Not much, says Tony Yates – although that doesn’t mean it is entirely impotent
This essay is part of Tortoise’s File on Recession 2021. To see the rest of the File’s contents, please tap here.
What can the Bank of England do? The short answer is: not much. The United Kingdom’s central bank doesn’t have as much latitude as it has enjoyed in the past. We must simply hope that their intention is… “steady as she goes”.
This might sound strange to anyone who observed the Bank being given control of monetary policy in 1997. This was, in effect, meant to pass the problem of dealing with recessions over to the technocrats, with politicians having made a hamfisted job of it up to that point.
And now we face a particularly dreadful recession, brought on by the pandemic – or, rather, by our collective response to the pandemic. Surely this is precisely the Bank’s moment to shine?
But when you look at the options facing the governor of the Bank of England and his colleagues, you realise that they aren’t really options at all. Many of them are dead-ends.
Let’s start with the big policy of the last recession. The great financial crisis depressed demand so much that interest rates had to be cut to zero. After that, the Bank embarked on “quantitative easing” – creating new electronic money and using it to buy government bonds.
The Bank targeted longer-term bonds, which sometimes trade in lumpy, illiquid markets, and the intention was to make those markets more liquid, and raise the price of the bonds. This has the effect of squeezing the rate of interest paid on the bonds, and this, it was hoped, would then transmit itself into the interest rates that individuals pay on longer-term mortgages, or that companies pay when they borrow. This, the thinking goes, would then boost spending, employment and inflation.
In all the years since, quantitative easing was never reversed – and now the pandemic has swept away any idea that the £745bn sitting on the Bank’s balance sheet will be reduced in the near future.
The Bank could do more, but it may be that diminishing returns have set in: more quantitative easing might not lower longer-term interest rates through the steps we went through in the past – because those rates are already very low indeed. In this case, it wouldn’t be worth trying to do more to hammer down those rates by the last few tiny fractions of a percentage point.
Negative interest rates
But quantitative easing isn’t the end of the story. The Bank of England has been hinting that their interest rate options aren’t exhausted, after all. They are looking into whether interest rates could simply be set below zero, and (with some guidance about them not rising again soon) thereby pull longer-term rates down below zero, too.
Negative rates are a pretty odd idea. Normally, when you borrow from a lender, you expect to pay a positive interest rate. That is, not only are you in line to pay them back what they loaned you (the “principal”), you also give them something more on top – to compensate for the risk and inconvenience they took on by lending to you in the first place.
Whereas, with negative rates, we are talking about lenders paying borrowers to borrow! But it is not as crazy as it sounds. Many governments around the world are already being paid to borrow, as their bonds trade at prices that imply negative rates.
A reason for negative rates is storing wealth from one period to the next, particularly in forms that are very safe. Consider the demographics of emerging economies: more middle-aged, middle-class people means more saving, but those savings could be under risk from rapacious local regimes, so paying people – in the form of negative rates – to store your wealth suddenly makes some sort of sense.
As for the UK’s economy, the notion is that negative interest rates will do what low interest rates do, only more so – stimulating lending and spending. So why has the Bank not gone below zero before? Why are we only hearing now that the views of some members of its policy-making board might be changing?
The answer, in part, is that traditionally the floor for central bank interest rates was thought to be roughly zero because that is the interest rate on cash. If the Bank of England tried to push the rates it offered to banks below zero, the banks themselves could not follow because their depositors would switch into the now-more-attractive cash. This process would shrink – or “disintermediate” – banks’ balance sheets at a time when we really need them to lend to struggling businesses.
But now it’s thought that the situation is not that simple. After all, banks offer lots of convenience to us. Digital payment services make many transactions quicker and cheaper than they would be if cash had to be physically carted about and exchanged. They are safer and more reliable, too.
This means that it is possible that pushing central bank rates below zero will allow banks to follow suit without causing a rush to cash. We don’t really know how low the real floor for rates is, but it might be as much as a half to one percentage point below zero.
This all sounds promising, but, in truth, the effects of negative interest rates could be quite marginal: there is no guarantee that negative Bank of England rates would transmit fully through to the rates people borrow at. Going below zero would therefore not drastically alter the calculation that the government has to make about how much fiscal support to pump into the economy.
What’s more, there are longer term worries – expressed by economists such as John Cochrane – about whether negative interest rates might spur innovation in other means of payment, such as advanced payment cards and private digital currencies.
“Innovation” may sound like a good thing – and, in some ways, it might be. But it could also undo the effect of the interest rate cut, and create a small but tangible risk of people moving out of our currency, meaning that we lose control of monetary policy altogether.
The term “monetary financing” tends to spark either hope among those of those tired of the current institutional shackles on monetary policy, or terror among those of a more conservative bent who fear another Weimar Republic or Zimbabwe. Neither response is appropriate.
In fact, forms of monetary financing are already in place. In March, the Bank extended an overdraft facility that the Treasury has with it – known as the “Ways and Means’ account – up to £20 billion, as a backup for funding the coronavirus support measures.
When this account is used, the Bank of England is literally creating new electronic money out of thin air. And the government then spends it.
Governments that have careened down this route do end up creating hyper-inflation. As more money chases the same amount of goods, prices rise; this inflation causes demand for the money to fall, so prices rise further; and the end result is wheelbarrows full of cash and paper shortages and widespread immiseration.
The key thing is whether the Bank’s policymakers are letting the government do good or bad monetary financing. Good monetary financing is what needs to happen for the Bank’s monetary policy objectives – the inflation target, stability in the real economy – to be achieved. The bad sort is when concerns about inflation are simply shoved to one side.
Like any overdraft, monetary financing is supposed to be temporary and eventually reversed. Seeing whether this happens or not will help to inform our eventual judgement on the Bank and the government – were they doing the right thing or not?
The second wave of Covid-19 means that more fiscal support is going to be required. As this week’s Tortoise Slow Newscast demonstrated, even former deficit hawks such as Mervyn King, the former governor of the Bank of England, are of this mindset. So the Bank needs to stand ready to provide more monetary financing.
Another consideration: the government’s “bounce back” loans to troubled businesses are unlikely to be paid back in full; and the banks themselves may get into difficulty because of loans they themselves made to businesses that are now distressed. Both problems could ultimately mean more government borrowing and more temporary use of the Bank of England balance sheet to sort it.
A new target
The last 20 years have taught us that the state can rack up quite a lot of debt without the markets getting queasy. Indeed, we shouldn’t be afraid when the national debt surpasses the size of our national income – as it has now.
But there are limits both on borrowing and on what we should be prepared to borrow. Future generations will have their own disasters to fight, and we have to preserve fiscal space for them. There will have to be a reckoning over the debts accrued during the pandemic.
This reckoning can happen slowly, with some tax rises and some growth. But it may also happen with some inflation, too. The Bank of England’s current two per cent target was built for different times, and it is not macroeconomic heresy to suggest that, at least for a while, it might be surpassed. Many of us have suggested it could be raised permanently, to something like four per cent, for different reasons.
So while nothing the Bank can do now will make a huge difference, it is still in a position to help the government provide fiscal support throughout the crisis and to ease the fiscal burden once the crisis has passed. It should do this – and almost certainly will.