Are central banks flying blind in turbulent economic times? Lessons from London
About the Author: Leslie Lipschitz is a former director of the IMF Institute, taught at Johns Hopkins University and Bowdoin College, was a visiting scholar at the Brookings Institution, and an advisor at Investec Asset Management.
The financial market turmoil in the UK, precipitated by Chancellor of the Exchequer Kwasi Kwarteng’s policy statement on September 23, raises two questions.
First, in circumstances of fiscal profligacy, can a central bank in an open economy with sophisticated financial markets both curb inflation and preserve financial stability? One aspect of this issue is a slightly new and more complicated twist on the old problem of “fiscal dominance”—fiscal policies that require central bank compliance—that undermine monetary policy. But now, rather than governments directly undermining monetary policy, their statements affect financial markets and constrain central banks for fear of instability.
Second, has the transmission of macroeconomic policy to the real economy become highly unpredictable? The classic macroeconomic effects of fiscal initiatives can be dominated by capricious risk premia and asset price volatility; monetary policies aimed at reducing inflation through conventional credit market effects can be amplified or negated by asset price movements, demand-side wealth effects, and/or financial instability.
The political actions and reversals in the British economy between September 21 and October 3 were clearly dramatic (rather than just incipient), but not entirely new. They forced the Bank of England to face problems similar to those anticipated by the European Central Bank a few months earlier: how to counter inflation with higher interest rates without risking a financial crisis in fragile areas of the financial market.
The Chancellor’s statement came shortly after the government announced spending increases aimed at easing the burden of rising energy costs for households and businesses. The statement outlines planned tax cuts and other changes aimed at accelerating the growth of economic activity. The measures were to be financed by additional borrowing and the declaration was not accompanied by official cost estimates. Two days earlier, the Bank of England had raised interest rates by 50 basis points – a significant figure, but lower than the Fed’s 75 basis point increase in the same week despite the inflation outlook even more worrying in the UK. The bank’s immediate response to the Chancellor’s statement was to announce that it was not considering any monetary policy action until its next meeting in early November.
Although the Chancellor’s statement hardly sounded like a recipe for financial collapse, there were a number of obvious problems.
First, by most estimates, the growth of the UK economy has been supply-limited. Absent sufficient spare capacity to elicit a significant real supply response, the additional demand would likely drive prices higher in an already highly inflationary environment. The Chancellor’s statements have failed to produce credible and meaningful supply-side improvements in the immediate future. Certainly, tax cuts – for both households and businesses – and additional capital cost allowances would, in themselves, be positive on the supply side over time; but they would not have much impact in the low growth and tight supply environment that was to prevail in the near term. Strengthening the supply side of the UK economy – primarily increasing labor productivity, which is below levels in France, Germany and Italy – would require more granular microeconomic policies than those proposed by the Chancellor.
Second, the overall context of the measures envisaged was problematic. Conventional wisdom holds that, all other things being equal, fiscal easing coupled with monetary tightening should lead to higher interest rates, real or nascent capital inflows, and currency appreciation. But, for the UK, the assumption of all other things being equal did not apply. Monetary tightening in the UK has occurred against the backdrop of similar, if not more aggressive, tightening elsewhere. Furthermore, as detailed below, for the UK, higher bond yields in response to inflation expectations could have very problematic implications for financial stability. It is therefore not surprising that the pound fell rather than rose.
Third, the measures would worsen the fiscal outlook. The UK’s National Institute for Economic and Social Research has estimated that the announced tax cuts along with additional spending would raise the deficit by around five percentage points of gross domestic product and reverse the projected decline in the debt-to-income ratio. GDP. But even after these deficit- and debt-increasing measures, the UK’s public debt ratio would still be lower than that of the US and major European countries (other than Germany). Surprisingly, the International Monetary Fund was quick to join in the chorus of criticism of the Chancellor’s statement, despite backing expansionary fiscal measures in other economies with similar supply constraints, inflationary risks and even more alarming public debt ratios.
