Bank of England announcement: our response

Written by Frank Van Lerven on August 4, 2016. 

The Bank of England (BoE) has just announced its new monetary stimulus package. By lowering interest rates and expanding quantitative easing, the stimulus will exacerbate inequality and encourage an already highly-indebted household sector to borrow even more. The new government has pledged to build an economy that works for everyone and has made a strong commitment to tackling inequality. If it’s serious, it should support fairer and more sustainable monetary policy measures than those announced today.

The policy package   

In response to increasing economic uncertainty prompted by the recent Brexit vote, the BoE has just announced its new monetary stimulus package. With seven years of interest rates at their lowest point in history, interest rates will be cut even further from 0.5% to 0.25%.
A fresh round of QE will also take place with £70 billion being added to the current £375 billion programme. This time round however, the BoE will buy up to £10 billion of corporate bonds and just £60 billion of government bonds. In addition, the BoE has announced its new £100 billion Term Funding Scheme (TFS).     

Why is a stimulus needed?

In short, economic data post-Brexit suggests that there is a lot of uncertainty in the economy – there will be a reduction in investment and spending:

	Services PMI	Manufacturing PMI	Composite PMI	Business Confidence Index	Consumer Confidence Index	Retail Sales Index
Before Brexit	52.3	52.4	52.4	-5	-1	+4
After Brexit	47.4	48.2	47.7	-47	-13	-14

Why lower interest rates will be ineffective

The monetary policy package is intended to get the private sector to alter its borrowing and spending behaviour.
Before 2009, the BoE had never cut rates below 2% and since then, they haven’t increased above 0.5%. Cutting rates to 0.25% is unprecedented. It is ultimately intended to convince people to spend today what they would’ve spent tomorrow – but the other side to that is the build-up of private debt, which creates headwinds for the real economy.
If our primary tool to prevent a financial crisis and potential recession is to encourage more bank lending and thus more private sector debt, we should be worried. Especially considering that the BoE already identified high household debt as the biggest risk to the UK economy. Indeed, encouraging more debt onto an overly indebted private sector is effectively a ‘hair of dog strategy’.  
The other problem is that bank lending is not only supply-constrained but also demand-constrained. That is, relaxed lending constraints will only boost banks’ ‘capacity’ to lend. Banks will also need customers to come in and apply for new loans. Given uncertain economic conditions and potentially poor prospects for growth, there is no guarantee that there will be an extra billion pounds of new lending in the coming year. As John Maynard Keynes pointed out, policies aimed at encouraging more private debt when there is already so much of it, amount to “pushing on a string”.

Why more QE will be ineffective

In 2009, QE may have been the best tool available in a hurry, and the financial crisis may have been worse without it. But we are in a different situation now. Banks do not need more liquidity, the interbank lending market is not in danger of freezing up. As 35 economists recently mentioned in a letter to the Chancellor coordinated by Positive Money:

“The risks facing our economy have little to do with the availability of liquidity in the financial sector, and all to do with businesses and households cutting spending due to an increasingly uncertain economic outlook.”

By pumping money into financial markets, QE firstly relies on making wealthy asset-holders feel better off, which should induce them to spend and consume more. But this ultimately leads to more inequality (as the Bank of England has admitted) – not to mention massive asset bubbles that prompt further financial instability.

Wealth Inequality Since 2010

Secondly, like cutting interest rates, QE relies on encouraging businesses and households to take on more debt.

Indeed, QE that involves buying corporate bonds (or corporate QE) is specifically designed to lower the borrowing costs of corporates. But corporate borrowing costs are already at an all time low – so QE is likely to have little effect in this regard. Moreover, it involves the BoE choosing which big corporates get cheap money. Finally, UK corporates are sitting on over £1 trillion of cash piles – which they are not spending. Which begs the question of why should corporate QE incentivise more spending and investment?


Why TFS is likely to be ineffective
By aiming to lower borrowing costs for the private sector,the interest rates banks charge is also lowered. This means that low rates and QE also hurt banks’ profits – something Frances Coppolla has very eloquently pointed out – so some banks might find it difficult to cut their lending rates even further. The BoE has therefore started a new “Term Funding Scheme”, that will provide £100bn of funding to banks at an interest rate close to the Bank Rate. According to the BoE this should ensure:  

“This monetary policy action should help reinforce the transmission of the reduction in Bank Rate to the real economy to ensure that households and firms benefit from the MPC’s actions.”

The problem with this solution (other than amounting to ‘pushing on a string’, encouraging yet more debt and jeopardising financial stability), is that it’s also unclear what the BoE means by ‘real economy’. From Carney’s comments it seems that he includes mortgage lending in his definition of real economy (which we do not). We know that if banks have the opportunity of lending to property markets rather than businesses they will end up fuelling a housing bubble and lending to businesses will stay low. In 2008 just 8% new loans went to business, and 40% went to mortgages. It seems TFS is unlikely to significantly promote a change in bank lending behaviour. So it will most likely fail to stimulate an increase in private sector incomes, and is likely to lead to more financial instability (as we explain here).
Why we need Public Money Creation?
These “hair of the dog” strategies show the extent to which the monetary policy toolbox available to the BoE needs to be updated. Pumping money into financial markets, promoting asset bubbles, jeopardising financial stability, exacerbating inequality, and promoting more private debt should not be considered acceptable ways of stimulating our economy. We need other more fair and sustainable methods which do not rely on increasing inequality or private debt. We need money creation for the public.
Public Money Creation is where the BoE creates money and puts it directly into the real economy. This can be done in several ways (click here for more information).The Bank can make money available to be given directly to ordinary people (i.e. to pay down their debts and for spending), or use it to fund for use in financing infrastructure projects or affordable housebuilding. It should always be a decision for the Monetary Policy Committee to decide when and how much stimulus to deploy, but it’s a matter for the Treasury to expand the Bank’s monetary policy toolkit and decide where to put the money into the economy (i.e. through infrastructure spending or cash transfers). Some of the key benefits to Public Money Creation are as follows:

• It does not rely on the private sector taking on more debt in order to stimulate spending and aggregate demand;
• It will boost private sector incomes relative to debt burden, allowing the private sector to reduce its debt-to-income ratio;
• Money injected directly into real economy offers policymakers much more direct influence over macro-economy;
• By increasing spending in the economy without relying on additional private sector debt, it allows the private sector to pay down debt without a reduction in spending;
• Because Public Money Creation does not rely on increased levels of debt or pumping money into financial markets, it makes recoveries more stable and sustainable over the long-term;
• Whether through public spending or a citizens’ dividend, the benefits of monetary financing will be far more direct and much more evenly-distributed throughout society.