Monetary Policy Post Brexit: More Of The Same And Why It Will Not Work

Desmond Cohen

The UK (and maybe the world) faces severe and worsening economic conditions due to Brexit. Many commentators do not seem to understand that there are time lags in the economy’s response to Brexit and that it is far too soon to assess its probable impact. In its latest Inflation Report the Bank of England, however, sets out its analysis of the negative effects of Brexit, announcing changes in monetary policy. It concludes: ‘The outlook for growth in the short to medium term has weakened markedly…[with] a downward revision of the economy’s supply capacity….and eventual rise in unemployment’.

The Bank predicts little growth during the second half of 2016 with further declines in business investment (already falling pre-referendum) and weaker levels of personal consumption. Against a background of continued weakness in the balance of payments where in Q1 of 2016 the current account deficit was 6.9% of GDP and likely to worsen further in the coming months owing to the 10 per cent decline in Sterling. Indeed the fall in the exchange rate will have an impact on disposable real income due to rising import prices and their effects on domestic costs of production, depressing domestic consumer expenditure. Whether there will be much if any pick-up in export volumes will depend critically on what set of trading relationships are established post Brexit and whether any rise in external demand is forthcoming as a result of the sterling depreciation.

Given this economic scenario what has the Bank proposed? In summary it is the following:

The Bank of England’s Monetary Policy Committee (MPC) sets monetary policy to meet the 2% inflation target, and in a way that helps to sustain growth and employment. At its meeting ending 3 August 2016, the MPC voted for a package of measures designed to provide additional support to growth and to achieve a sustainable return of inflation to the target. This package comprises: a 25 basis point cut in Bank Rate to 0.25%; a new Term Funding Scheme to reinforce the pass-through of the cut in Bank Rate; the purchase of up to £10 billion of UK corporate bonds; and an expansion of the asset purchase scheme for UK government bonds of £60 billion, taking the total stock of these asset purchases to£435 billion. The last three elements will be financed by the issuance of central bank reserves.

What is one to make of these proposals? Inflation is not a problem although the effects on prices from the fall in sterling against other currencies will eventually feed through into costs and prices. More worrying for future levels of inflation is the impact of Quantitative Easing (QE) where a further expansion of £60bn is proposed on top of the enormous increases since 2009 – taking the total to £435bn. Furthermore the purchase of corporate bonds and the new Term Funding Scheme to reinforce the cuts of Bank Rate to 0.25% will also add to domestic liquidity. The effects of all this monetary easing are totally unpredictable and the Bank’s rationale unconvincing.

On QE the Bank has written that, ‘cash injections lower the cost of borrowing and boost asset prices to support spending and get inflation back on target’. It may do to a degree but does one really believe that the economic benefits derived through changes in asset prices are worth the potential future cost in terms of inflation? QE has certainly been a major factor in house price inflation where the cost of housing (both to buy and to rent) is massively out of line with incomes, with all sorts of negative externalities (including increasing rates of homelessness and greatly increased government expenditure on housing support). No one (apart perhaps from the Bank) really believes that a worthwhile expansion of domestic demand is feasible and desirable through the wealth effects of rising asset prices. If one wants to boost domestic expenditure so as to increase demand then fiscal policy is surely the preferred instrument.

The other key change is the further reduction in short-term interest rates which were already at historically low levels. A further cut of 0.25% is unlikely to lead to any increase in long-term business investment which has been generally depressed since the financial crisis of 2008/9.. Indeed there is doubt about whether the cuts in Bank Rate will be passed on by financial institutions – now the rationale for the new Term Funding Scheme.

Financial institutions are much more likely to pocket the cut in Bank Rate rather than pass it on to their customers – both business and private. After all, QE itself puts downward pressure on bank profits and to a degree is not at all welcomed by financial institutions including insurance companies and pension funds. Both of these are facing severe financial problems directly as a result of current monetary policy, with many pension funds experiencing severe deficits and increasingly exploring risky investment strategies.

Another key question is how will households respond to the cut in Bank Rate if this in part is passed on in lower lending rates. Here there is also great uncertainty in part because falling output will further depress employment and rising import prices will directly and indirectly impact on real disposable incomes via the 10% fall in sterling. These depressive forces will be strengthened by the impact of even lower interest rates on savings which are already so low as to have adversely affected incomes, especially of pensioners.

The Bank argument that falling interest rates will lead to dissaving looks very unconvincing. Even more worrying is the effect of continued extremely low interest rates on the whole culture of savings in the medium- to long-term since it must surely be an objective of policy to encourage savings for retirement rather than have these costs fall on the state. Current policies have had significant distributional effects since the continuing low interest paid to savers has in effect subsidised borrowers,

Also imponderable is how will personal borrowers respond to yet another cut in short-term interest rates – whether there will be a greater demand for both secured (mainly mortgage debt) and unsecured credit (on bank cards and so on). The last thing the Bank surely wants to encourage is yet further speculation in housing funded by lower interest rates.

