The Bank of England acts—but will it be enough?

Project Fear has come alive with the Bank of England announcing a drastic revision of its previous economic assessment of the economy, and announcing a robust set of measures designed to mitigate the effects of what it sees as the drag in the post-EU referendum economy—including cutting interest rates from 0.5 per cent to 0.25 per cent. We should welcome the Bank’s attempts to administer some painkillers to the UK economy, while also noting that the Bank alone is not equipped to undo the damage Brexit will do to the economy and to living standards.

Bank’s eye view

First, consider the Bank’s broad economic view. The economic outlook for 2016 is pretty much baked in the cake thanks to a fairly decent first half of the year. The initial second quarter GDP data have the economy 2.2 per cent stronger than a year ago. It is exceptional—I couldn’t find an instance—for the Bank to cut interest rates when the last known GDP data were above 2 per cent. But the Bank expects stagnation in the second half of 2016, and has slashed the 2017 growth forecast from 2.3 per cent to 0.8 per cent, and the 2018 outlook from 2.3 per cent to 1.8 per cent. It is not predicting a recession, per se, but it seems reasonable to expect a quarter or two of economic contraction starting very soon.

The Bank thinks unemployment will now rise to 5.6 per cent by 2018, though this could be an under-estimate if demand turns out weaker than the Bank is forecasting. It says that inflation will now be twice as high in 2016 at 0.8 per cent, close to 2 per cent in 2017, and 2.4 per cent in 2018. Remember, if there is no parallel bounce in wages and salaries, most people will become worse off as a consequence because their real incomes will be reduced. While the Bank has a formal mandate to keep inflation at 2 per cent, it is also has a duty to maintain economic stability and to prevent circumstances arising in which deflation would return. The exchange rate is the main factor driving up inflation, and the Bank is happy to see through this and divert its attention elsewhere.

Measures to help

Next, what has the Bank agreed to do? It cut the bank interest rate from 0.5 per cent to 0.25 per cent for the first time since 2009, and announced a further QE programme of gilt purchases of £60 billion over the next six months, taking the total under the programme to £435 billion. In addition it announced it will buy up to £10 billion of corporate bonds, where the companies are identified as those that make a material contribution to the UK economy. These programmes are of course designed to a) lower interest rates for borrowers that have liabilities at floating interest rates, which includes about 80 per cent of non-financial company loans, and half of all mortgages. Homeowners with fixed-rate mortgages should benefit when they come to refinance to the extent that gilt yields are lower. In addition, lower yields are also designed, as before, to induce investors to seek out commercial and economic ventures where risks are higher but which might add more to economic activity. And don’t forget that Sterling, which dropped about two cents against the US dollar and which should be expected to drop further, also imparts at the margin a stimulus to the export sector, and to some industries such as tourism.

The most interesting part of the package was the £100 billion Term Funding Scheme (TFS), under which the Bank will lend money to banks at the Bank rate or close. The Bank is certainly aware that in a world of rock-bottom interest rates, banks might be unwilling or unable to cut their deposit rates further than they have, and would therefore be unwilling to lend more (at lower rates) because of the threat to their business and profitability models. So the TFS is supposed to allow banks to pass on the lower interest rates by providing the facility directly to banks that apply and are eligible.

This all supposes that banks have borrowers that want to incur new debt. If there is no credit demand this scheme is a dead duck. But to the extent banks can identify new loan opportunities, the scheme should certainly help. The scheme is for four years, and banks will be able to apply for 5 per cent of the stock of their outstanding loans to UK businesses and households. They can gain access to funding that is commensurate with the increase in their net lending and the costs to the banks, including fees, are attractive if their net lending rises. If not, the costs and fee structure becomes a burden to them.

Government is key

The Bank’s measures, which Governor Carney said could all go further if needs be, will really come into their own if the Government delivers on a coherent economic programme to strengthen the economy’s capacity to expand and sustain itself. This means not only addressing the potential shortfalls in demand in the economy between now and 2018, but also, as the Bank makes a point of saying in the Inflation Report released today, if it acts promptly and judiciously to put into effect arrangements that make good the supply shock which the UK will experience on leaving the EU. This concerns not just trade arrangements, but also labour supply arrangements, and of course the investment, both local and foreign direct investment, without which productivity will stagnate or decline.

We should certainly beware the risk of and possible costs of a recession in 2016-17, but this isn’t even the worst that could happen to us. The supply shock which feeds directly into our potential growth rate and productivity is less noticeable and more corrosive of wealth creation and the standard of living of most citizens. The Bank and the Governor have told us clearly that rectifying these issues is not their turf.