Finding a reverse gear

The Bank of England’s Monetary Policy Report is required reading for those interested in UK macro trends and today’s report was no exception. Listening to some of the media commentary ahead of the report’s release, people might have been forgiven for believing that monetary tightening was imminent. In reality, that was never the case although the BoE did provide some guidance on the sequencing as to how the easing of the policy throttle will occur.

The economic outlook supports lifting the foot off the gas

Turning first to the details, the BoE’s macro forecast suggested that UK GDP will grow by 7¼% in 2021 and 6% in 2022, and only slow to trend (1.5%) in 2023. One implication of this is that the level of output will get back to pre-recession levels by end-2021, which is a far sharper rebound than expected a year ago. As a result the output gap is expected to be almost eliminated this year and an excess demand position is anticipated in 2022 (i.e. a positive output gap). With inflation projected to hit 4% in Q4 2021/Q1 2022, questions have been raised as to whether the current exceptionally lax monetary stance is warranted.

One member of the MPC (Michael Saunders) voted to limit gilt purchases to £850bn (it currently stands at £825bn) rather than press on to the currently mandated upper limit of £875bn. Although the idea of calling a halt before reaching the current target is unlikely to make a great difference in the grand scheme of things, it would send a signal of intent that the BoE is prepared to scale back its asset purchases as circumstances dictate. Indeed, when the MPC announced an expansion of the upper limit for gilt purchases to £875bn in November 2020, inflation was expected to peak at 2.1% in late-2021/early-2022 whilst output was not expected to get back to pre-recession levels until early-2022 (i.e. one quarter later than in August).

As the MPC minutes pointed out, the MPC “had policy guidance in place specifying that it did not intend to tighten monetary policy at least until there was clear evidence that significant progress was being made in eliminating spare capacity and achieving the 2% inflation target sustainably.” Although “some members of the Committee judged that … the conditions were not yet met fully”, it is hard to know what more evidence they need to justify scaling back monetary easing with inflation running at twice the target rate and with the output gap set to close. It is important to stress at this point that I agree with those who believe it is perhaps too early to significantly tighten policy. But this is not to say there is a case for easing off the throttle. On the basis that the stock of assets purchased is more important for policy purposes than the flow of purchases, setting a lower limit for gilt purchases implies a very moderate reduction in the degree of planned monetary easing.

Dealing with tightening

The BoE did indicate that when the time for tightening comes, its preference is to use Bank Rate as the instrument of choice and suggested that “some modest tightening of monetary policy over the forecast period is likely to be necessary.” As the Resolution Foundation has pointed out, this has the advantage of being swift to implement and can swiftly be reversed if necessary. But the BoE also indicated that it “intends to begin to reduce the stock of purchased assets, by ceasing to reinvest maturing assets, when Bank Rate has risen to 0.5%.” This could lead to a swifter unwinding of the balance sheet than might be expected and would go a long way towards assuaging the concerns of those who believe the balance sheet is too big.

To illustrate the impact of this, we start by looking at the details of the debt stock currently held by the BoE (here). We can use this information set to determine the precise maturity date of gilts on the balance sheet and my calculations suggest that the median maturity of gilt holdings is just over eight years. Assuming that Bank Rate reaches 0.5% by end-2023 and does not fall back below this level, allowing all maturing debt to roll off will halve the balance sheet in money terms by 2034. Further assuming nominal GDP growth of around 4% per year in the longer term, gilt holdings would decline from around 40% of GDP in 2021 to 12% by 2034. The BoE may, of course, choose to reinvest a certain proportion of maturing debt, rather than letting it all run off, and the resultant stylised scenarios are shown in the chart below. It is notable that even if gilt holdings remained at £875bn over the longer-term, the GDP assumption used here would be sufficient to reduce the balance sheet relative to GDP back towards 2013 levels even in the absence of any direct action.

In addition, the Bank suggested that it would be prepared to consider selling off assets once Bank Rate reaches 1%, thus adopting an even faster rate of balance sheet reduction. In my view, for what it is worth, this may prove unnecessary given the sharp pace of reduction generated by ceasing reinvestment. It may also significantly complicate the government’s efforts to finance the deficit. After all, if the BoE is selling gilts into a market which is saturated by primary issuance, the upshot is likely to be a sharp rise in bond yields.

