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Quantitative Easing in the Bank of England

The issue of the balance sheet has been discussed by a number of analysts since there is no consensus on what the appropriate size for the assets of the bank should be, and how positive it is to have a very large balance as that acquired by the main banks in the world. Some analysts believe that at present the balance sheet of the main banks in the United States, the United Kingdom and the European bank has expanded sufficiently, and the committees of these banks have wanted to materialise a change in asset acquisition policies.

Many people believe that the purchase of assets increases the balance sheet unnecessarily due to the limited scope of this measure in the real economy in terms of job creation and economic growth.

After the 2008 crisis, the Federal Reserve and the Bank of England, among others, multiplied their balance sheets several times through a quantitative easing program which consisted in the issuance of money to finance the purchase of government bonds and corporate debts. The long-term objective of this measure was to keep interest rates low in the medium and long-term in order to support the financial system and demand for loans, which would reactivate the economy.

Many analysts believe that the decision to modify the balance sheet was made due to the limited response of the economy in the short term to reductions in the interest rate after the financial crisis.

When the authorities of the main banks issued their intentions in 2014 to normalise their policy and begin to reduce their balance sheet, financial markets became more volatile due to the change in expectations of investors who expected higher interest rates in the long term. But it is not clear yet how much the balance sheets would be reduced or what the possible consequences of this policy change would be, so in the next part of the article, it will expose the main findings of Charles A. Goodhart in his paper, A Central Bank’s Optimal Balance Sheet?

The paper criticises the centralisation of monetary policy studies since it is well known what the effects are of the intervention on the interest rate, but not the study on the normalisation of the balance sheets of banks. The conjuncture of the paper was given at the moment that the FED was announcing the reduction of the size of its balance sheet by not reinvesting its internal cash flows of interest payments and the maturation of the principal.

It was expected that the announcement would come out between September and October 2017 and that some banks such as the European Central Bank (ECB) and the Bank of England would follow in the footsteps of the FED soon after. What the market had discounted is that the reduction of the balance sheet would be gradual, to be only the non-reinvestment of its cash flow instead of selling the portfolio of banks directly. But for Goodhart, what had not been discussed was what the final objectives of normalisation were and what the equilibrium balance of the banks would be.

Quantitative easing involves not only public debt assets but also the purchase of financial and corporate assets in some countries to support credit flows in weak markets. But with the normalisation of the balance sheet, the direction of the credit as its supply and demand should be determined by the market, and the assets held by the banks in equilibrium should be only public debt assets.

Although the banks have already expressed their desire to normalise their balance sheet, there are still different points of view on what the result of the normalisation policy should be. That is why the author exposes two different points of view about the people who defend the permanence of the expanded balance sheet and those who are against it.

Those in favour of a larger balance sheet mention that the payment of interest on excess reserves or offering Reverse Repos (RRPs), central banks can continue to control the official short-term rate and thus fulfil the mandate of monetary policy without having to import the size of the reserves of commercial banks and their own balance sheet.

Furthermore, according to the defenders of a large balance sheet, central banks can create additional liquidity for the benefit of the public sector since their assets generally have a higher rate of return than their liabilities, so this positive dynamic can be followed with large balances that end up contributing to the public sector.

The truth is that the optimal size of a balance sheet is unknown, and consensus may never be reached. The only thing that is not proposed is to continue increasing these balances but to maintain the current levels that, as already mentioned, would not have negative effects according to these people.

Analysts who are against the big balance sheet criticise the fact that the people who make the analysis of the quantitative easing and balance sheets of the central banks come from the central banks themselves, so they are not the most suitable and objective people to perform this work. In addition, they could be under political pressure, so it would be best for people outside the institutions to do the analysis on what is best for the banks and the economy.

It is also clear to them that with normalisation, it is likely that short-term interests will increase which would lead to higher payments on their liabilities, while the increase in the rates that are paid to their assets would increase more slowly, which would go against the argument in favour of having a large balance. It would be the opposite because it would reduce the central bank’s liquidity by generating losses, although the magnitude of this will depend on how the bank’s balance sheet is made up.

It is clear that there will always be a continuing concern about financial stability and according to Goodhart, there is a consensus on the need to continue satisfying the demand for liquidity of the financial system in general. But that could be achieved with a great variety of assets in the system and not necessarily everything has to be done through the massive holdings of commercial bank reserves in the central bank.

Another problem that is generated by the maintenance of satiety of liquidity is that the desired level of liquidity can be altered over time, so it would not be possible to differentiate if the economy is in a stage of growth or a crisis, so an imbalance in the sizes of the balance sheets would be generated in the long term.

