Bank of England – Page 11 – Digital Finance Analytics (DFA) Blog

Contagion In A Finance-Connected World

Interesting speech from Kristin Forbes, External MPC Member, Bank of England “Global economic tsunamis: Coincidence, common shocks or contagion?”

She explores why countries are sometimes highly vulnerable to major events that occur outside their borders, while at other times seem fairly immune. Why do some negative events turn into global tsunamis – while others are just local ripples? Here are some extracts. The full analysis however is worth reading. It highlights the significance of markets that are more globally linked than ever before.

Consider 2 major periods of stress in the global economy: the Asian Crisis (1997-98) and the Global Financial Crisis (2008-2009).

Figure 3 shows equity indices during these events for the region/country where the stress originated (in red), plus other major country groups. The Asian Crisis corresponded to sharp falls in equity indices for the Asian economies under stress (not surprisingly). These falls were mirrored (albeit to a lesser extent) in the advanced economies outside the euro area, but seemed to have minimal effect on other emerging markets. The euro area seemed immune to the Asian wave, with sharply higher – instead of lower – returns. In contrast, the Global Financial Crisis sharply affected equity indices not only in the US, but in all country groups. The equity indices for all groups are basically on top of each other for almost a year from June 2008; the Global Financial Crisis is aptly named and was clearly a global tsunami.

Did these disparate spillovers in equity markets correspond to similar patterns for what people in these countries care about most – real incomes and growth? Figure 4 shows GDP growth to answer this question. The Global Financial Crisis continues to merit its name – corresponding to precipitous and simultaneous declines in growth in each region, followed by simultaneous rebounds. Patterns during the Asian Crisis, however, are quite different than for equity markets. GDP growth in the advanced economies is stronger and more stable than implied by the falls in this group’s equities. GDP growth in the other emerging markets is more negatively affected than implied by the relative stability in their equity markets. And growth in the euro area is middle of the pack – showing none of the outperformance suggested by the region’s strong equity returns.

This lecture attempts to better understand these different patterns of global spillovers – especially during periods of economic stress. It addresses a number of questions. Why do economic tremors in one country sometimes evolve into devastating tsunamis in others – and sometimes fade into small ripples? When do international spillovers in financial markets also harm incomes and economic growth? How have these relationships evolved over time? And perhaps most important, how can countries create ‘tidal breaks’ against these powerful waves originating outside their borders?

The results have important implications for investors. I’ll show you that equity markets around the world move together much more closely now than in the past. This makes it more difficult for investors to diversify their portfolios and to generate returns through ‘alpha’ (differentiating oneself from average market movements). I will also provide some insights on why this has been happening and what to watch to predict when these patterns change. A common, global factor has been playing a more important role in causing markets to move together. This is affected by changes in global risk sentiment, commodity prices, and changes in US monetary policy, with events in China recently playing a more important role. Particularly striking, equity markets around the world seem to all respond in more similar ways than in the past to these global factors. It is as if they are all now sailing in the same type of boat.

This analysis also has important implications for policymakers. Policymakers are continually concerned that negative shocks originating abroad will spread to their own shores. This analysis helps understand when this concern is more likely to become a reality – and exactly what to be concerned about. It shows that sharp reactions in financial markets should be put into context. These movements certainly matter – but the international spillovers to growth and incomes tend to be much smaller than in financial markets. For policymakers concerned about supporting and stabilizing domestic incomes in the face of these external waves, this is good news. The waves emanating from abroad in financial markets can be imposing – and do have important domestic effects – but these effects on the real economy are usually more muted.

Finally, and perhaps most important, although policymakers can usually do little to stop the events that generate waves abroad, they should not despair. Certain policies can make a country more resilient. Steps such as reducing leverage and strengthening banking systems can mitigate the effects of dangerous international waves.

She concludes: There are some periods and regions where GDP growth rates do move more in sync, however, such as during the Global Financial Crisis and today in the euro area. Moreover, movements in financial markets will have important effects on incomes and growth over time, especially if they persist. When do countries become more synchronized? The analysis here suggests that common shocks play an important role, especially changes in global risk measures, global commodity prices, US monetary policy, and more recently changes in China’s economic outlook. Contagion (when the bad news originates in a specific country or countries) has also played a role, but has been less important than global events in driving the increased synchronization in equity markets over time. Perhaps most important, countries worried about the effects of these common shocks and contagion need not despair. Steps such as reducing bank leverage and strengthening financial systems appear to be powerful in terms of increasing their resilience to these adverse winds blowing from abroad.

UK Bank Rate Unchanged in September 2016

The UK Bank Rate was held at 0.25%, government bond purchases at £435bn and corporate bond purchases at up to £10bn. Inflation remains well below target and business investment weak.

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 on 14 September 2016, the MPC voted unanimously to maintain Bank Rate at 0.25%. The Committee voted unanimously to continue with the programme of sterling non-financial investment-grade corporate bond purchases totalling up to £10 billion, financed by the issuance of central bank reserves. The Committee also voted unanimously to continue with the programme of £60 billion of UK government bond purchases to take the total stock of these purchases to £435 billion, financed by the issuance of central bank reserves.

