No deal and the Bank — Midweek note

Today the Bank of England kept interest rates on hold at 0.75% with an 9–0 unanimous decision by the Monetary Policy Committee. Quantitative Easing remained unchanged at £435bn. The decision was probably the right one; inflation is running just under target and growth is modest at best, not the conditions that require tighter or looser monetary policy.

What is most interesting about the policy announcement is their guidance on policy in a no deal Brexit scenario. The Monetary Policy Summary and minutes of the Monetary Policy Committee state that:

“The monetary policy response to Brexit, whatever form it takes, will not be automatic and could be in either direction.”

This is essentially the Bank hedging their bets as to what policy would be most optimal to pursue. They can either target price stability (keeping inflation down) through tighter monetary policy or boost economic output (GDP) through looser monetary policy. The Bank’s own no deal economic forecasts suggests inflation could peak at 6%.

Those same economic forecasts suggested that output could take a dive of up to 7.75%, a fall greater than that of the great recession.

So what should the bank prioritise? There are trade offs to both policies. Targeting lower inflation requires higher interest rates. This will have an impact on private consumer debt such as mortgages and loans. Those on variable rate contracts are most likely to be effected, higher costs on these will adversely affect consumption, likely deepening the hit to output. Alternatively, looser policy which involves slashing interest rates is likely to improve lending conditions but add to inflation. There is also little room to cut without running into the zero lower bound. Cutting rates is unlikely to be too effective at this point.

As with most concepts in economics, there is no free lunch. Taking either path is likely to have its adverse affects.

The recession will be largely supply side related in nature, of which the Bank has diluted influence. Instead it will fall to fiscal and political policy to see the United Kingdom through unsteady waters. Let’s hope the chancellor is willing to turn on the spending taps.

All graphs have been pulled from the Bank of England: https://www.bankofengland.co.uk/-/media/boe/files/report/2018/eu-withdrawal-scenarios-and-monetary-and-financial-stability.pdf?la=en&hash=B5F6EDCDF90DCC10286FC0BC599D94CAB8735DFB

Photo credit: Bank of England