Perhaps the biggest problem with an excessively high balance is that the disadvantages outweigh the advantages according to Charles A. Goodhart. This is generated because the long-term interest rates remain excessively low, so it is best to reduce the size of the balance in a gradual manner. In addition, the size of the balance sheets has become so large and debt levels are generally so widespread, which implies greater sensitivity in the future to increases in interest rates so that monetary policy could face some restriction.

In conclusion, the objective of monetary policy, in general, is to provide economic stability. But with excessive quantitative easing, the opposite can happen, since in the short term this generates a monetary stimulus, but in the long term, imbalances can be created. For example, in the long term, excessive QE and a stable economy could trigger high inflation beyond what is desirable by central banks.

In addition, this excess liquidity can generate a bubble in assets due to the fact that short-term interest rates are low, which encourages the valuations of some assets to exceed their fair value. This is an issue addressed by the monetary policy committee of the Bank of England which found that in the last year many assets have excessively increased their value which can be risky in the medium and long term, as a vertiginous decrease in the values of shares and other assets could be transferred to the real sector, affecting the growth path of the economies.

There are also critics since quantitative easing may be guilty in the long run of the creation of economic cycles since this policy created liquidity to get out of the financial crisis which kept interest rates low. But this was not necessarily positive because access to credit was facilitated and it may have generated the obtaining of credits to people who are not able to pay, so if this policy is followed, it is possible that the Financial system would suffer in the future, but for the moment what generated this large amount of liquidity was an economic boom.

The opposite can happen when that large amount of money is removed in the economy because as mentioned by the writer of the paper, an excessively large balance could have generated an imbalance in the economy without certainty of what could be the point of equilibrium of the economy. It is possible that a counter-cycle of the boom is generated because the long-term rates will increase with the reduction of the balance sheets, generating a narrower credit market affecting the main motor of many economies in the world, the consumption. It is clear that this reduction in the balance will be moderate to not have a major impact on the economy, but there is no certainty as to how this will turn out.

In the case of the Bank of England, you can see the progress of the balance sheet from 2015 to the third quarter of 2015. As is evident, there has not been a decrease in the value of the balance, although in the last three instalments it has not increased drastically, although its value continues to rise. The US Federal Reserve and the European Central Bank have already given some clues as to how they will reduce the excess liquidity, but the British bank has not yet commented on this.

 

 

Graph 66. The stock of APF HOLDINGS. Data Taken from

https://www.bankofengland.co.uk/asset-purchase-facility/2017/2017-q3

 

Graph 67. Gilts. Data Taken from

https://www.bankofengland.co.uk/asset-purchase-facility/2017/2017-q3

 

Graph 68.Term Funding Scheme. Data Taken from

https://www.bankofengland.co.uk/asset-purchase-facility/2017/2017-q3

 

Graph 69. Corporate Bonds. Data Taken from

https://www.bankofengland.co.uk/asset-purchase-facility/2017/2017-q3

 

Although there is no defined route by the English bank of how it will normalise the liquidity it is evident that a large part of the assets are the Gilts that are bonds issued by the British government, so if it is taken as true the central idea of the paper A Central Bank’s Optimal Balance Sheet?, the English bank can start its reduction with corporate bonds and other assets that do not represent a large percentage of its balance. After the bank reduces or eliminates those assets, the credit market will respond to supply and demand forces as stipulated that it should be.

With the measure taken by the MPC in November 2017 to raise the interest rate, this may be the beginning of the normalisation of the balance sheet, as the meaning of this measure was to keep interest rates low to inject dynamics into the economy. But the current conjuncture of the British economy is different from the one that existed after the 2008 crisis because of the Brexit elections.

Inflation is at very high levels, so the Bank of England has decided to start raising its rates which could be complemented with the normalisation of the balance sheet since it is expected that a smaller balance will generate a reduction in the inflation indexes.

In addition, the global context is favourable to observe higher inflation rates since the world economy is growing at higher rates than expected, which may lead to higher inflation rates. The Federal Reserve has already begun its normalisation since October and it is expected that the European Central Bank will start soon, as will the Bank of England for the latest monetary policy decisions.

According to the main newspapers of the world, more aggressive increases in interest rates are expected in the United Kingdom due to the good performance of the economy in the world and in this territory. Logically, the United Kingdom has not shown the same dynamics as other countries such as the United States due to the risk associated with the United Kingdom until it is clarified how negotiations with the European Union will end.

