Brexit: What’s a central bank to do?
We are in an unprecedented time for central banking. Ever since the financial crisis, and the shaky recovery therefrom, central bankers have experimented with increasingly unorthodox mechanisms to kick-start economies back into growth-gear.
In this period of uncharted central banking policy, and as we enter a renewed period of economic uncertainty ushered in by Brexit, the problem central bankers now have to answer is how to respond given that a) several unconventional post-2008 policy answers (e.g. Quantitative Easing, negative interest rates etc.) have met with mixed success, and b) having exhausted some of these avenues, what alternative stimuli might be available.
Focussing on the Bank of England (BoE), the first, and most traditional, monetary lever it’s likely to pull is to reduce interest rates to kick-start borrowing and spending. Whilst the Bank confounded expectations by declining to reduce interest rates at July’s Monetary Policy Committee meeting, it did make suggestions that it may lower interest rates as soon as August.
The challenge in the current context however is that low interest rates may simply divert savers and investors into alternative vehicles, potentially fuelling asset bubbles in areas over which the BoE has already consistently expressed concern (e.g. housing). Second, interest rates and currency valuations go hand in hand. With GBP at one point falling to a 31 year low against the dollar and a host of other currencies, currency devaluation via further interest rate reductions is not something the Bank will want to amplify. Finally, and crucially, interest rates don’t really have much room to go lower. That means that the Bank is not only constrained in its application of this policy lever, but also that by cutting rates too low it risks having exhausted its first option in the event of a further downturn.
The second, more modern lever, is Quantitative Easing (QE), sometimes referred to as “injecting liquidity”. There are several technical and theoretical ways in which QE should boost the UK economy (covered here) and as such, since 2009, the BoE has engaged in £375bn of QE, primarily through the purchase of UK Government Bonds (“gilts”). Following the Brexit vote however, Mark Carney announced that “the Bank of England stands ready to provide more than £250 billion of additional funds through its normal facilities”1, signalling the Bank’s willingness to expand the QE regime to combat any Brexit imposed malaise. However, whilst QE sounded rather nice in theory when it was introduced, as with so much in economics, the reality has been a little different. In fact the broad consensus is that QE has been largely ineffectual (not just in Britain but globally) since it was first introduced to Anglo-America (Japan had already had a dalliance with QE in the early 21st century) post-financial crisis.
Given the shortcomings in the above two policy levers, the Bank is looking for alternative options. Hence their third, and newest, response to stimulate the UK economy is to relax the requirements on UK banks to hold a “countercyclical capital buffer” (CCyB). This buffer, which, until the 5th July, was equivalent to 0.5% of UK bank’s “exposures” (RWAs) was designed to require banks to hold more capital in periods of “excessive credit growth”. This was to protect against unforeseen losses arising from rapid expansion in credit, which is usually accompanied by a corresponding decrease in average credit quality. On Tuesday, when the BoE reduced the CCyB requirement from 0.5% to 0%, approximately £5.7bn was tied up on UK bank’s balance sheets in CCyBs. Based on current UK leverage ratio requirements, this means that UK banks were essentially freed up to lend up to an additional £150bn of funds to UK businesses and individuals.
But is this wise?
First off, this action may be somewhat premature. As yet there is no concrete data to suggest that the UK economy is tipping back into recession, and thus the Bank may have jumped the gun in trying something new. Secondly, and somewhat perversely, within its financial stability report published on the same day, the BoE revealed concerns that highly leveraged households might struggle to repay increasing levels of debt. What’s more, the BoE revealed in its February 2016 Credit Conditions Survey that the annual growth rate of UK consumer indebtedness had hit 9.3%, the highest pace since December 2005. This sounds a lot like the “excessive credit growth” the CCyB was explicitly designed to mitigate against. Finally, with the total stock of UK household debt at “unprecedented” (according to the OBR) highs, and gross savings now lower than during the financial crisis (according to Barclays), any sudden economic downturn could lead to swathes of defaults, and trigger a new economic and banking crisis.
Ultimately, what you will notice about all three responses is that they depend to a large degree on the expansion of credit, and hence debt, to fuel spending. But we cannot pay our way out of any impending recession on a foundation of debt; we’ve already built the modern economy and the post-crisis recovery on a mountain of it. No, the problems the BoE is trying to solve go far deeper, and potentially both far beyond their remit and consequently their ability, to solve.
It’s been said that “the job of the Central Bank is to worry”. As traditional BoE policy responses prove increasingly ineffectual, and with more modern alternatives yet to be proven, in the event of a new downturn, they may find that’s all they’re able to do.
- Some of this additional liquidity will come in the form of liquidity auctions, where banks bid for cash from the BoE directly, rather than being exclusively QE.