Whilst there clearly are some risks associated with a policy of running down the balance sheet, the BoE believes that “the impact on monetary conditions of a reduction in the stock of purchased assets, when conducted in a gradual and predictable manner and when markets are functioning normally, is likely to be smaller than that of asset purchases on average over the past.” In other words, running down the balance sheet gradually is likely to have only a modest impact on the economy. However, it is generally accepted that central bank balance sheets will not fall back to pre-2008 levels any time soon. For one thing, there has been an increase in demand for central bank reserves by the banking sector due to changes in regulation and banks’ risk management techniques which has resulted in increased demand for high quality liquid assets. For this reason, it is unlikely that the BoE will follow a policy of full disinvestment over the medium-term.

The likes of the now-departed Andy Haldane expressed concern that the BoE’s balance sheet was too big. Therefore reducing it over the medium-term is likely to diminish the criticism that the BoE is somehow engaged in deficit financing – a point Governor Andrew Bailey was keen to refute during today’s press conference. Nonetheless, balance sheet management is a policy tool which is here to stay. With downward pressure on equilibrium interest rates, as a result of population and productivity trends, the scope for using conventional interest rate policy is diminished and balance sheets will therefore remain a useful addition to the policy armoury. But just as increasing balance sheets proved to be controversial, so the process of running them down will likely prove to be a lot more difficult than currently imagined, as the 2013 US taper tantrum illustrated.

Cummings and goings

In recent months I have tried to steer away from politics and focus on economics. But as a line from the fictionalised memoir The Tattooist of Auschwitz recently reminded me, anyone “who lectures on taxation and interest rates can’t help but get involved in the politics of his country.” So it was that two years after Boris Johnson was elected as leader of the Conservative Party I watched this week’s BBC interview with Dominic Cummings, architect of the Brexit campaign and until December Johnson’s chief of staff, which lifted the lid on life in Downing Street (a short summary for non-UK based viewers can be found here on YouTube). It was many things – compulsive viewing; exculpatory; self-justifying; incoherent and despite Cummings’ denials, clearly motivated by revenge. But most of all it shone a light into the tawdry workings of British politics in recent years and acts as a reminder of how far standards of governance have fallen.

The context of the interview was also interesting. The BBC, and particularly its political editor Laura Kuenssberg, has come in for significant criticism in recent years that it has given the government an easy ride over its many policy failings. In this case Kuenssberg asked some very direct questions, although as many people pointed out, she has not given the same grilling to anyone still in government (though largely because they refuse to submit to such scrutiny). For all that, the interview was highly illuminating and raises questions for anyone with an interest in good governance.

The lies that they told

I will start with Cummings’s observations on Brexit, having pointed out for the last five years that he headed a campaign that wilfully lied to the electorate. He admitted that “on questions such as whether Brexit is a good idea, no-one on earth knows.” This from a man who led a campaign to persuade the electorate that it was! He went further to suggest that “it is perfectly reasonable to suggest that Brexit was a mistake.” As an insight into Cummings’ character, this speaks volumes. His efforts to try and appear thoughtful and rational contradict some of the policies he has long espoused and confirm David Cameron’s judgement that he is a “career psychopath.”

Cummings also denied lying about the costs of membership (the infamous £350 million per week claim), arguing that it was designed to set a trap for his political opponents and dismissed claims that it misled people into voting for Brexit. He further dismissed claims that he used Turkey’s willingness to join the EU to persuade the electorate that the UK was about to be swamped with huge numbers of immigrants. But in the immortal words of Mandy Rice-Davies almost 60 years ago “he would, wouldn’t he.” Cummings did implicitly admit that he did not present the information in its true context (aka he lied) but he justified doing so in order to get people to talk about the issues.

