Bank of England’s crazy gamble has not paid off

The Bank of England’s mandate to maintain financial stability is being challenged. It has been a difficult couple of weeks. The collapse of Silicon Valley Bank caused shockwaves in the industry and exposed weaknesses within the global banking system.

Palo Alto’s favorite bank was dissolved shortly after. This was followed by problems in Signature and First Republic, which culminated in Credit Suisse being bought out by UBS and Swiss government.

The war against inflation in Britain is not going according to plan. It has fallen steadily since October, when it reached 11.1pc. However, the latest data shows it increasing in February to 10.4pc, which is significantly higher than the forecast 9.9pc. This indicates that the Bank will not be able to renounce its commitment to increasing interest rates.

The Bank of England’s dual mandate is being challenged by banking failures. It must, on one hand, protect price stability and, on the other hand, ensure financial stability. The interest rate increases that are being made to stabilize prices are the direct cause of the bank failures we see.

Silicon Valley Bank did not experience an explosion due to highly flammable financial products. Most of the stress it experienced was caused by losses on perfectly vanilla US Treasury Bonds.

What is the reason that safe assets banks used to boost their balance sheets have become toxic waste? It’s because of years of quantitative ease (QE) as well as zero interest rate monetary policy, commonly known as ZIRP.

The central banks of the world believed that large amounts of cash were being deposited into the banking system, and that this would stimulate the economy following the Great Recession.

Many of the QE articles are misleading. As some claim, central banks didn’t engage in massive “money printing”. No helicopter flew above my backyard issuing twenty-pound notes. Instead, QE was what could be described as a “maturity Swap”. The Bank of England removed the gilts from the banking system which paid out stable coupons and replaced them by zero-interest yielding cash reserves. This is why we had extremely low interest rates across the board, and ZIRP.

This very low interest rate placed enormous pressure on everyone with money to manage. They were forced to search for assets with positive yields.

This allowed money to be forced into every crevice and crack of the financial system. Investors piled in and the yield of junk bonds dropped, while stock valuations rose. Cash buyers flood housing markets, whether they are ordinary savers who have become “bank of mom and dad” or sophisticated private investors that have snatched up properties for yield-hungry pension fund funds.

The great hunt for yield was more like hunting the snark by the end. The asset prices went skywards, and the whole financial industry became tired and cynical due to years of exhausting QE.

The yields on American junk bonds fell to 4pc in the summer 2021. This is a lower interest rate than that associated with high-quality Treasury bonds. Stock market valuations hit a new high in 2022. The Shiller cyclically adjusted price-to-earnings ratio reached nearly 37. This was far higher than the 1929 peak of 27. It was only beaten by the dotcom bubble, which rose to almost 44 in 2000.

You would occasionally hear murmurs of trepidation and whispers in the City. One might ask, “What happens to the house of cards if interest rate ever has to rise?” This was a common question. However, it wasn’t in good taste. Fears that might have arisen were quickly quelled by news of another asset purchase program and another low inflation print. The cheap cash continued to flood the markets, making them continue to move forward.

Did central banks not see trouble ahead if inflation returned? Evidently not. They were steadfastly convinced that we would all be in deflationary stagnation. We were assured that the world had ‘turned Japanese’. After all, Japan had endured 30 years of deflationary stagnation.

Retrospectively, we must admit that this was a strange bet made by the wise men of financial system. They didn’t just wager that inflation would not return; they also bet the Bank and the house that it would.

The idea of central bank independence is that central bankers can be given an explicit, non-contradictory directive to follow and that they will. By piling all in on QE and ZIRP and all the other acronyms-turned-incantations we have become familiar with this past decade, central banks painted themselves into a corner.

The worm has now turned. Inflation is back. The central bankers seem shocked, but economic historians may be less shocked. However, when interest rates are raised to combat price instability, financial markets swing and banks creak. The central bankers then lose their ability to see their price stability mandate and their financial stability mandate simultaneously with their left eyes. They cannot do both.

It is what is done that is done. The seeds have been sown and the fruits will soon be reaped, whether or not we like it. Now the question is, was it worthwhile? QE and ZIRP did QE really stimulate the economy or were they just causing financial markets to go crazy?

These are the questions you need to ask. From my position, I can see much froth but very little substance. Dismally low rates of real capital investment, small-business formation, and productivity remain. People who manage tech startups that don’t understand deposit insurance are paying ten dollars.

What about the credibility of the central bank? Their mandate has been overthrown by the judgement of Solomon: The baby will be divided. The whole episode will end in tears, it seems. Both financial stability and price stability can be compatible but only insofar that central banks aren’t willing to make crazy experiments with monetary excess.