The package of measures announced by the Committee at its August meeting led to a greater than anticipated boost to UK asset prices. Short and long-term market interest rates fell notably following the announcement; corporate bond spreads narrowed, and issuance was strong; and equity prices rose. Since then, some of the falls in yields have reversed, driven by somewhat stronger-than-expected UK data and a generalised rise in global yields.

Many banks announced cuts in Standard Variable Rate and Tracker mortgage rates in line with the cut in Bank Rate. Deposit rates fell in August, although on average these falls were slightly smaller than the cut in Bank Rate. Fixed rates on new mortgage lending also fell.

Overall, while the evidence on the initial impact of the policy package is encouraging, the Committee will monitor closely changes in asset prices and in interest rates facing households and firms and their effect on economic activity.

The MPC set out its most recent detailed assessment of the economic outlook in the August Inflation Report. Based on the data available at that time, the Committee judged that the UK economy was likely to see little growth in the second half of 2016. In light of the tendency for survey indicators to overreact to unexpected events, the Committee expected some bounce-back in surveys of business and consumer sentiment following the sharp falls in the immediate aftermath of the vote to leave the European Union. Nevertheless, since the August Inflation Report, a number of indicators of near-term economic activity have been somewhat stronger than expected. The Committee now expect less of a slowing in UK GDP growth in the second half of 2016.

It was more difficult to draw a strong inference from these data about the Committee’s projections for 2017 and beyond. Moreover, there had been no new information since the August Inflation Report relevant for longer-term prospects for the UK economy.

In the August Inflation Report, the Committee judged that some parts of the economy would be more sensitive than others to heightened uncertainty. Business and housing investment were expected to decline in the second half of 2016, while consumption growth was expected to slow more gradually, alongside households’ real disposable incomes. While most business investment intentions surveys weakened further since the August Inflation Report, the near-term outlook for the housing market is less negative than expected and the indicators of consumption have been a little stronger than expected. Overall, these data remain consistent with the Committee’s judgement in the August Inflation Report that business spending would slow more sharply than consumer spending in response to the uncertainty associated with the United Kingdom’s vote to leave the European Union.

Data on global economic activity have generally been in line with the Committee’s August Inflation Report projections, with growth in the United Kingdom’s major trading partners expected to continue at a modest pace over the next three years.

Twelve-month CPI inflation remained at 0.6% in August, lower than projected at the time of the August Inflation Report, and well below the 2% inflation target. As the unusually large drags from energy and food prices attenuate, CPI inflation is expected to rise to around its 2% target in the first half of 2017, consistent with the August Inflation Report, albeit with the projection a little lower over the remainder of 2016 than had been anticipated in August.

The Committee’s view of the contours of the economic outlook following the EU referendum had not changed. News on the near-term momentum of the UK economy had, however, been slightly to the upside relative to the August Inflation Report projections. The Committee will assess that news, along with other forthcoming indicators, during its November forecast round. If, in light of that full updated assessment, the outlook at that time is judged to be broadly consistent with the August Inflation Report projections, a majority of members expect to support a further cut in Bank Rate to its effective lower bound at one of the MPC’s forthcoming meetings during the course of this year. The MPC currently judges this bound to be close to, but a little above, zero.

Against that backdrop, at its meeting ending on 14 September, MPC members judged it appropriate to leave the stance of monetary policy unchanged.

Monetary versus macroprudential policies

Monetary policy, as currently being implemented, is failing to deal with the current raft of economic issues, including low inflation, stagnant wage growth, high asset prices and ultra low policy rates. When coupled with politicians taking a back seat and their inability to tackle the core issues, macroprudential measures are being tried, in a massive real-time experiment. This coupling of monetary and macroprudential action is largely untested. Can they work in tandem?

A Bank of England working paper “Monetary versus macroprudential policies causal impacts of interest rates and credit controls in the
era of the UK Radcliffe Report“, attempts to look at this issues, with some interesting results. They conclude that macroprudential policy is better suited to achieving financial stability goals than monetary policy.

The Global Financial Crisis and its disappointing aftermath are widely viewed as a major macroeconomic policy disaster from which lessons must be learned. Yet agreement on the precise failures and, thus, the necessary lessons, has been elusive in many areas, from mortgage regulation to fiscal policy, and from global imbalances to central banking. In the latter case, the role of macroprudential policies remains fraught, with doubts about whether they should exist, if they work, and how they should be designed and used.

