Articles - Monetary policy - how to turn off the taps?

Monetary policy in the UK has been ultra-accommodative since the financial crisis of 2008; the base rate has been held at a historic low of 0.5% since March 2009 and has been combined with a £375bn quantitative easing programme. To date, and in combination with a Government driven austerity plan, this has helped the UK economy slowly but surely regain its composure; recent economic growth has improved with 2014 GDP up 2.82% year on year and unemployment dipping below 6% for the first time since the credit crunch.

 Simon Bentley, Head of LDI Client Portfolio Management at F&C Investments
 Whilst positive for UK p.l.c. it creates a significant challenge for the Bank of England’s Monetary Policy Committee (MPC); namely, how and when to turn off the taps of loose monetary policy without derailing the recovery. With the base rate close to zero there is little scope for further easing and so as a monetary policy tool it would be useful to have a higher base rate in order to be able to adjust the flow of money in both directions rather than just the one. However, household debt levels remain close to their pre-crisis highs making the man on the street highly sensitive to a rise in interest rates. Soaring property prices have ensured that debt levels remain high even though unsecured borrowing has fallen. This means that the economic recovery could stall or go into reverse if rates are increased too far too soon.
 We must also remember that whilst the UK is an island nation, it is highly sensitive to global flows and thus monetary policy elsewhere in the world. If we quantify the level of “looseness” of UK monetary policy as 8 out of 10 then Eurozone policy has been turned up to 11! This means that short term Eurozone rates are so low, and negative in some cases, that UK rates look positively attractive. Therefore, a rise in UK rates will likely drive flows into the UK causing sterling to appreciate. A strong currency might be great for British holidaymakers but is like a wet weekend for British business as it affects the competitiveness of exports.
 The even lower for even longer attitude to UK base rates has caused longer dated gilt yields to fall sharply. This has been exaggerated by demand from UK pension schemes who are rightly keen to hedge their liability risks. The current Government has done a good job of reducing the UK’s budget deficit which means that (ignoring the election for a moment!) it will need to borrow less over the coming years leading to a reduction in net new gilt issuance. This will further serve to keep longer dated yields low and accommodative for longer term borrowers.
 So, what to do? The MPC needs to tighten policy as the economy continues to recover both through a higher base rate and higher long dated yields. Although the two are linked, there are a couple of things that would affect the latter more than the former, such as increased gilt issuance. It will be difficult to tighten policy much before Europe does as this will put upward pressure on sterling. The US, however, could provide some assistance in this regard as an increase in US rates would help dilute any differential between UK and Eurozone rates. Timing wise therefore, the Fed probably needs to blink first.
 The MPC does have another interesting potential tool up its sleeve in the form of £375bn of gilts. Selling these gilts back to the market would create sufficient supply to dampen prices and push longer dated yields up. A secondary benefit would be felt by all the under-hedged UK pension schemes whose liabilities would fall as a result of this move.
 In conclusion, the MPC have a delicate balancing act to perform. Monetary policy will need tightening to avoid a return to boom and bust economics but the economy is more sensitive than ever to rising rates. This is the result of both internal factors such as high debt levels and external factors such as the level of UK rates relative to the rest of the world. Any rate hikes will need to be slow and steady and give some consideration to US and Eurozone rates as well. It will be easier to raise rates once the US has kicked the process off and even easier if the Eurozone begins tightening.
 If you wonder what is trumpeting in the corner of the room, it is of course the elephant of the UK election. This could tighten monetary policy all by itself in the form of higher gilt yields through higher borrowing or uncertainty around Europe. However, with no clear outcome we will have to wait until 7 May or beyond to determine the impact of this!

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