Many households since 2009 have been encouraged by low interest rates on mortgages and their plentiful supply to take on large amounts of additional debt so that the ratio of mortgages to income is now extremely high. Any increases in interest rates are thus likely to cause immediate problems with repayments and thus lead to possibly catastrophic falls in house prices. This is a potentially significant effect of any shift in monetary policy away from low interest rates.,

How about unsecured borrowing? Total unsecured debt in the UK by households (excluding mortgage debt) rose by £48bn in 2012-2015 to £353bn in 2016. So during the years after the financial crash when personal incomes were squeezed and real wages fell in the UK households responded by taking on additional debt. The scale of the problem is such that a report by the TUC (Britain in the Red) found the following:

Overall, 11 per cent of households holding any form of unsecured debt are estimated as over-indebted in 2015, more than double compared to the 5 per cent in 2012. Of the over-indebted households, half are extremely over-indebted and so paying out more than 40 per cent of their income to their unsecured creditors).In total, 3.2 million households or 7.6 million people are over-indebted, an increase of 700,000 or 28 per cent since 2012. On this basis nearly one in eight of all UK households are currently over-indebted). Likewise, 1.6 million households are in ‘extreme debt’.

If it is highly undesirable to encourage yet further borrowing by a personal sector that is already highly leveraged, where is the domestic demand growth going to come from if the economy is not to enter a deep recession? We have seen that the business sector faces such uncertainly and such weak demand growth that firms will not seek to expand their stock of fixed assets. Monetary policy under present conditions mirrors exactly the state that Keynes wrote about in the General Theory where there exists a ‘liquidity trap’ such that easing monetary conditions simply leads to the holding of excessive balances and a weak demand response (at best).

Key Policy Choices for the UK

What needs to happen?

Firstly, the British Government needs to make it clear now that it will seek a permanent and ongoing trading relationship with the EU that as far as possible retains the existing set of arrangements. Anything else will leave the economy floundering in a world of uncertainty that will lead to falling output and rising unemployment. The referendum has already worsened economic performance and policy needs to be re-set so as to sustain output and employment.

Secondly, Government needs to re-establish growth through a fiscal and industrial strategy that meets the needs of the country rather than one which is ideologically based. If UK is to compete in a globalised world then it needs public investment in both infrastructure and in human capital. It is precisely at a time of historically low interest rates that Government should expand its investment expenditure, through borrowing mainly and through higher taxation on the top 1%. So there is no choice but to invest in skills, training and education if UK is to remain a major trading country.

Finally, the argument that increasing the public debt will be inflationary has been shown to be a fable (see Robert Skidelsky, ‘The Scarecrow of National Debt’). During the period of the Cameron government fiscal policy was a significant drag on the economy – totally unjustified in terms of constraints in financing borrowing in the capital markets. One consequence of neo-liberal fiscal policy was a major cutback in the level of public investment that is so essential for supporting investment by the private sector.

Conclusions: Policy Choices for Europe

It is evident that special factors flowing from the decision on Brexit affect British economic policy and hence the recent monetary policy changes identified above. But the UK is not alone in having relied on monetary instruments to stabilise its economy after the financial crisis of 2008. Both the US Federal Reserve and the European Central Bank have pursued a similar path and all the key Central Banks now face the same set of problems. In the UK a policy of fiscal austerity was imposed by Government whereas the Eurozone countries were required to operate within the discipline of the so-called Stability Framework. The latter restrained the use of fiscal policy as an instrument of economic stabilisation and as a result many countries in the euro zone have had years of anaemic growth and high levels of unemployment

The key question now facing all of the Central Banks is how to re-establish more normal monetary conditions and when to do so. Clearly at some point rates of interest will have to be ‘normalised’ but how to bring this about and what levels should be established are matters of judgement. The attempt by the Bank of England recently to establish a new lower rate of interest was largely frustrated because insurance companies and pension funds in particular did not want to exchange existing holdings of government debt for cash. Currently the Bank of England and the European Bank are holding huge stocks of debt that they have purchased and in order to push up interest rates they will have to sell this debt with capital losses. It is by no means obvious what this means nor how Central Banks will manage these changes to their balance sheet.

Perhaps more important are the effects on economic and social systems of moving to higher levels of interest rates in the near future. In part Central Banks have been using rate changes as a means of influencing their exchange rate – a beggar-my-neighbour policy that is generally condemned but doesn’t prevent countries from doing it. Shifting to higher interest rates might cause widespread distress especially where households (and to a degree companies) have borrowed extensively. There would also be widespread economic disruption in the Eurozone if higher interest rates were to be established. Given the already high levels of unemployment in Italy, Spain, Portugal and France any further fall in demand caused by higher interest rates would be disastrous.

Larry Summers asks whether the US and Europe are facing a set of structural conditions where for years to come output and incomes will grow much more slowly than in the past (see ‘Secular Stagnation and Monetary Policy’). A similar set of predictions was made during the Great Depression of the 1930s but the expected impact never materialised – in large part because of the recovery in demand associated with re-armament. It was this injection of war-related demand that made it possible for economies to escape from the Keynesian ‘liquidity trap’. Many countries are now locked into such a trap and it is not at all clear how they exit and what role monetary policy needs to play. Clearly there is no case for the current fiscal straightjacket that the UK and the Eurozone have imposed on themselves and the case for injecting demand through budgets has been made by many eminent economists. But this is new territory for central bank governors and for treasuries across Europe and the USA – there is no roadmap . Trial and error will be the way forward but current monetary and fiscal policies certainly need to be re-visited and reformed.