The monetary death marches continue. The fourteenth increase in interest rates by the Bank of England is unscientific and unnecessary. It also underestimates powerful global forces that are washing over these islands.
It is pushing policy beyond what is safe or therapeutically useful for no other reason than to validate expectations on the futures markets. The inflation rate is already falling and it has little to do with recent Threadneedle Street actions.
The British economy has slowed down and is likely to slide into recession. This recession will be even deeper. This rate squeeze will have a full impact on the private sector debt of 151pc (BIS data), but it won’t be felt until next year and possibly later, given that debt contracts are maturing at a much slower pace.
The Bank of England is the only major central bank actively selling bonds as part of its quantitative tightening policy. This is an experiment which has never been done before, and is more difficult to calibrate.
The Bank could be incubating an entire credit crunch, which will lead to the bankruptcy of tens and thousands of viable companies. If such a situation is allowed to continue, it could snowball and cause a cascade of destruction that would be difficult to stop.
Why are these actions being taken? China’s deflation is a major factor in global inflation.
In many parts of the world economy, the producer price index has already fallen. Drewry’s shipping index is down 80pc since its peak, to $1.576 per container. It has now fallen below its long-term mean. Jan Hatzius, Goldman Sachs, said that disinflationary forces were now hitting with a vengeance.
In the US and most of Europe, on a quarterly basis, inflation is only slightly higher than when central banks held interest rates at zero while injecting liquidity an outrance through QE. Even the slow and almost useless indicators of annual price inflation are moving in the right direction.
Four tightening shocks are hitting the UK at once. Only two of these are given serious consideration by the Bank of England: its own rate rise to 5.25pc and fiscal drag due to stealth taxes and bracket creep, which will subtract 0.5pc of growth from this year’s and double it next year.
The Bank may be in perilous water if it fails to recognize the other two shocks.
When US Federal Reserve tightens, contractionary impulses spread through the international dollarised financial system.
“Europe feels the impact of both its own tightening and that of the US. Global liquidity in dollars is decreasing,” said Philip Turner. He is a former senior official of the Bank for International Settlements.
BIS estimates there are 12 trillion dollars in offshore credit contracts that are outside US jurisdiction. Global finance is lubricated by this. Some credit comes in the form cross-border loans, such as a Saudi bank lending to a Turkish firm, or a French lender lending to property developers in China via Hong Kong.
The Fed shuts off the flow of dollars to companies around the globe, because the market is strong and the borrowing costs are low. The global economy will then be shaken.
In 1928, the Strong Fed stopped lending to Europe and sparked the Great Depression. In 1982, the Volcker Fed caused the Latin American debt crises and in 1998, the Greenspan Fed started the East Asia Crisis.
Does it happen now? We will know. We will find out.
The European authorities were taken by surprise, thinking that the strong euro would make them invincible. The eurozone banks were shocked when the dollar funding market for three months in Europe frozen, making it impossible to rollover liabilities. The Fed was ultimately the one who bailed out European Central Bank through foreign exchange swaps. The eurozone and not the US was responsible for the economic depression.
The ECB, the Bank of England, and other central banks claim to be more aware of this risk, but they continue to tighten their own policies on top of those of the Fed, causing a double-whammy to economies that are already stuck in a state of stagnation.
The second shock that is underestimated is the slow-burning damage caused by quantitative tightening. The true extent of monetary tightening does not only include the increase in the policy rate. “It is also shrinking of the balance sheet,” said Professor Turner. He now works at the National Institute for Economic and Social Affairs.
The Bank of England is a New Keynesian extreme, claiming that the sale of bonds does not matter. According to their model, both QE and QT can be viewed as asset swaps. In a crisis, buying bonds can restore confidence. However, selling them later has the same effect as watching paint dry.
After studying America’s stormy first experiment with QT, Fed economists Andrew Lee Smith and Victor Valcarcel came to the opposite conclusion .
The researchers found that QT’s liquidity effect was twice as powerful as the original QE. Asset sales wreaked havoc on US money markets but after a long lag.
Anyone who was in the market at the time could have seen this. QT caused a crash in the stock market. Powell Fed had to retreat, and eventually revert back to new QE.
Professor Turner approaches the subject from a Wicksellian viewpoint of the BIS. He argues in a paper he wrote with Marina Misev of the University of Basel that the current monetary pressure is “too little, too late”, and that it threatens to destabilise an already vulnerable financial system.
The paper suggests that central banks should pay more attention to credit data, which “capture monetary policy mid-transmission”, before they cause the economy to spiral out of control.
This credit data is absolutely dire. In the ECB Bank Lending Survey, ‘s net demand for lending in the second quarter fell by 42pc. This is the lowest ever recorded. The net fixed investment demand for Italy dropped by an alarming 55pc. The credit to households has now contracted in absolute terms.
The situation in the UK could not be worse. The housing market is at the centre of the storm. The credit crunch has been less severe, but money supply numbers are nearing collapse. Simon Ward, from Janus Henderson, says that real M1 money is down 7.4pc in the last six month. He said that the latest rate hike was just a further step into overkill.
The Monetary Policy Committee, despite its name, does not focus on money but rather wages and prices. This is not confirmed by the falling inflation expectations. Although it will take longer for services to deflate, the process has already begun. The PMI index of new service orders fell in July.
The MPC could serve us better if they stopped worrying about an illusory spiral of wage-price in the services sector and began paying more attention dollar liquidity, and the indicators that show us the direction the British economy will take. It is currently hitting a brick wall.