Reflecting this range of skepticism, several countries have recently taken quite varied courses of action in retooling their policy regimes since 2008. For example, facing a heating up of their housing markets in 2010–12, Sweden and Norway took quite different policy actions. Sweden’s Riksbank tried to battle this development using monetary policy tools only, raising the policy rate, and tipping the economy into deflation, as had been predicted by the dissident Deputy Governor Lars Svensson, who subsequently resigned. Across the border, the Norges Bank implemented some cyclical macroprudential policies to crimp credit expansion and moderate mortgage and house-price booms, without relying as much on rate rises, and they managed to avoid such an out-turn. Elsewhere, other countries display differing degrees of readiness or willingness to use time-varying macroprudential policies. The Bank of England now has both a Financial Policy Committee and a Monetary Policy Committee, and the former has already taken macroprudential policy actions under Governor Mark Carney. As Governor of the Bank of Israel, Stanley Fischer utilized macroprudential policies against perceived housing and credit boom risks, but now as Vice-Chair at the Federal Reserve his speeches lament the lack of similarly strong and unified macroprudential powers at the U.S. central bank. Yet as one surveys these and other tacks taken by national and international policymakers, two features of the post-crisis reaction stand out: the extent to which these policy choices have proved contentious even given their limited scope and span of operation, and the way that the debate on this policy revolution has remained largely disconnected from any empirical evidence. And of course, the two features may be linked.

This paper seeks a scientific approach that might address both of these shortcomings, by bringing a new and vastly larger array of formal empirical evidence to the table. To that end, we turn to the last great era of central bank experimentation with the same types of macroprudential instruments: the postwar decades from the 1950s to the early 1980s when many types of credit controls were put in play. We go back and construct by hand new quantitative indicators on the application of such policies in the UK, including credit ceilings, hire purchase regulations, special deposits, and the “Corset.” To evaluate the impacts of these policies, and to compare them with the impacts of the standard monetary policy tool of Bank Rate, we then implement a state-of-art econometric estimation of impulse-response functions (IRFs) to the two policy shocks by developing a new approach to identification that is also original to this paper, one that we shall refer to as Factor-Augmented Local Projection (FALP). Our approach unites the flexible and parsimonious local projection (LP) method of estimating IRFs with the Romer and Romer approach of using forecasts to mitigate the selection bias arising from policymakers acting on their expectations of future macroeconomic developments. To ensure greater robustness, we also borrow from the factor augmentation approach that has been employed in the VAR literature as a means to control for other information correlated both with changes in policy and future macroeconomic developments. We subject our results to a range of robustness tests, most of which give us little reason to doubt our main results.

We report three main results. First, we find that monetary and credit policies had qualitatively distinct effects on headline macroeconomic indicators during this period. Increases in Bank Rate had robust negative effects on manufacturing output, and consumer prices especially, and positive effects on the trade balance. However, the estimated response of bank lending to an increase in Bank Rate is not statistically significant. By contrast, we find that credit controls — liquidity requirements on banks, credit growth limits, and constraints on the terms of consumer finance — had a strong negative impact on bank lending. We also find some evidence that credit policies may have depressed output, improved the trade balance, and led to an increase in consumer prices. But our evidence here is less strong than for corresponding shifts in Bank Rate. Overall, our estimates suggest that monetary and credit policies spanned different outcome spaces during this period. This result supports the notion that today’s macroprudential tools, which are close cousins of the credit policies studied in this paper, might provide the additional independent tools required to help central banks meet both their monetary and financial stability objectives.

Second, we find that our estimated monetary and credit policy shocks were major drivers of macroeconomic dynamics over the 1960s and 1970s. A significant fraction of lending and output dynamics can be explained by these shocks. Moreover, we find that a large fraction of the pick-up in inflation in the 1970s can be attributed to expansionary monetary policy shocks — that is, interest rates were substantially looser in the latter part of our sample than would have been expected given available econonomic forecasts and the information about the state of the economy contained in our estimated factors.

Third, our impulse responses indicate that credit policies had moderating effects on modern-day indicators of financial system vulnerabilities, while the effects of monetary policy actions were less clear cut. Contractionary credit policies had large and persistent negative effects on the credit-to-GDP ratio; they also reduced banks’ loan to deposit ratios (a measure of their resilience), and increased the spread between debentures i.e. term corporate debt instruments and gilts (a measure of investor risk appetite). In contrast, we find that contractionary monetary policy led to a persistent increase in the credit-to-GDP ratio, as the fall in GDP exceeded the fall in credit. Contractionary monetary policy actions also led to a small reduction in banks’ loan-to-deposit ratios, but led to a large persistent increase in the debenture spread. Our results therefore provide some support to the view that macroprudential policy is better suited to achieving financial stability goals than monetary policy.

Note: Staff Working Papers describe research in progress by the author(s) and are published to elicit comments and to further debate. Any views expressed are solely those of the author(s) and so cannot be taken to represent those of the Bank of England or to state Bank of England policy. This paper should therefore not be reported as representing the views of the Bank of England or members of the Monetary Policy Committee, Financial Policy Committee or Prudential Regulation Authority Board

How the Bank of England rate cut will hit personal finances in the UK

From The Conversation.

The Bank of England has cut interest rates by 0.25 percentage points to a historic low of 0.25%. The move was expected and comes in response to worsening economic data following the UK referendum vote to leave the European Union.

The cut is part of a package of measures that also includes a big boost to the bank’s quantitative easing scheme, geared towards stimulating spending and growth in the real economy.

Conventionally, cuts in interest rates are used to reduce the cost of borrowing and the return on savings in order to stimulate firms to invest and households to spend. However, UK interest rates have been close to zero since March 2009 and the problem the economy faces right now is not so much the cost of borrowing but huge uncertainty about future prospects in the post-Brexit world.

