As the Bank of England announces an historic interest-rate cut and a new quantitative easing programme, Stewart Robertson discusses the potential impact on the UK economy.

 

The British economy has been rocked by the surprise ‘Brexit’ vote at the EU referendum on June 23. Manufacturing and services sectors contracted sharply in July, according to purchasing managers’ index (PMI) figures, prompting fears of a looming recession.

The Bank of England held interest rates at 0.5 per cent in a meeting on July 14, but senior personnel at the BoE indicated that stimulus measures would soon be in the offing. In a speech soon after the referendum, the BoE’s Chief Economist Andy Haldane said he was in favour of a “sledgehammer” approach – a far-reaching monetary easing package – to stabilise the economy.

On August 4 the BoE duly announced a clutch of measures designed to mitigate the economic damage inflicted by Brexit. The bank’s Monetary Policy Committee (MPC) announced it had voted unanimously to cut interest rates for the first time in seven years, to 0.25 per cent, an all-time low.

The MPC also announced a so-called ‘Term Funding Scheme’ for UK banks to ensure the rate-cut is transmitted to the wider economy. Under the scheme, the BoE will provide loans to banks at levels of interest close to the base rate, enabling them to provide cheap lending to their customers.

That wasn’t all. The BoE will also launch a new £70 billion quantitative easing programme, which will include £10 billion of corporate bond purchases from companies that contribute to the UK economy. Alongside these measures, the MPC sought to reassure markets about its future policy moves by signalling it would probably enact a further rate-cut again before the end of the year, although governor Mark Carney appeared to rule out a move to negative interest rates.

So is the BoE’s easing package the sledgehammer stimulus the economy needs – or more of a damp squib? In this Q&A, Stewart Robertson, Senior Economist for the UK and Europe at Aviva Investors, discusses the potential effect of the BoE’s latest policy moves. 

 

How has the ‘Brexit’ vote affected the BoE’s assessment of the economic outlook?

Stewart Robertson: According to the BoE, GDP growth will fall to 0.8 per cent in 2017, down from the 2.3 per cent rate it forecast in May. That’s the biggest downward revision in growth the MPC has made since it was established in 1997. House prices will fall slightly. Both imports and exports will weaken. Consumer growth will decline to negligible, but positive, levels. There will be an end to employment growth. Overall, it’s a bleak forecast.

Will the BoE’s monetary easing package help lessen the economic damage of Brexit?

SR: We’re in a grim place, so every stimulus helps. The actual impact of these measures at a grassroots level will be pretty small, though. The rate cut will have a marginal effect on the cost of borrowing. Does a rate of 25 basis points rather than 50 basis points really make that much difference? No.

However, the cut does provide a signal that the BoE is prepared to support the economy. Recent years have proved that those nebulous concepts of confidence and belief are very important in creating a climate for investment.  The new Term Funding Scheme is also important in that it should ensure cheap funding is transmitted to the wider economy. Speaking at a press conference after the announcement, Carney was adamant that banks had no excuse not to pass on the lower lending costs to their customers.

The quantitative easing programme is also a positive step, because when lending growth is compromised in an economic slowdown, quantitative easing enables you to create money in a different way. Taken together, these measures might weaken sterling further, which would make UK exports more competitive.

What will be the impact of the new corporate bond-buying programme?

SR: The BoE will buy £10 billion of corporate bonds over the next 18 months. There are plenty of gilts out there that the BoE could buy. But the bank wants to diversify into credit because it thinks it’ll get more ‘bang for its buck’; corporate bonds are typically high-yielding assets, and sellers are likely to move into even higher-yielding securities. That will help boost market activity. Issuance is also likely to rise.

Sensibly, the BoE has taken steps to stop ‘carpet-baggers’ – overseas companies that might be tempted to issue in sterling to take advantage of lower borrowing costs – by retaining discretion over which bonds are eligible. According to the BoE’s announcement, issuers must provide a “material contribution to the British economy” in order to qualify.

What further steps can the BoE take if this easing package proves ineffective?

SR: It’s likely that the BoE will cut rates further, to around 10 basis points, later in the year. The bank also indicated that it would be prepared to extend the Term Funding Scheme and ramp up quantitative easing if needed.

Carney indicated that he was against a move to negative rates. If economic conditions were to deteriorate significantly, then the BoE might have to reconsider that policy. For the moment, however, it is pretty clear the bank is not considering such a move.

Any move to negative rates might be counterproductive. By reducing the return on savings you aim to encourage spending – but such a move can have the opposite of the intended effect because savers need to put more money away to build the same sized savings pot. The outcome of a negative interest rate regime would be uncertain.

Do you expect the UK government to introduce fiscal stimulus this year?

SR: Automatic fiscal stabilisers will kick in as growth slows, which will probably curb the slow improvement in the fiscal deficit that we’ve seen over the past few years. As for activist fiscal initiatives, we’ll have to wait for [chancellor] Philip Hammond’s Autumn Statement. There’s been no hint as to what action he might take yet.

Further evidence of economic slowdown between now and September may put pressure on the government to begin spending on new infrastructure projects or on refurbishments to existing schools, roads and hospitals. These projects could be funded through the issuance of infrastructure bonds. Such bonds could, in turn, be purchased by the BoE, which would help to align fiscal and monetary policy.

Tory governments are generally averse to ‘tax-and-spend’ policies, however. Hammond may choose to wait until the next Budget in March 2017. By that time, the economic impact of Brexit will be much clearer. 

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