The Bank of England Chimes In
November 12, 2008
The Bank of England, like Australia’s central bank, has reduced its key rate by 200 basis points since September. In fact, the BOE accomplished such in just two steps of 50 basis points in October and 150 basis points to 3.0% last week. There had been three previous cuts of 25 basis points each but none since April. Rising CPI inflation, which doubled to 5.2% in the year to September from 2.5% last March, had put the cabash to monetary easing even as British growth prospects progressively darkened. The central bank today published a new quarterly Inflation Report, explaining the transformation from vigilance against inflation to aggressive rate cutter.
The report opens with the declaration that banking and financial markets were last this unstable in 1914, well before the world depression. “A marked deterioration in the outlook for domestic and global economic activity” has resulted. All components of real GDP, aside from government spending, will be affected. Recession commenced in the second half of this year, fanned by this “exceptional volatility in financial markets,” “a substantial tightening in the supply of money and credit,” and significantly weaker export prospects. By 2009, on-year growth could be showing on-year declines of 2% or more. Commodity prices, expected inflation, and wage increases already are receding, and the drop in output and demand will escalate the decline in actual inflation. If the bank rate stayed at the new level of 3.0%, the report envisages on-year CPI inflation dropping to around 2.0% around mid-2009, near 1.5% by end-2009, and to less than 1% in 2010. Indeed, a fan chart in the report implies about a 25% risk of sub-zero inflation around 3Q10. A substantially higher chance of sub-target inflation in the medium term had to be met with an extremely forceful delivery of monetary stimulus.
Sterling depreciation is augmenting that stimulus. Empirical research done over 15 years ago by the central bank suggested that a 4% change in the trade-weighted pound would produce about the same effect as a 100 basis point change in the key interest rate. Using that rule of thumb, monetary conditions have loosened by some 360 basis points since October 7th and by around 675 basis points during the past twelve months. Such rules of thumb assume a normally functioning banking system. Judging by the weaker tone of hard economic data and the even more sluggish behavior of forward-looking survey evidence, the extensive quantitative boost to monetary conditions from a lower central bank rate and sterling depreciation does not offset the tightening of the money market that was induced by banks clamming up on their own.
The same catalyst caused the Bank of England and Reserve Bank of Australia to shift to a high-octane easing stance. Of the many steps toward the abyss since a banking problem surfaced in August 2007, none was more pivotal than the decision to let Lehman fail. Protecting taxpayers and avoiding limitless moral hazard were cited at the time for drawing a line in the sand in Washington’s handling of that particular investment bank. In the end, far greater ground on both of those two issues was squandered. A battle was won at the cost of losing a war. Maybe the definitive narrative of what really happened with Lehman will emerge. Whatever the thinking, a terrible miscalculation regarding the fallout from that decision was made, as it is inconceivable that a different choice would not have been selected if officials had anticipated the chain of events that followed. Along similar lines, news emerged today that none of the $700 billion of TARP, which stands for “troubled asset relief program” will be used for the government to acquire bad assets. From the beginning, the tactics and strategic thinking of policymakers in response to the crisis has been composed on the fly. That’s not necessarily a bad thing. The New Deal was crafted in much the same manner. However, it underscores how much is still unknown and how unpredictable and uncertain future economic trends actually are. Continuing market volatility is about the only thing one can be sure of in this environment.
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