This is both disingenuous and dangerous – dangerous because it has set a precedent for people in public life to make all sort of false claims “in order to generate debate.” But if such lies are not called out, such statements tend to become accepted as truth by those prepared to propagate the falsehoods. Until recently I always thought that George Orwell’s 1984 was a satirical novel warning us of the consequences of totalitarianism (“Ignorance Is Strength”). I now realise that it has become an instruction manual for zealots intent on pursuing their particular interests.

How not to run a government

Given the character of the man, it says a lot about Boris Johnson’s style of leadership that Cummings was appointed the prime minister’s chief of staff. Cummings has little time for Johnson’s ability to lead (although this is undoubtedly coloured by his December sacking) but he clearly thought that Johnson was the only politician capable of “getting Brexit done.” Another insight into Cummings’ character was his response when asked why he took on the role. He told Kuenssberg that he did so only under certain conditions and seemed genuinely baffled when she asked whether he was motivated by any sense of public duty. There was very much a sense that Cummings used the role to pursue his own agenda rather than that of the country. Under the UK’s constitutional arrangements this is highly dangerous. Outside election periods, it is very difficult to call the prime minister to account and they have near-total carte blanche to do whatever they think necessary in order to pursue a particular policy. Giving someone like Cummings the protection of the prime minister’s office is like giving sticks of dynamite and a box of matches to a toddler.

The whole interview exposed the lack of strategy from the current government and the underhand tactics that it used to achieve the one goal that it had – that of getting Brexit done. Outside of this policy, the government seems to be largely rudderless and Cummings gave more insight into its dreadful handling of the pandemic with his central claim being that the prime minister put “his own political interests ahead of people’s lives.” Whilst Cummings' motivation can be called into question, he at least served a purpose by directing the spotlight towards the vacuum at the heart of government.

A deep-seated problem

All this matters because, as I have pointed out numerous times, well-run economies tend to deliver the best outcomes for their citizens. Whilst economics tries to be value neutral, it is hard to accept that the values demonstrated by the British government’s actions in recent years represent a good platform to deliver the best economic outcomes. An excellent post by Professor Geoff Mulgan highlighted that the government is representative of a narrow clique whose interests do not necessarily coincide with those of the wider electorate. Two of his main points bear repeating. The first is that this group does not really understand economics and thus does not grasp the implications of many of their policy slogans. A second point is that this clique “doesn’t really do ideas. It’s much better at commentary and critique than prescription.” 

A second critique was offered by the journalist, broadcaster and clergyman Giles Fraser, who notes that previous Conservative governments were at least guided by some form of moral compass. Even the pro-market Thatcher government, which was widely criticised for its apparent indifference to the social hardship caused by some of its policies, was deeply rooted in a moral view of the world (see, for example, this 1978 article by Margaret Thatcher in the Daily Telegraph). I will come back to the subject of economics and morality another time, but suffice to say a government that continues to make missteps which, (to reuse my all-time favourite political quote from fictional spin doctor Malcolm Tucker) are “the result of a political class, which has given up on morality and simply pursues popularity at all costs”, suggests we are sliding down a very slippery slope.

Last word

Although I do not like a lot of what Cummings stands for, I do understand his position. He sees an ossified political system which is ripe for reform and is prepared to do anything in his power to effect change. But hitching his campaigning zeal to the personal ambition of a Boris Johnson has resulted in a hollowing out of Britain’s political culture. More worrying still is that the vast majority of the electorate do not seem to care. Like him or loathe him, however, I urge people to watch the Cummings interview and make their own minds up as to whether the social, political and economic course upon which Britain is embarking is one that they are comfortable with.

QE inside out

Twitter can often be something of an intellectual cesspool in which people continue to shout across the cultural divide without ever hearing the views of the other side. It can, however, be a source of great enlightenment and I was very taken by a post (here) by Alfonso Peccatiello explaining why QE can never be inflationary. Having thought about it, there are many elements of this Twitter thread which are wrong. Nonetheless, it served a very useful purpose in forcing me to assess the nature of money and for that it is to be commended.