Both firms and households, when faced with uncertainty, tend to pull in their horns and conserve their resources as a buffer against whatever adverse events might be around the corner. Moreover, households have been squeezed in recent years by poor wage growth and inflation, so have little capacity to spend more. But while the latest rate cut might not prompt you to rush out and spend, it is still likely to have an impact on your personal finances and so cannot be ignored.

Borrowers and savers

For borrowers, mortgage and credit card rates will not necessarily fall – though the Bank of England’s package includes some ultra-low-cost funding for banks, which if taken up, may see the rate cut passed on to some borrowers. But for existing borrowers, at least the day when their repayments eventually rise has been pushed further into the future.

Savers may not be so lucky and can expect further cuts to the paltry returns on savings accounts (less than 1.5% on easy access accounts and around 2% if you can tie your money up for five years). The only good news is that, since the introduction of the Personal Savings Allowance in April this year, most savers now get their interest tax-free.

If you want higher returns, you will need to consider riskier investments. The quantitative easing part of the package will tend to push up the price of corporate bonds, reducing their return and encouraging investors to look to shares. Although markets had already factored in the 0.25% rate cut, the extra quantitative easing could give a further boost to the stock market over the medium term, fuelling concerns about asset price bubbles.

Insurance and inflation

The interest rate cut may also push up the cost of many types of insurance. The premiums you pay for insurance are invested to provide a pool from which claims are paid. Typically, insurers use a high proportion of relatively safe investments, such as government stocks. When the returns on these fall, insurers may try to recoup the lost return by increasing premiums, though the ability to do this depends on the level of competition between insurers. This can apply to any type of insurance, such as car and home policies, but is a particular problem with annuities (insurance against living longer than your savings would last).
Bank of England governor, Mark Carney. Twocoms / Shutterstock.com
The rate cut adds further downward pressure on annuity rates, making them look even less attractive, and is likely to make more people approaching retirement opt for “drawdown”. This means leaving your pension savings invested and drawing income (and lump sums) straight from this pot. Unlike annuities, your income is not secure and may have to fall if your investments perform poorly, and there is no guarantee that your money and income will last for life.

It’s unlikely that the Bank of England’s measures, which were widely anticipated, will have much impact on the exchange rate, which has already fallen substantially in response to the referendum result. However, the bank acknowledges that the combination of the exchange rate fall and its new measures may push price inflation above the 2% target rate. Again, this is good news for borrowers, who will see the value of fixed debts fall, but is bad for savers.

Whether the Bank of England measures alone are enough to stave off the economy flat-lining or falling into recession is a moot point. Tax cuts and increases in government spending are likely to be needed too – and much sooner than the planned Autumn Statement, the regular mini-budget that typically takes place in December.

Author: Jonquil Lowe, Lecturer in Personal Finance, The Open University

Bank of England Cuts Rate, Lifts QE

The Bank of England has thrown the kitchen sink at the UK economy, today, reacting to the Brexit vote. 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. Savers will be badly hit, once again. The rate cut may well hinder productivity, not support growth.

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.

Following the United Kingdom’s vote to leave the European Union, the exchange rate has fallen and the outlook for growth in the short to medium term has weakened markedly. The fall in sterling is likely to push up on CPI inflation in the near term, hastening its return to the 2% target and probably causing it to rise above the target in the latter part of the MPC’s forecast period, before the exchange rate effect dissipates thereafter. In the real economy, although the weaker medium-term outlook for activity largely reflects a downward revision to the economy’s supply capacity, near-term weakness in demand is likely to open up a margin of spare capacity, including an eventual rise in unemployment. Consistent with this, recent surveys of business activity, confidence and optimism suggest that the United Kingdom is likely to see little growth in GDP in the second half of this year.

These developments present a trade-off for the MPC between delivering inflation at the target and stabilising activity around potential. The MPC’s remit requires it to explain how it has balanced that trade-off. Given the extent of the likely weakness in demand relative to supply, the MPC judges it appropriate to provide additional stimulus to the economy, thereby reducing the amount of spare capacity at the cost of a temporary period of above-target inflation. Not only will such action help to eliminate the degree of spare capacity over time, but because a persistent shortfall in aggregate demand would pull down on inflation in the medium term, it should also ensure that inflation does not fall back below the target beyond the forecast horizon. Thus, in tolerating a temporary period of above-target inflation, the Committee expects the eventual return of inflation to the target to be more sustainable.

The MPC’s choice of instruments is based on a consideration of their likely impact on the real economy and inflation. The MPC has examined closely the interaction between monetary policy and the financial sector, both with regard to ensuring the effective transmission of monetary policy to households and businesses, and with consideration for the financial stability consequences of its policy actions.

The cut in Bank Rate will lower borrowing costs for households and businesses. However, as interest rates are close to zero, it is likely to be difficult for some banks and building societies to reduce deposit rates much further, which in turn might limit their ability to cut their lending rates. In order to mitigate this, the MPC is launching a Term Funding Scheme (TFS) that will provide funding for banks at interest rates close to Bank Rate. This monetary policy action should help reinforce the transmission of the reduction in Bank Rate to the real economy to ensure that households and firms benefit from the MPC’s actions. In addition, the TFS provides participants with a cost effective source of funding to support additional lending to the real economy, providing insurance against the risk that conditions tighten in bank funding markets.