It is likely that with a more aggressive rate hike the normalisation will also be faster, but we will wait for the next quarterly reports of the bank’s balance to observe what the pace of normalisation will be like. The composition of the assets is a determining factor since a large part of it is made up of public debt and if what is stated in the paper serves as the guidelines that banks will follow, it is first expected that banks will dispose of corporate debt and other assets, which is a small part as seen in the graphs above.

In conclusion, the Bank of England has a good profile on its balance sheet since almost all of its assets are public debt, which means that the possible effect and noise that standardisation will generate may be small. With the increase in rates, the first step towards normalisation was taken for the medium and long-term, as mentioned several times, central banks will do everything possible to reduce their balance sheets very slowly, avoiding possible undesired effects. In 2018, a more aggressive rate hike is projected due to the behaviour of inflation in the United Kingdom, although no statement has been issued such as that issued by the FED which mentions an exact date to begin normalisation.

When this process begins, it is not known to what extent an equilibrium level will be considered, as there is no consensus on how much the indicated level of liquidity in the economy is, and the level chosen by each central bank may be different. The European Central Bank has also issued statements, although it has not initiated this process. We will have to be alert to the possible effects that this will generate in the market and what decisions the Bank of England will make during the following years since by the middle of 2019 it is expected to conclude negotiations with the European Union so that normalisation could be affected if the financial system presents a marked weakness. The evolution of the balance since 2009 can be seen in the article Asset Purchase Facility Quarterly Report 2009-2017 where there have been two important moments of increases in assets and the composition of the sheet has also changed over time.

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Inflation Reports – Bank of England November 2017

In the inflation report of November 2017, the decision of the Monetary Policy Committee (MPC) was published. They decided to raise the interest rate by 0.25% to 0.5%. In the explanation of the decision, the MPC mentioned that the Consumer Price Index (CPI) had increased in September more than expected, reaching levels of 3%. But the concern according to the committee was not the figure of September and November, but the trend that it was taking as it was accelerating more than expected.

This is why the committee decided to increase the bank’s rate because they expected that after the adjustment of the economy due to the Brexit process, inflation had to progressively return to the 2% target, but this also required the help of monetary policy.

In the conjuncture seen by the bank at the end of 2017, there was high inflation, a deceleration in the main sectors and an economy growing at high rates compared to the last years, so the committee decided that the right decision was a moderate increase in rates.

The committee was very emphatic that future decisions would be determined over time since the United Kingdom was at a special juncture that could not be compared to any other situation before, so there was still great uncertainty as to how the negotiations would end with its main commercial partner, the European Union.

As mentioned in previous reports, the MPC was emphatic that monetary policy could not prevent the economic adjustment generated by the exit of the economic union since its commercial relationship could be affected due to a change in the negotiation parameters, such as tariffs and the free mobility of people and capital. But they admitted that monetary policy could help in the transition to be less traumatic for the British.

The growth of domestic consumption grew very slowly because the income of households and their purchasing power was not the same as they had before the elections. As in the May meeting, net trade had been reinforced by greater global expansion and a past depreciation of the pound sterling. Business investment was still affected by the uncertainty around Brexit, but it was growing at moderate rates due to better global demand, high profitability rates and low cost of capital.

With employment at low rates unseen since several decades ago, inflation well above the bank’s target and economic growth above the rates of recent years, the committee saw greater possibilities to strengthen its monetary policy for the long term to bring inflation to the target of 2%, without affecting the labour market and growth.

The committee in its report explained how the rate increase affected the macroeconomic variables. The first effect was a reduction in borrower flows and an increase in the loans obtained from commercial banks. The opposite effect was felt by savers who received higher rates of return for the money they had in banks in their savings accounts. An increase in the interest rate makes it more attractive to save today to consume in a later period and makes it less attractive to borrow due to the higher cost of the flows. And finally, the bank mentioned the effect of an increase in the rate on the exchange rate with other currencies and the valuation of British assets.

The committee did not expect the effects of the interest rate rise to be so drastic, since analysing with the stress test carried out by the financial policy committee, the committee observed a financial system that could be solvent in the face of challenging situations. In addition, about 60% of mortgages in the market were indexed at fixed rates so that consumers would not be affected so much by this measure, except for consumption because the interest rate rise will directly affect credit cards and other types of loans.

The bank also considered that the balance sheets of the companies were in good shape and the proportion of the profits required to meet the monthly payments of the debt fell to their lowest level during the last two decades.

In the expectations of the committee as already mentioned, it was projected that monetary policy would continue to support the economy and the labour market, but it was expected that during the next meetings the interest rate would continue to increase moderately to control the long-term inflation.