Inside versus outside money

At issue is the nature of “inside” versus “outside” money. Peccatiello argues that “inside money never reaches the real economy. Outside money does” and to the extent that he characterises QE as inside money, it cannot therefore impact on inflation. I suspect there is some confusion about definitions here and in order to get a better handle on this, we need to understand the concepts under discussion. The notion of inside versus outside money was introduced into economics by the seminal work of John Gurley and Edward Shaw, Money in a Theory of Finance, published in 1960. It was a very innovative work for its time and looked at the interaction between the real economy and monetary growth. As they put it, “real or “goods” aspects of development have been the center of attention in economic literature to the comparative neglect of financial aspects.”

Gurley and Shaw (G&S) define inside money as originating from within the private sector. Since one private agent’s liability is simultaneously another agent’s asset, inside money is in zero net supply within the private sector. Thus, funds held in bank accounts would be classed as inside money because they are an asset of private firms or households but a liability of private sector banks. Conversely, outside money derives from outside the private sector and is either fiat (unbacked) or backed by some asset that is not in zero net supply within the private sector. An increase in the stock of currency by the central bank would be classified as outside money, because although it is an asset of the private sector it is a liability of the public central bank.

The vexed question of money neutrality

Since outside and inside money represent different types of liquidity, they have differing effects on the wider economy. One implication of this is that the money stock is not homogenous – money is not just money as it is comprised of these two differing types. This calls into question the notion that money is neutral (i.e. it does not impact on real quantities in the long run and serves only to impact on prices). In light of the debate regarding the impact of liquidity creation by central banks and the recent surge in inflation, this may help us to shed some light on the monetary transmission process and the role of QE within it.

Without boring the reader with the details of the process, G&S demonstrate that in their general equilibrium framework inside money is neutral but outside money is not (the interested reader is referred here). How do we categorise QE?  In the sense that the central bank creates reserves to buy assets from the private sector (in this case, the non-bank private sector) but uses them to buy government bonds, they are merely swapping one type of outside money for another (cash for bonds). Consequently, the inside-outside composition of private sector assets remains unchanged. I thus agree with Peccatiello that QE can be categorised as inside money. If we accept the proposition of money neutrality, this implies that QE is unlikely to have any long-term impact on real activity. But this does not mean that it has no impact on prices. Indeed, classical monetary theory argues that if it does anything, QE will impact on price inflation.

Moreover, monetary neutrality relies on the absence of frictions but, as the work of Karl Brunner and Allan Meltzer has demonstrated, such frictions do exist and thereby allow monetary policy to have an impact on the real economy – perhaps only for a limited period of time. QE may not have had the impact on the economy that central banks hoped but there is in theory scope for it to boost activity. Analysis conducted by the BoE in 2011 suggested that the initial round of asset purchases boosted UK GDP by 1.5% to 2% compared to what would have happened in its absence.

Should central banks continue with asset purchases?

If we therefore accept that asset purchases do impact on inflation and prices, does it make sense for central banks to continue the programme, particularly in view of the surge in US inflation to 5.4% last month – the fastest rate since 2008? The short answer would appear to be no. Whilst it is true that the prices of used cars contributed a third of the monthly rise in the CPI in June, which is likely to be a temporary phenomenon, there is evidence that prices are rising rapidly across the board. Accordingly the Fed is widely expected to taper its asset purchases before too long with suggestions that the Fed will broach the subject at next month’s Jackson Hole symposium. Investors will recall the 2013 experience when the prospect of a slowdown in Fed asset purchases prompted the infamous taper tantrum which resulted in a spike in bond yields. However, with financial asset prices at red hot levels, taking some air out of the market may actually not be such a bad thing.

Last word

Whilst there is general agreement that QE has been the primary driver of asset prices in recent years, there remains much debate about its impact on the wider economy. Whilst I have never been persuaded of some of the claims made for it by policymakers, I have never accepted that it has zero impact. Even if the effects are small, such has been the magnitude of asset purchases that even small spillovers will show up in GDP and inflation data. This 2016 paper by Martin Weale and Tomasz Wieladek offers evidence that in contrast to the claim made by Peccatiello, “US (UK) QE had a similar (much larger) effect on inflation and (than) GDP.” If asset purchases have helped the economy to avoid a slow post-pandemic recovery, they have done their job. But having done their job, it may now be time to think about scaling back.