The expansion of the Bank of England’s asset purchase programme for UK government bonds will impart monetary stimulus by lowering the yields on securities that are used to determine the cost of borrowing for households and businesses. It is also likely to trigger portfolio rebalancing into riskier assets by current holders of government bonds, further enhancing the supply of credit to the broader economy.

Purchases of corporate bonds could provide somewhat more stimulus than the same amount of gilt purchases. In particular, given that corporate bonds are higher-yielding instruments than government bonds, investors selling corporate debt to the Bank could be more likely to invest the money received in other corporate assets than those selling gilts. In addition, by increasing demand in secondary markets, purchases by the Bank could reduce liquidity premia; and such purchases could stimulate issuance in sterling corporate bond markets.

As set out in the August Inflation Report, conditional on this package of measures, the MPC expects that by the three-year forecast horizon unemployment will have begun to fall back and that much of the economy’s spare capacity will have been re-absorbed, while inflation will be a little above the 2% target. In those projections the cumulative growth in output is still around 2½% less at the end of the forecast period than in the MPC’s May projections. Much of this reflects a downward revision to potential supply that monetary policy cannot offset. However, monetary policy can provide support as the economy adjusts. Had it not taken the action announced today, the MPC judges it likely that output would be lower, unemployment higher and slack greater throughout the forecast period, jeopardising a sustainable return of inflation to the target.

This package contains a number of mutually reinforcing elements, all of which have scope for further action. The MPC can act further along each of the dimensions of the package by lowering Bank Rate, by expanding the TFS to reinforce further the monetary transmission mechanism, and by expanding the scale or variety of asset purchases. If the incoming data prove broadly consistent with the August Inflation Report forecast, a majority of members expect to support a further cut in Bank Rate to its effective lower bound at one of the MPC’s forthcoming meetings during the course of the year. The MPC currently judges this bound to be close to, but a little above, zero.

All members of the Committee agreed that policy stimulus was warranted at this time, and that Bank Rate should be reduced to 0.25% and be supported by a TFS. Eight members supported the introduction of a corporate bond scheme, and six members supported further purchases of UK government bonds.

These measures have been taken against a backdrop of other supportive actions taken by the Bank of England recently. The FPC has reduced the countercyclical capital buffer to support the provision of credit and has announced that it will exclude central bank reserves from the exposure measure in the current UK leverage ratio framework. This latter measure will enhance the effectiveness of the TFS and asset purchases by minimising the potential countervailing effects of regulatory requirements on monetary policy operations. The Bank has previously announced that it will continue to offer indexed long-term repo operations on a weekly basis until the end of September 2016 as a precautionary step to provide additional flexibility in the Bank’s provision of liquidity insurance. The PRA will also smooth the transition to Solvency II for insurers.

Forget Super Thursday, the Bank of England can only offer Mildly Useful Thursday

From The Conversation.

The Bank of England is expected to announce on Thursday measures to stimulate the UK economy following signs that there will be a significant economic downturn following the vote for Brexit. The Bank may cut interest rates, inject another dose of quantitative easing or conjure up something new to give the economy a monetary boost.

Although some have dubbed this “Super Thursday”, it cannot hope to be anything of the sort. The Bank only has tools to help ameliorate the immediate damaging impact of the Brexit vote. It can do little to address the underlying structural problems of the UK economy; structural problems that are likely to deepen unless the government makes a U-turn and uses fiscal policy as a means to stimulate long-term economic growth.

The impact of the Brexit vote will be revealed over many years. The immediate evidence is patchy but the initial signs are that the economy is slowing down. The Purchasing Managers’ Index, which is a lead indicator of GDP, shows that the UK economy suffered a significant deterioration following the Brexit vote.

Sterling totters. J D Mack/Flickr, CC BY-ND

Sterling has weakened and this was expected to stimulate manufacturing exports. But the immediate evidence suggests that even manufacturing activity is slowing down. The Bank is also expected to revise downwards its growth forecast for the UK economy – not simply because of its macroeconomic model but also, as the Financial Times has reported, because some of its economists have been talking to businesses and finding out the story from the horse’s mouth.

Stimulating

The Bank, assuming the mantle of the “muscular” interventionist, is expected to introduce further monetary stimulus to help business confidence and encourage spending. This should help to reduce the depth of the emerging downturn and it will assuage markets that at least there has been some response to deal with the impact of the Brexit vote.

But there is little evidence that monetary stimulus alone will address the long-term weaknesses of the UK economy. There are two major limitations of excessive reliance on monetary policy to manage the economy.

First, it does little to expand the capacity of the economy by stimulating new investment. Second, it increases the inequality of wealth: the big gainers are those who own assets which are propped up by the monetary stimulus such as housing, bonds and shares. Very low interest rates have increased demand, but this demand has served to increase the prices of existing assets – such as the cost of housing. It has had little impact on the creation of new assets, such as house building and corporate investment and expansion.