Brexit remained the main concern of the economy and the bank because without having finished their negotiations, the impact felt in the economy was strong and the economy was still accommodating by a currency that depreciated, which increased the prices of imported goods and an economy that was growing at slow rates, despite the fact that world growth was improving significantly. The following chart shows the main sectors of the economy and how they change their contribution to economic growth.

Graph 58.  Contributions to average quarterly GVA growth. Retrieved 5th February 2018 from

https://www.bankofengland.co.uk/-/media/boe/files/inflation-report/2017/nov.pdf?la=en&hash=950B4B1481D081CA035FC076CF9FFFFB08F658A6

In the MPC vote, it was decided to raise interest rates with a result of 7 to 2 in favour of the measure. The committee voted unanimously to maintain the sterling stock of investment-grade non-financial grade bonds at £10 billion. The committee also voted unanimously to keep the stock of purchases of UK government bonds at £435 billion.

On the international scene, the committee observed a global economic acceleration during 2017, including the G7 (excluding the United Kingdom). All measures of investor confidence and demand for products have remained robust throughout the year and have exceeded the expectations that had in committee. Despite this, the United Kingdom has not benefited from this international panorama.

This better outlook for global growth and the confidence of the markets since 2016 has been an important factor in boosting the prices of risky assets in the world and financial conditions in many countries. Despite this, the growth of the UK during the first half of 2017 was modest and investors were still very cautious with their projections about how the negotiations between the UK and the European Union would culminate.

With the volatility existing since the referendum, the pound sterling has lost about 15-20% of the values reached at the highs of 2015. In addition, the price of the shares of companies concentrated in the United Kingdom has suffered severe discounts in relation to companies from the same sector that are located in other countries. The following chart shows the behaviour of the pound sterling.

Graph 59. Sterling exchange rates. Retrieved 5th February 2018 from

https://www.bankofengland.co.uk/-/media/boe/files/inflation-report/2017/nov.pdf?la=en&hash=950B4B1481D081CA035FC076CF9FFFFB08F658A6

Regarding the labour market, the committee observed a drop in the unemployment rate, but a timid response of wages to this narrow labour market. An explanation to this phenomenon where there are fewer unemployed, but the salary does not increase could almost be due to the fact that there are many people who have stopped looking for a job or are underemployed, so we see an unemployment rate that should be higher. If that were the scenario of the labour market, companies could still find skilled workers without having to raise wages to attract that new workforce.

The expectations that the committee had about inflation were a little moderate because if agents expect high inflation in the future in basic goods and wages, future inflation will be high and will have persistent factors. Therefore, the committee took the decision to raise interest rates. In some surveys conducted, it was evident that agents did not believe that inflation would be in the short-range in the short term.

In conclusion, the main conclusions reached by the committee and the possible risks faced by the economy of the United Kingdom at the November meeting were:

  • Global growth remained strong and accelerated in recent months.
  • Net investment and trade supported British demand, but the growth of domestic consumption continues to show moderate rates which are consistent with the loss of purchasing power of households due to the depreciation of the pound sterling.
  • Significant upward pressure on inflation from imports and energy prices has increased the pressure on expectations for the coming quarters. Inflation has been very close to 3% between November and October and the speed for inflation to return to the target rate will depend on how quickly these pressures disappear as well as on the behaviour of domestic prices.

The following table shows the projections of the main variables by the committee.

Graph 60. Forecast summary. Retrieved 5th February 2018 from

https://www.bankofengland.co.uk/-/media/boe/files/inflation-report/2017/nov.pdf?la=en&hash=950B4B1481D081CA035FC076CF9FFFFB08F658A6

Compared to the projections that the bank had at the meeting in May, a lower GDP was expected due to the slow growth of the economy where the services and consumption sectors have affected growth. Inflation accelerated in the last months of the year, so the intervention of the bank was necessary, increasing interest rates. It is also possible to analyse that the labour market has continued its positive path with a significant reduction in the unemployment rate, but wages have not kept pace and it is possible that some people have left the labour market and have stopped looking for work which is not an advance of the economy.

The Bank of England has been consistent with the conclusions it drew at its previous meetings where it was evident that the rate hike could not be very aggressive due to weak economic growth and the lack of response from rising wages, but at very moderate rates. The bank in its two meetings prior to the November meeting had stressed that monetary policy could be adjusted in any direction since as the United Kingdom was in a special situation and there was no certainty about what the conditions of the economy were going to be at the end of the year.

The increase in rates at the November meeting is consistent with the behaviour of inflation that accelerated during the last months of 2017 reaching close to 3%, which is considered the maximum level allowed for deviation from the target range. What also helped make the decision was the good behaviour of unemployment that continues to decline to levels not seen for a while.

