The Bank of England’s Monetary Policy Committee meets this week and expectations are high that it will ease policy to offset the negative effects of Brexit. A better decision would be to stand firm. Under current conditions, there is substantial risk that a cut in interest rates or an expansion of quantitative easing would have perverse effects. Other policy instruments are more able to address the liquidity and credit concerns during this political hiatus when uncertainty is so high.
Under normal conditions, a cut in interest rates stimulates businesses to borrow and households to cut savings and spend, thereby boosting the economy. But after eight years of ultra-low interest rates and in the face of heightened uncertainty post-referendum, neither channel to growth is likely.
Much more probable are the offsetting effects. A cut in rates would erode banks’ already slim net interest margin, decreasing their willingness to lend. QE would lower long-term rates and thereby push up the pension liabilities of companies with defined-benefit plans, as Ros Altmann, pensions minister, has warned. Higher pension costs would reduce the funds available for investment. In any case, businesses are reassessing their strategies and unwilling to take on additional risk until the post-Brexit policy environment is better understood.
The household response to lower rates is also problematic. A large contingent of people in their 50s and 60s looking towards retirement are “target savers” who are aiming to build a large enough savings portfolio to fund their retirement expenses. Lower interest rates increase the amount they need to save to reach their targets. Some will have stock market investments that could benefit from QE, but many are rightly cautious at that age about the risk of market volatility. Consumers who are already retired are also hit by lower interest rates on their savings. Most do not benefit from lower mortgage costs as 72 per cent of the over-65s own their home mortgage-free, according to government figures.
An additional consideration of the MPC this week should be the effect of policy easing on sterling. The pound has fallen more than 10 per cent since the referendum vote, approaching historic lows. While there are benefits to some businesses from a lower pound, there is also a risk to financial stability from such a sudden fall. Part of sterling’s current weakness is probably due to market expectations of an interest-rate cut, but the fulfilment of that expectation could set off another surge of selling, driving the pound further below its long-run average. Such a savage weakening of sterling could provoke a strong boost to inflation, threatening household spending and economic growth, as well as the MPC’s 2 per cent inflation mandate.
The Financial Policy Committee’s easing of capital requirements on UK banks last week was a timely and well-targeted response to Brexit-induced uncertainty. Since then UK gilt yields have fallen to historically low levels. The latest auction of 10-year gilts drew such strong demand that they were issued at 0.91 per cent, less than half that at the previous auction. This may be a sign of investor concern about the UK economy, but it hardly constitutes a message that more QE is needed to keep long-term rates from rising. Rather the market thinks that Mark Carney, BoE governor, has given it a one-way upside bet with his clear hint that the MPC will ease monetary policy.
This puts the MPC in a difficult position. It will not wish to undermine the governor’s credibility by failing to deliver on his steer to markets. Yet some members at least will recognise the risks outlined above. The FPC has already provided an important support to financial stability which should not be undermined by a cut in interest rates. Global markets seemed to have shrugged off the shock of Brexit and moved on to the positive jobs figures in the US. The FTSE 100 is above its pre-referendum level. The MPC should avoid overreacting to the early market jitters and settle for a small, largely symbolic, addition to QE.
This commentary appeared in The Exchange on FT.com on 13th July 2016