… Mr Carney. EPA/ANDY RAIN

The Big Problem

One of the major long-term problems facing the UK economy is stagnant productivity, the prime determinant of future prosperity and income growth. There are a number of drivers of productivity including investment in capacity, investment in education and the creation of new ideas. Monetary stimulus can do little to stimulate these.

Low interest rates may stimulate private sector investment in normal times, but such investment is discouraged by economic and financial uncertainty. An active fiscal policy is required to address the productivity problem, including state investment in infrastructure, housing and education.

And the productivity problem is likely to get worse in the long-term as the UK wrestles with its post-Brexit legacy. First, the UK will find it more difficult to trade with both Europe and the rest of the world. This will lead to a widening of the UK’s trade deficit or a permanently lower exchange rate – or possibly a combination of both. Second, the level of foreign direct investment into the UK economy is likely to fall as foreign firms remain in, or move into countries within the EU single market.

Flagging up problems. ruskpp/Shutterstock

Third, there will be serious disruptions to the UK’s innovation system. Universities are one of the strong aspects of the UK system, but their ability to attract funding and world-class researchers will be hindered when (or if) the UK leaves the single market. Furthermore, much business research and development in the UK is carried out by overseas firms, which may fall if such firms move or expand abroad.

A New Industrial Policy?

The Brexit vote has led to a new government and a new opportunity to recast economic policy. The new Prime Minister has indicated her support for industrial policy and she has established a new Department for Business, Energy and Industrial Strategy. But we have been here before and the rhetoric and rebranding has often not been followed by action.

The decisions of the Bank of England that will be announced on Thursday may be mildly useful, but they can’t hope to be much more than that. They can do little to alter the long-term direction of the economy. The key issue is whether the new government acknowledges the important role for the state in driving long-term growth and re-orientates fiscal policy towards increasing public investment in infrastructure, education and innovation.

Author: Michael Kitson, University Senior Lecturer in International Macroeconomics at Cambridge Judge Business School, University of Cambridge

Bank of England Tightens IRB Mortgage Models

The UK Prudential Regulation Authority (PRA) proposes to set out a revised approach to IRB risk weights for residential mortgage portfolios and guidance as to how firms model probability of default (PD) and loss given default (LGD) for these exposures. The effect will be in some cases to lift the amount of capital held against mortgages.

This follows a review of the causes of variability of residential mortgage risk weights for firms with permission to use the IRB approach to calculate credit risk capital requirements which showed that first firms’ approaches to modelling PD vary. The majority of firms either use a highly point-in-time (PiT ) approach or a highly through-the-cycle (TtC) approach. In both cases a deficiency in risk capture was identified. Secondly, firms’ house price fall assumptions for UK residential mortgage LGD models vary widely.

So the PRA proposes that firms would be expected to adopt PD modelling approaches that avoid the deficiency in risk capture identified in the PiT and TtC models currently used by firms, and calibrate their models using a consistent and appropriate assumption for the level of model cyclicality.

The PRA also proposes to expect firms not to apply a house price fall assumption of less than 25% in their UK residential mortgage LGD models.

The PRA expects, in general, that these changes will result in firms having to recalibrate existing models rather than develop new ones. The PRA proposes that they will come into effect by 31 March 2019, though the PRA may on a case by case basis allow a longer period for firms to meet these expectations.

By way of background:

in December 2014, the Financial Policy Committee (FPC) raised concerns about excessive procyclicality and lack of comparability of UK banks’ residential mortgage risk weights in the 2014 UK stress test. The FPC mentioned in December 2015 that work was underway to try to investigate these issues, stating that in “the United Kingdom, the FPC and PRA Board are also considering ways of reducing the sensitivity of UK mortgage risk weights to economic conditions. The 2014 stress test demonstrated that the risk weights on some banks’ residential mortgage portfolios can increase significantly in stressed conditions”.

In implementing PiT models in the United Kingdom, firms’ residential mortgage models estimate a PD for the next year based upon the previous year’s default rate. This means that PDs are based only on very recent experience.

The PRA believes that for residential mortgages, this approach leads to capital requirements that are excessively procyclical. This is because under this approach mortgage assets, which are long term and cyclical, are calibrated based only on short term experience. This can lead to Pillar I capital requirements which are too low in an upturn and too high in a downturn, because a short term change in default rates leads directly to a change in the capital requirement for what is a long term asset. In turn this means that capital ratios may also appear too good in an upturn and too bad in a downturn.

A procyclical capital framework, where capital requirements are high in a downturn and low in an upturn, can encourage credit exuberance in a boom and deleveraging in a downturn. With major UK firms holding around £1 trillion of UK residential mortgage exposure, this is an asset class where excessive variability of capital requirements can be detrimental to financial stability.

TtC models, as implemented by UK firms, adopt a static approach whereby the PD does not vary with changes in the general economy. These models tend to use a relatively limited number of inputs, that do not change with time, to estimate average default rates for each borrower over an economic cycle. The borrower’s PD does not therefore change with economic conditions, and capital requirements vary much less than with PiT models.

