Bank of England plots strategy to calm fretful markets

By:
Solomon Teague
Published on:

The BoE still has plenty of monetary weapons in its policy arsenal, including expanding an asset-purchase programme akin to the ECB, but, amid febrile market confidence, it needs to tread carefully.

Bank of England (BoE) governor Mark Carney has sought to reassure markets amid the storm after the UK’s decision to leave the EU. He has fuelled expectations of rate cuts, while downplaying the possibility of negative rates.

At its July 14 meeting, the BoE would like to appear relatively relaxed about the sharp turn in the sterling, perhaps implicitly suggesting the downward move could serve as a shock-absorber to correct imbalances, rather than a free-fall that signals a dangerously bearish outlook for the UK economy. 

The BoE's communication challenge is made particularly acute given the confidence that has drained away as the political parties struggle to get to grips with the Brexit aftermath

The Bank will attempt a delicate balancing act by ensuring it doesn’t stoke economic fears among investors in sterling-denominated assets, perhaps creating a self-fulfilling prophecy. However, if markets are already shaken, it will not want to watch on passively. Most therefore expect to see a 25 basis point rate cut, at least, over the course of the summer.

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Nicholas Laser-
Ebisch, Caxton

Caxton FX analyst Nicholas Laser-Ebisch says: "Adopting a more accommodative monetary policy will provide an incentive for UK businesses and individuals to borrow and invest more money in the local economy to try to boost growth."

The risk, he notes, is measures that reduce the value of the pound could hurt UK consumers and importers. 

"The Brexit vote could possibly have a smaller negative effect than anticipated, and cutting interest rates could be seen as unnecessary overkill which would drive down the yield on gilts and UK corporate bonds," he warns.

The weaker pound has already provided some stimulus by boosting export competitiveness, and will add to inflationary pressures, thereby cutting real household incomes. Any further cuts could add to that problem.

However, Ross Pepperell, partner and director of research at consultancy CheckRisk, does not believe the BoE will be overly concerned about importing inflation.

He says the BoE "will be heartened by looking at the experience of the euro in the past two years. No material inflation was imported when the euro went from $1.40 to $1.05 nine months later. There were crosswinds of swings in commodity prices, which muddy the picture, but overall I don’t think they will be concerned."

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Ross Pepperell,
CheckRisk

However, a relatively relaxed attitude towards inflation is unlikely to pave the way for negative rates, says Pepperell, adding: "I am dubious as to whether we will see negative rates in the UK. The evidence appears to be mounting that they are counter-productive."

ING has conducted surveys that contribute to this body of evidence. Among households in Europe – including the UK – it has found negative interest rates, in fact, encourage households to save more, not less. 

"It therefore compounds the negatives for the economy," says James Knightley, senior economist at ING. "People have to work harder to achieve their savings goals and it also has a negative feedback on spending as it makes people feel nervous.

"If rates go too low, or negative, it will hurt bank profitability due to a flatter lower-yield curve, which will disincentivize lending. It will also hurt the incomes of those relying on interest income from savings and may not benefit borrowers if banks do not lower their own interest rates."

Final throw

However, much depends on how the political situation develops. With rates standing at a mere 0.5%, the BoE has limited firepower and it cannot be ruled out as a final-throw-of-the-dice measure.

Jérôme Legras, managing partner at Axiom Alternative Investments, says: "Negative rates are still a possibility for the UK. Yes, it would be bad for banks, but so is lowering rates in positive territory – the difference is incremental. Getting from 10bp to zero is a bit less painful than from zero to -10bp, but only a bit less. So negative rates are probably still on the table if the BoE decides the economy needs it."

ING's Knightley predicts, with the BoE's toolbox nearly empty, it "will throw everything at the UK in an effort to shore-up confidence and hope that it works". 

This means 25bp cuts in August and November, probably backed up with an expansion of quantitative easing (QE), taking total purchases to £0.5 trillion, up from £375 billion. In addition, ING expects to see some credit easing, such as bumping up the Funding for Lending Scheme.