It is clear that the bank does not rule out future low rates depending on how the main economic variables will continue since it is the first time that the committee faces a situation of this type. But it is likely that in 2018 there will be an increase in rates by the MPC if inflation is still well above the target.

Graph 61. Averages of other forecasters’ central projections. Retrieved 5th February 2018 from   https://www.bankofengland.co.uk/-/media/boe/files/inflation-report/2017/nov.pdf#page=42

 

If we analyse the projections of agents that do not belong to the Bank of England, we can appreciate that the projections for the next three years are similar to the expectations that the bank had in the November meeting. The variable that most differed in the projections was the unemployment rate. As mentioned above, the British labour market has presented a strange situation showing very low unemployment rates in recent periods, but not with wages so there could be some imbalance in the labour market to explain this. This is why it is important to monitor in the future how the labour market will continue to behave in order to have an indication of what the next monetary policy decision will be.

It is also evident that inflation will be above the target range until 2019 according to surveys made to market agents and for the Bank of England, the goal will not be achieved until after 2020. This will be the most decisive factor to project future decisions of Monetary policy since by mandate the main objective of the bank is to maintain price stability. According to the inflation reports, it is expected that by the end of 2019 the Brexit negotiations will be completed, so until that moment it will be clear what the terms of trade will be between the United Kingdom and the European Union, so it is not expected that in the short term, the pound sterling will stabilise.

Graph 62. GBP/USD. Retrieved 5th February 2018 from

https://www.investing.com/charts/live-charts

If the market response is analysed after the November meeting, it can be seen from the graph that sterling continued to appreciate in the last months of the year, so it can be concluded that the markets have received the decisions of the MPC well, and expectations are no longer as pessimistic as a year ago.

But if its value is compared with the Euro, that appreciation has not been generated and remains at low levels since the decision was made to leave the European Union. So, there is still much uncertainty about what the results will be at the end of Brexit, which means that the pound sterling has not yet recovered the levels it had before the elections.

Graph 63. GBP/EUR. Retrieved 5th February 2018 from

https://www.investing.com/charts/live-charts

 

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Asset Purchase Facility Quarterly Reports 2009-2017

The Bank of England Asset Purchase Facility (APF) was established as a subsidiary of the Bank of England on the 30th of January 2009 to fulfil the mandate of the Treasury Chancellor. The mandate was then expanded to allow the fund to be used as a monetary policy tool. In order for the transactions to be transparent to the general public, the bank decided to publish quarterly reports to show the composition of the balance sheet of the Bank of England. The bank’s executive directors of markets, monetary and statistical analysis were designated as directors of the facility. These directors make recommendations on the assets that the bank will buy, and the Governor of the bank makes the final decision on acquisitions.

The Fund’s initial objective was to improve liquidity and increase the flow of corporate credit by purchasing high-quality assets from the private sector, including commercial bonds and corporate bonds. These purchases would be financed by the issuance of treasury bills. The scope of the APF of the Bank of England was determined to be delimited by the monetary policy committee to meet the 2% target for inflation.

The first meeting took place in March 2009 and the committee decided to bid £75 billion on assets financed by the issuance of central bank reserves. In order to buy this amount of assets, the bank acquired mainly debt from the United Kingdom government and, to a lesser extent, private sector assets. The objective of this measure was to stimulate the supply of money and credit, to raise the growth rate of nominal spending to a consistent level in order to reach the goal of the inflation rate in the short term.

The same decision was made at the following May meeting. In the quarterly report of May 2009, it was mentioned that the acquisition of the Gilts began on March 11. The Gilts are bonds issued by the British government in pound sterling and are generally considered low-risk bonds. The British Gilts are equivalent to the U.S. Treasury securities. The Gilts can be of two types:

  • Conventional issued in nominal terms
  • Indexed to inflation

At the end of 2009 purchases by the committee increased considerably to reach amounts of £175 billion, but as at the start of this procurement program most of the assets acquired would be from government debt. These changes in the maximum purchase limits were modified at the request of the monetary policy committee. Since the end of 2009, the bank announced that it would act as a seller, as well as a buyer of corporate bonds in the secondary market.

During the 2010 meetings, the committee voted to keep the asset acquisition cap at £200 billion. In November 2010 the bank announced a series of changes in the mechanism. The bank would give twelve months notice in advance of its intention to withdraw the Commercial Paper Facility, which reflected the bank’s better expectations regarding the economy and the British financial system and expected to sell more corporate bonds relatively. These better results were expected due to the economic recovery after the crisis of 2008, which led the economy to hit bottom in 2009, so in 2010 an economic recovery had started which moved to a better financial system.

