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Cover image by: Sylvia Chang
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In recent months, the Bank of England (BOE) has been engaged in monetary tightening, involving raising short-term interest rates as well as selling government bonds (the latter being a reversal of quantitative easing). The sale of government bonds was meant to withdraw liquidity from the economy. Selling bonds means that bond yields are likely to go up—which is what has happened. Yet the recent fiscal announcement by the government caused a dramatic surge in bond yields that alarmed the BOE. Consequently, last week it completely reversed course, saying that it will purchase bonds and that it will do so at “whatever scale is necessary.” Indeed, it said that, initially, it will purchase 65 billion pounds worth of bonds. It justified its action by saying that the current situation creates a “material risk to UK financial stability.”
The BOE action was met with relief by investors. Bond yields plummeted, not only in the United Kingdom but in the United States as well. The yield on the British 10-year bond fell by almost 50 basis points (bps) in one day while the yield on the US bond fell by 22 bps. In addition, equity prices increased sharply, the price of oil increased, and the value of the US dollar fell against the pound, the euro, and other currencies.
Although investors were pleased that the BOE stepped in to repair the perceived damage done by the government, this is hardly a long-term solution. After all, the new BOE approach is effectively an expansionary monetary policy at a time when Britain continues to face high inflation and requires monetary tightening. It is possible that the government could find a way to reverse course. Perhaps it can indefinitely postpone tax cuts, at least until inflation has been brought under control.
Meanwhile, despite the BOE intervention in the bond market, the BOE’s chief economist said that there might be big interest-rate hikes at the next policy meeting in November. In other words, the BOE has not completely reversed monetary policy. Instead, it is attempting to stop the mass sell-off of bonds. That sell-off threatened to dramatically increase the cost of servicing government debt. It also threatened to boost capital costs to an unsustainable level.
As for government’s fiscal policy, the fiscal expansion could disrupt the BOE’s ability to address inflation. Cutting taxes stimulates the economy and likely adds to inflationary pressure, thereby requiring a greater degree of monetary tightening. On the other hand, the energy subsidies will likely stifle inflation temporarily by halting the rise in prices paid by consumers.
The International Monetary Fund (IMF) urged the British government to “re-evaluate” its fiscal program and suggested that the new policy could intensify inflation. The IMF also said that “given elevated inflation pressures in many countries, including the UK, we do not recommend large and untargeted fiscal packages at this juncture. It is important that fiscal policy does not work at cross purposes to monetary policy.”
Aside from the IMF, there were direct or veiled criticisms of British fiscal policy from the US government, credit rating agencies, and private sector economists. Outside of the British government itself, it is difficult to find support for the current policy. The bigger issue, however, is what happens next. If the government reverses or eases its policy stance, then markets will likely calm down. If not, then the crisis could continue, with further downward pressure on the pound.
Is there any precedent for a British government roiling financial markets soon after taking office? Yes. In 1955, Anthony Eden, long-serving foreign minister under Winston Churchill, finally became prime minister and was seen as a steady hand who was likely to serve for many years. In 1956, however, his decision to participate in an invasion of the Sinai Peninsula, with the goal of restoring British control of the Suez Canal, led to a run on the pound. The US government only offered to help stabilize the pound if Britain would reverse course. It did, and by the end of 1956, Eden was ousted by his own party.
In the current crisis, an economic policy shift has led to a sell-off of government bonds and the pound, leading the BOE to step in. Yet unlike during the Suez Crisis, the intervention is not conditional. The United States only helped stabilize the pound after Britain agreed to remove troops from the Suez Canal. In this case, the BOE did not require the government to reverse course on its fiscal policy before it chose to purchase bonds. The risk, then, is that the government might feel that it can continue with an expansive fiscal policy because the BOE will effectively fund its largesse. Yet if the bank had failed to act, the crisis would likely have gotten worse.
So far, the government has been publicly unrepentant. As for the BOE, if investors start to believe that it will fund future government deficits, then the decision to purchase bonds could ultimately backfire, leading to renewed crisis. Thus, it is likely that the bank could only do this one time.