In the UK firms use a form of TtC approach known as ‘variable scalar’ that use as inputs the PDs derived from relatively PiT models. Variable scalars then transform the average PiT PD for a portfolio into a static TtC PD, by using a multiplier, or scalar, that varies through time.

The PRA has found that, for residential mortgage portfolios, firms using TtC approaches, including variable scalar approaches, are unable to distinguish sufficiently between movements in default rates that result from cyclical factors (for example, factors that impact the economy in general) and those that result from non-cyclical reasons (for example, the specific performance of one borrower). These approaches only take account of a small number of risk drivers that do not change with time, and the PRA has found that this results in risks not being sufficiently captured. For example, if a particular portfolio deteriorates due to poor underwriting (rather than due to a downturn), then capital requirements calculated using variable scalar approaches may not increase as they should.

UK Progress On Creating A Fair and Effective Market

A status update has just been released describing some of the steps taken to reform the wholesale Fixed Income, Currency and Commodities (FICC) markets, following the earlier review. Whilst some of the legal and process related issues have been addressed, there are many cultural and behaviourial issues which remain to be addressed by market participants. The review stresses that Firms must create, both individually and collectively, cultures that place integrity, professionalism and high ethical standards at their core to ensure that behaviours are not limited to complying with the letter of regulation or laws. It took years for the ‘ethical drift’ that resulted in misconduct to occur and it will take time to build new ethical norms in financial markets. Progress is at a critical point.

The Fair and Effective Markets Review (FEMR) was launched in June 2014 to conduct a comprehensive and forward-looking assessment of the way the wholesale Fixed Income, Currency and Commodities (FICC) markets operate; help to restore trust in those markets in the wake of a number of high profile abuses in both UK and global financial markets; and to influence the international debate on trading practices.

On 10 June 2015 a Final Report was published, setting out 21 recommendations to:

raise standards, professionalism and accountability of individuals;

improve the quality, clarity and market-wide understanding of FICC trading practices;

strengthen regulation of FICC markets in the United Kingdom;

launch international action to raise standards in global FICC markets;

promote fairer FICC market structures while also enhancing effectiveness; and

promote forward-looking conduct risk identification and mitigation.

Now a status update has been presented to Chancellor of the Exchequer, the Governor of the Bank of England and the Chairman of the Financial Conduct Authority.

The job is far from done. A key theme that came out of the ‘Open Forum’ held by the Bank in November 2015 was that there remains a lack of trust in financial markets and financial institutions because of past misconduct. Participants saw cultural and ethical changes as an essential component of building a social licence for financial markets.

Responsibility must now fall increasingly to market participants to see through the changes in market practices and behaviours that are necessary to restore the reputation of the industry and thereby deliver markets that are both fair and effective. Firms must create, both individually and collectively, cultures that place integrity, professionalism and high ethical standards at their core to ensure that behaviours are not limited to complying with the letter of regulation or laws. As was indicated in the Final Report, a failure to do so will inevitably lead to further regulation and/or legislation.

While authorities can put in place legislation and regulation, firms are responsible for creating, both individually and collectively, cultures that place integrity, professionalism and high ethical standards at their core to ensure that behaviours are not limited to complying with the letter of regulations or laws. The work of the FMSB to ensure that market practices and structures are consistent with broader principles of fairness and effectiveness is therefore of vital importance and must be sustained. The complementary work of the Banking Standards Board (BSB) to promote high standards of behaviour and competence in the banking sector has a crucial role to play in this area too and we strongly support its work.

They state that the initial momentum must not be lost. It took years for the ‘ethical drift’ that resulted in misconduct to occur and it will take time to build new ethical norms in financial markets. Progress is at a critical point. It requires all involved to see through the changes that have begun, and to be alert to future challenges, if the financial services of tomorrow are to be characterised by the high standards of fairness and effectiveness to which we aspire.

Bank of England maintains Bank Rate at 0.5%

At its meeting ending on 13 July 2016, the The Bank of England’s Monetary Policy Committee (MPC) voted by a majority of 8-1 to maintain Bank Rate at 0.5%, with one member voting for a cut in Bank Rate to 0.25%. The Committee voted unanimously to maintain the stock of purchased assets financed by the issuance of central bank reserves at £375 billion. The MPC sets monetary policy to meet the 2% inflation target and in a way that helps to sustain growth and employment.

Committee members made initial assessments of the impact of the vote to leave the European Union on demand, supply and the exchange rate. In the absence of a further worsening in the trade-off between supporting growth and returning inflation to target on a sustainable basis, most members of the Committee expect monetary policy to be loosened in August. The precise size and nature of any stimulatory measures will be determined during the August forecast and Inflation Report round.

Financial markets have reacted sharply to the United Kingdom’s vote to leave the European Union. Since the Committee’s previous meeting, the sterling effective exchange rate has fallen by 6%, and short-term and longer-term interest rates have declined. Reflecting the fall in the level of sterling, financial market measures of inflation expectations have risen moderately at short-term horizons, but only to around historical averages, and have fallen slightly at longer horizons. Markets have functioned well, and the improved resilience of the core of the UK financial system and the flexibility of the regulatory framework have allowed the impact of the referendum result to be dampened rather than amplified.