There were no major changes until the November 2011 meeting where the committee increased the spending on assets to £275 billion. The committee stressed that the measures were taken to incentivise the growth of the nominal rate of spending and thus achieve the objective of medium-term inflation. In addition, since 2011, the service provider authorises the bank to continue conducting transactions with the private sector even if the transactions have not been met with a monetary policy goal, but it is still the smallest part of the bank’s balance sheet. At the next meeting in the first quarter of 2012, it was decided to raise the asset acquisition ceiling again to £325 billion.

From mid-2012 until the end of that year, the purchase ceiling was increased to £375 billion, financed with central bank reserves. The main objective was to influence the supply of money and access to credit so that the expense would grow in the United Kingdom to meet the inflation target. In a report issued in 2013 by the MPC, hints were given on how the path of monetary policy would be in the future.

The committee expressed that they would not reduce the stock of purchases of assets financed by the issuance of central bank reserves, so it would reinvest the cash flows associated with the maturation of its assets until the desired level of unemployment was reached. The committee concluded that the purchases of assets would continue until the unemployment rate reached rates similar to the objectives of the bank and the British government.

The next clue that the committee gave was on the 12th of February 2014, where the desired unemployment threshold had already been reached for the committee. The Monetary Policy Committee communicated that it would maintain that level of assets without major change until the decision was made to increase the interest rate up to 0.5%. In its 2014 reports, the MPC expressed its preference to use the interest rate as the main tool of monetary policy given its greater scope in the economy.

Therefore, in the 2015 report of the bank’s balance sheet, the committee stated that they would continue to maintain the amount of assets in a stable manner until they were sure what the best decision would be regarding the interest rate, without giving clues about what the direction that monetary policy would take. It is concluded that the Bank of England like many central banks see the modification of the balance sheet as a support for the main tool that is the interest rate.

On the 4th of August 2016, the MPC voted in favour of introducing a package of measures designed to provide an additional monetary stimulus with a purchase of corporate bonds for amounts up to £10 billion. In addition, a financing plan was introduced to provide liquidity in instalments for banks at rates close to the bank rate in order to reinforce the transmission of rate reductions faced by households and businesses in the United Kingdom.

In addition, the target for the stock of purchases of UK government bonds increased to £435 billion. In the next two graphs, you can see the evolution of the balance sheet of the bank since the creation of the fund and in the second you can see the variation of the most representative assets, the gilts.

 

Graph 64. The stock of APF Holdings.

 

Graph 65. Gilts

Analysing the global situation of the normalisation of the balance sheet of the banks, it was expected that at some point the acquisitions by the Bank of England would not continue. In addition, if the reports issued since 2009 are analysed, it can be observed which were the key variables that led the bank to continue injecting liquidity into the market to incentivise spending and achieve the inflation target.

  • The unemployment rate did not show figures that eased the feelings of the Bank of England
  • The financial system in the first years after the crisis showed a weak and fragile behaviour
  • In the 2014 and 2015 reports, the committee estimated that the acquisition of assets would stagnate until the interest rate increased. But in 2016 with the elections on the permanence of the United Kingdom in Europe, it was not possible to stabilise the number of assets.
  • The use of the bank’s balance sheet to affect some macroeconomic variables while determining the correct monetary policy using the interest rate.

If the comments of the committee are taken into account in the last meetings of 2017, it is observed that:

  • The unemployment rate is one of the lowest in recent decades.
  • The inflation rate is above the bank’s objective.
  • Short-term stabilisation in the economy growing at low rates, but without much volatility.
  • Increase in the interest rate at the November meeting.

With these variables, it would be realistic to expect a normalisation of the bank’s balance sheet due to the fact that the variables that have generated an increase in the acquisition of assets have normalised over time. But like other banks such as the FED, normalisation would be slow so as not to generate shocks in the economy, thus achieving results such as the reduction of inflation. But since the normalisation of the balance sheet is slower than the acquisition of assets, these types of policies will not have the same effects. In addition, with each quarterly report, investors and the market, in general, will be able to adapt to the measures taken by the central bank.

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Inflation Reports – The Bank of England May 2017

The Inflation Report is a quarterly report issued by the Bank of England, which analyses many variables such as internal consumption, the growth of countries that are important in the international sphere, projections, among others. With the inflation report, first, we have a panorama for the agents in the economy about the current situation of the economy and second, we can have some clues about the decision of monetary policy that the bank could take, since the priority by mandate of the Bank is inflation, although it also tries to influence the growth and the labour market.

