Saturday, May 7, 2011

BOE Still Accentuates Negative

Saturday, May 7, 2011

Subdued recent U.K. economic data made the Bank of England's decision Thursday to leave interest rates unchanged a foregone conclusion.

The bank remains committed to its lower-for-longer approach to policy. But the eventual result for the U.K. economy is likely to be ugly.

The majority of the Monetary Policy Committee members stuck to their guns, leaving not only the base rate unchanged, but also the stock of bonds purchased under its quantitative-easing program. This was what the market had expected.

Bloomberg News

Mervyn King, governor of the Bank of England, in California last month.

Most economists figure the MPC will continue to ignore the U.K.'s high rate of inflation until there's evidence household earnings and consumption are growing. After all, rising prices are taking a bite out of Britons' incomes at a time when taxes for many are also going up. Meanwhile, public spending cuts and relatively high unemployment have been keeping a lid on wages.

But, as John Gieve, a former deputy governor of the bank, has pointed out, despite the softness of recent data, the fact is the worst of the financial crisis has passed and the U.K. is experiencing growth, however feeble. Nevertheless, the bank persists in maintaining emergency levels of monetary stimulus. Official U.K. interest rates remain at 300-year lows.

What's more, a speech by Mervyn King, the bank's governor, this week suggests the bank will aim to keep interest rates well below the rate of inflation for a long time to come.

"The economic consequences of high-level indebtedness now would become more severe if rates were to rise," Mr King said in comments to the European parliament this week. British households are among the most highly indebted in the world.

Mr. King and the rest of the MPC will be aware that throughout history, inflation has been a major mechanism for reducing public and private debt loads. But the governor has consistently denied the bank will seek to inflate away the U.K.'s debt burden by maintaining deeply negative interest rates.

That's not, however, the way things look. Inflation has averaged some 3.2% during the past three years. The bank's base rate has averaged 1.5% over the same time. Later this year, short-term real interest rates are likely to approach a negative 5%.

These negative interest rates are iniquitous for Britain's prudent savers and pensioners, who held back from the speculative mania of the years leading up to the financial crisis, a mania to which the MPC contributed by encouraging the biggest debt binge in history. The bank is now forcing these savers to pay most of the cost of the post-crisis adjustment.

But the repercussions are potentially more serious for the future of the U.K. economy. That's because the bank is engendering a pernicious form of moral hazard by not just socializing bankers' losses, but rewarding the bankers for their failures.

In essence, Mr. King says the U.K. is too heavily indebted for the Bank of England to even consider raising interest rates and so will not raise them until nominal debt levels relative to nominal gross domestic product have fallen sufficiently.

But the U.K.'s GDP growth prospects are distinctly lackluster. The National Institute of Economic and Social Research, an independent research institute, forecasts in its outlook published this week that U.K. GDP growth will come in at just 1.4% this year and 2.0% in 2012. That's well below the latest official estimates of 1.7% and 2.5%, respectively.

So with growth failing to lift the burden of debt, the Bank of England will continue to rely on negative interest rates.

But because banks aren't really passing on the low interest rates, Mr. King must know that most of this wealth transfer from savers won't be going to borrowers, but rather to bankers, in the form of fat interest rate spreads. Banks were meant to use these spreads to recapitalize their balance sheets. But various rescue mechanisms and subsidies granted them by central banks and regulators in the wake of the credit crunch have allowed bankers to take much of this windfall in the form of salary rises and bonuses.

In other words, intentional or not, the Bank of England's policy has been to effect a massive transfer of wealth from prudent savers into the pockets of those same bankers who so heavily contributed to the financial crisis.

"The Bank of England will presumably maintain an ultra-accommodative monetary policy, despite the dangers stemming from the inappropriate banking behavior that such a loose regime is likely to encourage," says Stephen Lewis, chief economist at Monument Securities.

What's more, the very loose monetary policy raises the risk that future inflation will run out of control, the NIESR warns.

Were the MPC to raise interest rates, savers would gain in income what borrowers and bankers lost. Economists, though, worry about how this will effect overall consumption, because savers tend to spend less of any increase in income than borrowers. But this effect is lessened to the degree banks' interest rate spreads tighten. It could be that a rate rise hurts bankers more than borrowers, while giving savers some much-needed relief.

Alternatively, the NIESR suggests the mix of monetary and fiscal policy should be readjusted, as "fiscal policy is too tight and monetary policy too loose."

But that's unlikely to happen. Chancellor of the Exchequer George Osborne has staked his political reputation on getting government finances under control as quickly as possible. And he's been supported by Mervyn King, who has, in return, promised easy money.

Even if most of that easy money goes to those who least deserve it.

Write to Alen Mattich at

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