Official data on economic activity covering the period since the referendum are not yet available. However, there are preliminary signs that the result has affected sentiment among households and companies, with sharp falls in some measures of business and consumer confidence. Early indications from surveys and from contacts of the Bank’s Agents suggest that some businesses are beginning to delay investment projects and postpone recruitment decisions. Regarding the housing market, survey data point to a significant weakening in expected activity. Taken together, these indicators suggest economic activity is likely to weaken in the near term.

Twelve-month CPI inflation was 0.3% in May and remains well below the 2% inflation target. Measures of core inflation have been stable at a little over 1%. The shortfall in headline inflation is due predominantly to unusually large drags from energy and food prices, which are expected to attenuate over the next year. In addition, the sharp fall in the exchange rate will, in the short run, put upward pressure on inflation as the prices of internationally traded commodities increase in sterling terms, and as importers pass on increases in their costs to domestic prices.

Looking further forward, the MPC made clear in its May Inflation Report, and again in the minutes of its June meeting, that a vote to leave the European Union could have material implications for the outlook for output and inflation. The Committee judges that a range of influences on demand, supply and the exchange rate could lead to a significantly lower path for growth and a higher path for inflation than in the central projections set out in the May Report. The Committee will consider over the coming period how the outlook for the economy has changed in light of the referendum result and will publish its new forecast in its forthcoming Inflation Report on 4 August.

The MPC is committed to taking whatever action is needed to support growth and to return inflation to the target over an appropriate horizon. To that end, most members of the Committee expect monetary policy to be loosened in August. The Committee discussed various easing options and combinations thereof. The exact extent of any additional stimulus measures will be based on the Committee’s updated forecast, and their composition will take account of any interactions with the financial system.

Against that backdrop, at its meeting ending on 13 July, the majority of MPC members judged it appropriate to leave the stance of monetary policy unchanged at present. Gertjan Vlieghe preferred to reduce Bank Rate by 25 basis points at this meeting.

UK Lowers Banks’ Capital Buffer, a Credit Negative – Moody’s

Moody’s says that last Tuesday, the Bank of England’s (BoE) Financial Policy Committee (FPC) reduced the countercyclical capital buffer (CCyB) applied to banks’ UK risk-weighted assets to 0.0% from 0.5% as a result of expected softening in the UK economy following the UK referendum to exit the EU (Brexit). The reduced CCyB gives banks greater flexibility in providing credit to households and businesses, but reduces banks’ requirements to hold loss-absorbing capital, which is credit negative.

The 0.5% reduction of the regulatory capital buffers for UK banks in aggregate equates to £5.7 billion of capital. Given the BoE’s estimate of bank sector aggregate leverage of 4%, this allows for an increase in banks’ lending capacity of £150 billion. Such measures reduce the likelihood of a credit crunch and allow the UK’s financial system to absorb shock rather than amplify the negative effects on growth and investment from the uncertainty following the Brexit Referendum.

In 2015, net lending to the UK banking sector increased by around £60 billion, a small proportion of the additional lending capacity created by this reduction in capital requirements. Increasing the UK banks’ lending capacity will likely support their profitability, which we expect to be pressured by the low-rate environment, likely fall in demand for credit and an increase in credit impairments from the uncertainty around the UK’s vote to leave the EU.

Although the PRA and the FPC deem that the banks will still hold sufficient idiosyncratic and systemic risk capital to withstand a severe but plausible stress, these reductions in capital buffers will, if used to support lending, increase banks’ vulnerability to unexpected idiosyncratic and macroeconomic shocks. The effect will vary across UK banks, with leverage-constrained institutions less affected than those that are relatively more capital constrained. At 30 March 2016, the aggregate common equity Tier 1 ratio of the UK’s seven largest banks stood at 12.3%.

In March 2016, the FPC raised the CCyB to 0.5% effective March 2017 from 0.0%, with a 1% target for later in 2017, for the UK’s six largest banks1 in response to domestic credit risks, mainly related to an overheating housing market. Concurrently, to ensure there was no duplication in capital requirements, the FPC recommended reducing Prudential Regulation Authority (PRA) supervisory buffers (Pillar 2B) by 0.5%, offsetting the initial introduction of the CCyB. Despite this reversal in the decision to raise the CCyB, the BoE recommended to retain and bring forward the reduction in banks’ PRA buffer, to the extent the level of individual bank buffers is driven by macroeconomic versus idiosyncratic risk factors, thereby increasing available capital to support lending to businesses and households.

The CCyB is a macro prudential tool whereby the FPC adjusts bank capital requirements on a systemwide basis with the aim of dampening procyclicality of bank lending to the UK economy. This is intended to reduce the negative effects of boom and bust economic cycles, which are costly for banks and the wider
economy.

Although the CCyB may help avoid a credit crunch, amid a period of prolonged uncertainty around the UK’s future trade relationship with the EU, demand for credit is likely to be subdued, raising questions about the policy’s effectiveness on the real economy.