In the May report, the bank had prospects that economic growth and inflation would continue to be influenced for the rest of the year by the response of households, businesses and financial markets to the expectations each had about the United Kingdom leaving the European Union. The behaviour of agents in the economy has been very volatile due to the behaviour of Brexit expectations since at the beginning of 2017 consumers were pessimistic about the negotiations for an organised exit. But according to the Monetary Policy Committee (MPC) that pessimism was reduced throughout the year to May.

According to the committee, the expectations of the agents improved due to moderate growth of the economy and a rebound in inflation. Sterling began to appreciate in the middle of 2017, possibly reflecting expectations of a more orderly Brexit process. The pound sterling appreciated 2.5% between February and May, but still below 16% of the highest level seen in November 2015. Due to the rise in inflation, real incomes of people fell so that the growth of consumption was reduced more than the bank predicted, but it was expected that in the last months of the year this variable would recover.

In the February projections of the MPC, it was expected that economic growth in the second quarter would stabilise in rates observed in previous periods and that at the end of 2017, the growth would be 1.9%, and in the following years would be close to 1.75%.

But at the meeting in May, we observed better global economic growth and better conditions in the financial markets, which led to better rates in the exchange between countries and orders of capital goods. There was also evidence of improvements in global demand which generated a rise in the prices of global assets, especially stocks.

The combination of stronger projections worldwide and the depreciation of the pound sterling led the MPC to improve its expectations on the net trade of the United Kingdom. This scenario, coupled with less uncertainty and better global growth rates, led the committee to expect better rates of capital investment so that exports would be able to respond to more robust demand.

Regarding inflation, the Consumer Price Index (CPI) was above the Bank’s target of 2% due to the strong depreciation of the pound sterling, which was transferred to the basic goods consumed by households, in addition to a moderate increase in local goods. The negative aspect for people was a lower than expected increase in salaries which ended up affecting the real income of households.

The MPC expected inflation to continue to rise above the target in 2017, even reaching levels above 3% in the fourth quarter. As already mentioned, the expectations of high inflation were great because, since 2015, the pound sterling had depreciated sharply due to the negotiations for the UK exit from the European Union and the due restructuring of the economy after this happens.

The trend of wage growth softened in recent years despite high growth rates in job creation. Some factors that could generate this weak growth of wages were:

  • Weakness in worker productivity growth.
  • The uncertainty of the negotiations of the exit of the European Union by companies, for which they were not willing to increase salaries until they knew what the result of the negotiations would be, because this directly influences their cost function.

But the MPC expected these factors to dissipate over time, which would lead to better rates of wage growth over time since the unemployment rate was falling to rates close to those considered to be an equilibrium.

The committee was aware that monetary policy was not enough to influence the real adjustment of the British economy, as it was a necessary and inevitable adjustment that the economy had to go through. In addition, there was no certainty of what the conditions of trade were going to be after the negotiations were concluded so that low growth combined with high inflation rates was normal.

If the bank will try to fully compensate for the effect of the depreciation of the pound sterling on inflation, higher unemployment rates and even very weak growth would be generated. That is why, despite the fact that the mandate of the bank is to have inflation close to its 2% objective, it is considered that in exceptional circumstances the committee must analyse and balance the macroeconomic variables so that imbalances are not generated in the economy.

That is why in the May meeting they decided to leave monetary policy unchanged to respond to the situation in which the British economy was. In a vote of 7 votes in favour and 1 against, it was decided to keep the rates at 0.25%. In addition, the committee voted unanimously to maintain the sterling stock of investment-grade non-financial grade bonds, financed by the issuance of central bank reserves at £10 billion. The vote was also unanimous to maintain the stock of purchases of government bonds of the United Kingdom.

The committee made it clear that the monetary policy would respond in any direction depending on the economic perspectives so that in the long term it would be possible to locate inflation at acceptable rates. In general, the committee considered that, if the economy followed the estimated projections, the monetary policy could be hardened in the future. The bank’s projections depended mainly on three aspects:

  • That the low level of the pound sterling will continue to stimulate the price of consumers beyond the projected period.
  • That the wage increases that remained modest will accelerate in the projected period.
  • That the more moderate growth in household spending will be balanced by a rise in other components of demand.

In terms of the global panorama, as already mentioned, there was a better situation in several countries such as the United States, where, like the United Kingdom, unemployment rates were at levels similar to those observed before the 2008 crisis, but not in the Euro Area.

