Carney acts, Chancellor delays a vital stimulus

I have been taken to task by a follower of @DHIMusings on Twitter who thought my last blog post heralding the belated arrival of the silly season was “infra dig.”

Perhaps I spoke too soon – the following week the Bank of England cut interest rates to a record low of 0.25% and announced a further £70 billion of “quantitative easing.” Not the usual August news. Gone are the days when a stockbroker could safely “sell in May and go away.” Now economics, like politics and the football season, hardly seems to take a summer break at all.

The Bank’s move was in response to a forecast weakening of growth after the Brexit vote, which some have predicted could push the UK into recession. Both actions are designed to achieve the same result – stimulating the economy by making it cheaper to borrow. The rate cut does this directly – commercial banks get less interest on their deposits with the central bank and are therefore more likely to lend the money to consumers and businesses to get a higher return.

The £70 billion, conjured out of the air by the Bank, will be used to purchase “gilts” – Government bonds – from banks and other bonds from large companies. This extra money will push up gilt and bond prices, so reducing the yield – the amount of interest paid on them – with a knock on effect throughout the debt markets.

Or at least that is the theory. The evidence suggests that these policy moves are not as potent as the theory would suggest. Interest rates have been at a historic low of 0.5% for five years and the latest round of QE comes on top of £375 billion of new money created by the Bank, yet the UK has experienced a weak recovery from the recession caused by the 2008 financial crash.

The experience of other central banks has been similar. They have slashed rates and pumped huge sums into their economies with only modest effects on growth rates.

Some have gone much further than Britain, cutting rates below zero. Commercial banks and others obliged to keep deposits at the central bank are charged for the privilege. This has led to some bizarre consequences, such as the regional government of the prosperous Swiss canton of Zug encouraging its citizens to delay paying their taxes so that it can reduce the penalties it pays on holding cash on deposit.

The UK is unlikely to follow suit. Governor Mark Carney has given a strong hint that the Bank of England will not resort to negative rates and the experience of other countries suggest he is right to be sceptical of their effectiveness. No major economy is exactly roaring away, despite these extreme monetary measures.

There seem to be two reasons for this. Firstly, confidence is low. Excess debt piled up in the boom years, wars, natural disasters and political uncertainty have weakened the willingness of consumers to spend and companies to invest. Families do not spend when they fear their incomes may fall because of unemployment or short-time working and firms do not increase capacity if they cannot see stronger markets for their goods and services. Low interest rates are not enough to overcome these concerns.

But also governments have been working against their own central banks. Instead of reinforcing the stimulus measures by cutting taxes and increasing spending, they have practised austerity, citing the need to reduce deficits.

In the UK one of George Osborne’s first acts as Chancellor was to increase VAT to 20% and to announce the first in a series of spending squeezes, which have restrained demand in the economy.

Mark Carney has drawn attention to the limits of monetary policy (interest rates and the money supply, which central banks control) to stimulate economies without the support of fiscal policy (taxes and spending, which are the preserve of governments.) Even with its latest move, the Bank’s forecast for the economy is not encouraging. In the short term it expects higher unemployment, falls in house prices and household incomes, and a rise in inflation. It believes growth will be flat in the second half of this year.

One of Theresa May’s first acts as Prime Minister was to abandon George Osborne’s pledge to balance the budget before the next election. In doing so she has given Philip Hammond, the new Chancellor, the scope he needs to “reset” economic policy (his own term).

His initial thought was to wait until the Autumn Statement, which usually comes in November, before acting. If the economic news continues to be poor there may be a case for acting earlier and introducing a package of measures to boost confidence, consumption and investment.

This blog from the David Hume Institute is reproduced here with permission

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