Investors evidently fear that a permanent increase in the budget deficit will likely crowd out private investment, reduce future fiscal flexibility, and undermine Britain’s competitiveness. Even those supportive of the notion that lower marginal tax rates are good for competitiveness suggest that tax cuts ought to be offset by other revenue enhancers or spending cuts, especially at a time of ruinously high inflation. Going forward, stability in British financial markets will depend on perceptions about the government’s commitment to fiscal probity.
Finally, the report found that the Federal Reserve’s favorite measure of inflation, the personal consumption expenditure deflator (PCE-deflator), remained high in August and that core inflation (which excludes the impact of volatile food and energy prices) actually accelerated in August. From the Fed’s perspective, this signals that inflation remains a serious problem and aligns with its evident determination to continue tightening monetary policy.
Meanwhile, home prices in the United States fell from June to July, according to the latest S&P Case Shiller report on home prices in 20 large US cities. Prices were down 0.8% from the previous month while still up 16.1% from a year earlier. The monthly decline was the first since 2019 and the biggest decline since 2012. This comes alongside other data indicating weakness in the US housing market, mainly due to a surge in mortgage interest rates. It also comes after a two-year period of stunning increases in US home prices.
Since Powell spoke, bond yields have gone way up, equities way down, and oil prices fell to the lowest since January. Evidently, investors have reassessed the risk of recession due to Powell’s words. Indeed, Powell no longer speaks about a soft landing for the US economy. Rather, he acknowledged that ending inflation might entail significant pain, including a significant rise in unemployment. Powell’s words were the first major statement since the last inflation report. That report had disappointed investors as it signaled more persistent inflation than had been expected.
Also, although bond yields are up sharply, breakeven rates (which measure bond investor expectations of inflation) have remained steady or are declining. This suggests that investors believe that the Fed will be successful in stifling inflation. Interestingly, the 10-year breakeven rate is now roughly the same as the five-year breakeven rate for first time since January 2021. This signals that investors now expect inflation to come down quite quickly and stay down, a measure of confidence in the Fed.
The belief that the likelihood of a US recession is higher than previously believed not only led to lower equity prices. It also led to a sharp decline in oil and other commodity prices. This will be helpful in suppressing global inflationary pressure. In addition, the rise in the interest rate gap between the United States and other countries led to a further sharp rise in the value of the dollar.
By country, consumer prices were up from a year earlier by 10.9% in Germany, 6.2% in France, 9.5% in Italy, 9.3% in Spain, 17.1% in the Netherlands, and 12% in Belgium. The highest inflation rate in the Eurozone was in Estonia at 24.2%. All three Baltic states had inflation in excess of 20%. The lowest inflation rate in the Eurozone was in France.
The ECB continues to tighten monetary policy. Its main policy tools are the short-term interest rate and the sale of bonds (which raises long-term bond yields). Both tools are meant to stifle credit market activity, thereby slowing the economy and removing inflationary pressure. Moreover, the goal is to anchor expectations of inflation to prevent a wage-price spiral. The inflation is mostly being driven by the political tug of war between Russia and the EU regarding the flow of natural gas. As such, the ECB lacks adequate tools to deal with the underlying cause of inflation. Thus, the possibility remains that the ECB will simply succeed in slowing an already at-risk economy while not necessarily having a big impact on inflation.
On the other hand, if natural gas prices peak and stabilize, or even fall, then the inflationary impetus from the energy crisis will abate and inflation should come down, especially if the economy weakens due to monetary policy. Regardless of the causes, ECB president Lagarde said that “we will do what we have to do, which is to continue hiking interest rates in the next several meetings.” Investors now expect a 75-bps increase in December.
Meanwhile, the natural gas crisis is getting more complicated. The Nord Stream pipeline was damaged in what NATO leaders are calling sabotage by Russia, although Russia denies complicity. For Europe, there is already substantial angst regarding the likely shortage of gas during the upcoming cold winter months. Russia likely wants to undermine European unity. This is starting to happen. Slovakia warned that the surge in gas prices could wreak havoc with its economy and called for help from the EU. How to fund such support, in turn, could become a controversial issue within the EU. The chief economist of the ECB suggested that member states boost taxes on the rich to fund energy subsidies for everyone else. He said that this would be a fair way to deal with the problem of high energy prices without causing a sharp increase in government debt.
Cover image by: Sylvia Chang