On the other hand, the committee expected global inflation to rebound especially due to the rise in fuel prices thanks to the OPEC agreement and stronger demand for raw materials, but still, there were special cases such as the United States where the behaviour of inflation was weak.

In conclusion, for the bank’s inflation expectations, it was presumed that for the rest of 2017, inflation would continue to rise due to the increase in food and energy costs, down to the fact that they are one of the most sensitive components of the CPI. In addition, the fact that the price of fuels has increased worldwide, the depreciation of the pound has meant that inflation also rises for this reason as it is more expensive for the British people, due to their reduction in purchasing power. The path of inflation in the following quarters of 2017 depended on how fast companies could pass the increase in external costs to the consumers.

Another problem that has generated high inflation is a slowdown in the economy because it has affected the purchasing power of households so that their consumption has been reduced and the devaluation was expected to cause inflation to be above that of the bank’s target range in the next three years.

Also, within the projections of the committee, a good dynamic of exports was expected for a better global demand for goods and services, and a devaluation already exposed that would serve as a boost to make their products more competitive. The following chart shows the main projections that the committee had at the May meeting.

 

Graph 53. Forecast summary. Retrieved on the 3rd of February 2018, From https://www.bankofengland.co.uk/-/media/boe/files/inflation-report/2017/may-2017.pdf?la=en&hash=92BA13788FBF71CBC9D800DDCD0EA3D217008867

Analysing what was stated in the inflation report by the Bank of England, it can be seen that the bank raised its rates in the meeting of November 2017. This was in line with what was stated in the report because it was not ruled out, tightening the monetary policy if the macroeconomic variables allowed it.

Throughout the year, the bank faced a trade-off between its main objective inflation and other important variables such as employment and economic growth. Inflation was above the target level of 2% imposed by the government due to the weakness of the pound sterling, which was a reflection of the uncertainty that the market had against the United Kingdom since 2015 when it was decided that it was going to start negotiating the exit from the European Union.

The uncertainty was generated due to the possible paths that the negotiations could take from stable commercial relations, without major sanctions such as tariffs on British exports or restrictions on capital flows, until the slow and clumsy negotiations that would generate an unwanted scenario on the part of the UK, and of the countries belonging to the economic union.

Since the fall of the pound sterling at the end of 2015, levels have not been achieved in its index with respect to other currencies seen before the Brexit results, which led to an increase in the cost of goods and services, which translated into a high inflation and a reduction in the consumption of the inhabitants of the UK.

During 2017, moderate economic growth was observed with low unemployment rates, but without a rise in wages. The following graph shows the behaviour of the unemployment rate in 2017. Based on the inflation report, it can be seen that the bank was correct in projecting lower unemployment rates at the end of the year.

 

Graph 54. UK Unemployment Rate. Retrieved on the 3rd of February 2018, From. https://tradingeconomics.com/united-kingdom/unemployment-rate

The following chart also shows how inflation continued to rise until the end of 2017, reaching levels close to 3%, which made it logical for the bank to raise interest rates due to the behaviour of inflation

 

Graph 55. CPI ANNUAL RATE. Retrieved on the 3rd of February 2018, From https://www.ons.gov.uk/economy/inflationandpriceindices/timeseries/l55o/mm23

The aspect that was not so positive was the economic growth due to the fact that it continued presenting moderate rates of growth.

 

Graph 56. Gross domestic product. Retrieved on the 3rd of February 2018, From https://www.ons.gov.uk/economy/grossdomesticproductgdp/timeseries/ihyq/pgdp

A few months after the May meeting, it was observed that the content of the inflation report was right for the British economy, and they decided to raise interest rates due to inflation that was increasingly growing and far from its objective. The behaviour of the market after the inflation report and meeting of the MPC in May can be seen in the following graph.

 

Graph 57 GPB:CUR. Retrieved on the 3rd of February 2018, From https://www.bloomberg.com/quote/GBP:CUR

You can see that sterling continued to appreciate since the May meeting so it is clear that investors have relaxed a bit more and are no longer so pessimistic about the UK situation. This appreciation has also helped households to recover a bit of the purchasing power lost since the Brexit elections, where a sharp drop in the pound sterling began and even after several years failed to reach levels seen before the crisis.

Following the foregoing in the inflation report, it can be concluded that the sterling trend continued since the beginning of the year and, as the committee mentioned, this is evidence of the change in expectations of the investors who expected smooth negotiations between the United Kingdom and the European Union, which would allow trade and capital regulations not to undergo drastic changes and the economy could grow at rates seen before the elections. In addition to the change in expectations, the November rate hike was also important because this shows signs that the committee sees a stronger economy.