MPC sends in the plumbers

10 August 2016

The package of measures that the Bank announced last week was not designed by Mark Carney. Most of this will have had to have been explained to him, as to the rest of us. Last week’s announcement marks the shift of power from the MPC to the backroom staff, who have some understanding of how the plumbing works – or doesn’t. The arrival of the plumbers is to be welcomed, but it has little or nothing to do with the risks to the UK economy from Brexit. Brexit has become the excuse to “do something” rather than just “standing there”.  
Financial markets are captivated by the redefinition of the lower bound for Bank Rate, long held to be the 0.5% that had prevailed since March 2009.  According to deputy governor Ben Broadbent, there is scope for Bank Rate to fall to about 10 basis points, but not below zero. However, it is the complexity of the announcements that Bank of England’s MPC made last week that is their striking feature. An alphabet soup of facilities and provisions speaks volumes about the urgent need to unblock the pipes of monetary transmission.
The irony contained in the package of measures is that some of the emergency plumbing issues are aggravated by the cut in Bank Rate. This is like your doctor prescribing one pill for your condition and three pills to counteract the known side effects of the first pill. The Bank of England continues its love-hate relationship with the commercial banks. Love, because the central bank knows that it cannot ease monetary conditions comprehensively without the help of the banking network. Hate, because the central bank has not forgiven the banks for leveraging their balance sheets to the hilt into the financial crisis and then crying “Uncle!”, or, in this case, “Auntie!”
If the cut in Bank Rate is fully passed on to borrowers and savers, it will cut bank profitability and make banks less willing to lend. Relaxations in the leverage ratio framework are designed to counteract this potential damage. If the cut in Bank Rate is applied more consistently to savers (First Direct has cut its cash ISA rate by 40 basis points, for example), than to borrowers, then bank profitability will be protected but the economic impact will be neutral, or worse.
Bank regulation is the key issue here. The onerous requirements of Basel 3 have significantly worsened the risk-reward trade-off for bank lending to the private sector. This remains the binding constraint on the transmission of low interest rates to the economy, and why most mortgage borrowers still have to pay a rate of around 4% even Bank Rate is 0.25%. A fat spread is also necessary to allow banks to deal with their ‘legacy issues’ – the ongoing parade of fines and penalties inflicted on the banks for their actual and alleged misdemeanours.
At the back of it all, there are tens of billions of pounds of bank loans that will never be repaid unless nominal values – incomes and expenditures at current prices – are greatly inflated. The health of the banks and the performance of the economy cannot be restored without first enduring a significant burst of inflation.

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