Of course, the UK is not the US Sterling does not have the safe haven status offered by the dollar. And, as the European Central Bank recently demonstrated, even the most fiscally fragile countries in the euro zone – Italy and Greece – benefit from the possibility of certain monetary zone safeguards. But there is no such protection for the UK. The Bank of England’s monetary stance was not enough to persuade markets that the inflationary effects of fiscal initiatives would be offset. The bank’s initial apparent complacency encouraged expectations of higher inflation and, together with additional government borrowing, led to an almost certain decline in the prices of longer-term government bonds (“gilts”). A chasm has opened up under gilt prices and the value of sterling.
It is worth elaborating on the particular circumstances of the UK.
London is a global financial center. The financial sector in the UK, which is very large relative to GDP, includes a large pension fund industry. During the many years of low interest rates, pension funds had used their holdings of gilts to underwrite purchases of bonds and interest rate derivatives that would effectively provide them with the leverage needed to invest in bonds. other less liquid but higher-yielding assets, while still appearing to match the structure of their pension liabilities. But a rise in gilt yields coupled with fear of a further rise – equivalent to falling market prices for gilts used as collateral – forced sales of these bonds to meet margin calls. Of course, a wave of such sell-offs – a crowd rushing for a narrow exit – exacerbated the downward pressure on gilt prices (the upward pressure on yields) and thus threatened a vicious circle with far-reaching implications. extremely detrimental to the stability of the financial sector and the economy more generally.
Hours after the bond market turmoil, the bank rushed to limit the damage by intervening directly in the bond market. It immediately reversed its policy of quantitative tightening – that is, selling bonds as part of a policy to mop up cash and fight inflation – and pledged to buy up to five billion pounds (about $5.6 billion) of long-term bonds. bonds every day for the next thirteen days of the week. Indeed, the bank was now the guarantor of gilt prices. As expected, this move eased fears and halted rising bond yields, at least temporarily, with the bank’s actual purchases well below the set cap. A few days later, the government did an about-face on the most controversial part of the Chancellor’s declaration, the reduction in tax rates for high earners. This change is politically significant but quantitatively insignificant. Nevertheless, a certain calm has returned. This may well give pension funds the time they need to unwind dangerous leverage.
The UK stands out for its huge financial sector, the locus of immediate trouble. But this recent experience should draw attention to two issues of broader application: the ability of central banks to simultaneously reduce inflation and prevent financial crises, and the difficulties in measuring the impact of monetary policy actions.
On the first point, the history of the past few days clearly shows that central bank policy cannot be independent of fiscal statements that affect financial stability. Despite the current calm, for the UK the fundamental problems remain. The government’s reversal of an element of the tax cuts still leaves a significantly weaker fiscal outlook. The bank calmed the initial turbulence in the bond market, but if it reappeared, it would face a dilemma: how could it inject money into the economy to support the bond market and, at the same time, adopt a position restrictive enough to reduce inflation? and sterling underlay? This problem of having one instrument and two objectives extends beyond the UK Central banks have sought to solve it through regulation of the financial sector. But regulations are static and financial innovation is dynamic. We will see recurrences of the dilemma with central banks trying to veer between reducing inflation and preventing financial instability. Without the cooperation of the tax authorities, this can be an incredibly narrow passage.
The second problem – the difficulty of assessing the impact of monetary policy action or inaction – is illustrated by the market’s reaction to the Bank of England’s seemingly dovish initial response to the Chancellor’s statement. and the bank’s subsequent reversal. The problem, more generally, has been exacerbated by the massive accumulation of debt – on the balance sheets of corporations, governments and central banks over the past few years of low interest rates – and by the accumulation of financial assets Household. These developments have altered the transmission of monetary policy. Beyond classic credit effects, the impact of monetary tightening has been heightened by financial market fragility, exchange rate implications, negative wealth effects on household spending and balance sheet risks for businesses and governments. The effects of monetary policy are therefore extremely difficult to measure. To a large extent, central banks are flying blind.
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