work. Selling pressure on the pound continued.

Chancellor Norman Lamont finally abandoned the ERM on Wednesday 16 September. The pound crashed 17% and the day became known as Black Wednesday.

During his press conference, Carney appeared to reference this sort of thinking. He might have to defend the pound, old-school style, and raise rates.

But journalists and economists in this morning’s papers are sceptical. It would do too much damage to the debt-based modern economy. Better to have the pound drop.

A more recent historical repeat is more likely. After the referendum, the BoE cut rates, believing the demand shock would trump all other considerations. The risk was deflation and a recession.

But the currency took the brunt of the beating, forcing the BoE to reverse its rate decision soon after. They’d added inflationary fuel to the pound’s inflationary fire. And the demand shock barely materialised.

Clueless in practice, not just theory.

The leeches and bloodletting theory of economic management

It took doctors thousands of years to do more good than harm. It’ll take economists longer. And the existence of central bankers completely rules out the possibility for now.

What bothers me about the BoE’s vaguely bi-polar policy position is timing.

The supply, demand and currency shocks are all once off shocks to the economy. They’re not ongoing issues. Prices will ratchet up, down, or nowhere, but then stabilise. By the time the BoE acts, the effect will be baked in. The BoE will only add instability.

So, not only does the BoE not know what effects Brexit will have when it comes to inflation, but it will react too late, and overdo it as well. It’s similar to the rate cut after the referendum. An embarrassing panic that comes too late and has to be reversed.

But what about the opposite scenario? What if Brexit works out rather well? Or even too well?

Believe it or not, even Carney has had to admit the possibility. He’s now warning the country that a decent Brexit deal will be so good he’ll have to raise interest rates faster than expected.

A Financial Times journalist asked an absolutely brilliant question on this, which should put fear into the hearts of UK borrowers. Imagine the following sequence of events.

A sudden recovery and rebound in economic activity from a Brexit deal.

A burst in Donald Trump-style economic growth from the new budget, which Carney’s press conference projections did not take into account according to him.

A surge in business investment growth, which has been pent up due to Brexit uncertainty.

Wage growth from lower immigration.

Domestic inflation pressures from low unemployment.

A trade boom with nations outside the EU.

In other words, what if everything goes embarrassingly well? What if the British economy is “unleashed”, as Carney summarised the FT journalist’s question.

His answer was helpful. The BoE forecast, in such a scenario, has inflation rising above target. And “one can draw conclusions from that.”

Readers, it’s time to prepare for interest rate hikes. Presuming the Europeans can hold their financial system together for that long.

A top down revolution in Europe

The Italian prime minister has thrown off his technocratic shackles and joined the populist swing of things. You’d think he was elected given his recent comments.

Here’s what he told the newspaper Corriere della Sera, according to the Express, in response to getting the blame for stalled economic growth:

Saying the government is responsible for the current unemployment and growth data is unreasonable and profoundly unjust.

The positive effects of our reforms will be seen from 2019.

Our revolution has just begun.

We put the first pieces, but the work to be done is ambitious: we want to change Italy from top to bottom.

And my personal favourite bit, “I would not see our dialogue with the European Commission as an exchange of concessions.”

Italy’s budget isn’t a negotiation. It’s an offer it can’t refuse. Or they’ll find a dead euro in their bed.
My book continues to anticipate the Italian crisis, every step of the way. We’re rattling through chapter nine faster than I’d expected. Chapter ten features Britain. You’d better catch up soon.

Until next time,

Nick Hubble
Capital & Conflict

Category: Central Banks

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