The only previous precedent for such an extended period of unchanged Bank of England rates came between 1932 and 1951 during which time the rate set by the Bank was 2% for almost the entire time. This is an unhappy precedent as this period included the Great Depression and WWII.
While we do not anticipate a similarly prolonged period of unchanged rates a move back to what are considered 'normal' rates in the UK still seems a long way distant.
Of course, this policy has involved a transfer from the prudent to the leveraged. Borrowers have seen interest income collapse while those with large borrowings have enjoyed dramatically lower financing costs. This may seem morally reprehensible to some, but economics is not a morality play. The central bank has to make a judgement of relative risks rather than rewarding the virtuous and punishing the imprudent.
Should morality come into economic policy?
There is a precedent for morality as a guide to economic policy. Andrew Mellon was the US Treasury Secretary in the early 1930s. His prescription to the aftermath of the Wall Street crash was to "liquidate labour, liquidate stocks, liquidate the farmers, and liquidate real estate". His view was that such a policy would purge the system of excess and create a sounder basis to rebuild. History has judged this episode as falling into the "operation successful…..patient died" category of success.
To put the UK experience in context in March 2009 the Bank of England moved to 0.5% Bank Rate and began the policy of asset purchases which has now risen to £375bn. This policy excited accusations that the Bank was financing the government deficit to claims that such dangerous money printing would lead to Zimbabwe-style hyperinflation.
The philosopher Isaiah Berlin wrote an essay called "The Hedgehog and the Fox". In this he playfully characterised some writers and thinkers as hedgehogs and others as foxes and "the fox knows many things, but the hedgehog knows one big thing". The foxes in the current context know that central bank manipulation of vital price signals can lead to dangerous distortions and store up future problems. This point is conceded. However, the "one big thing" that is ignored in this thinking is the enormous deleveraging that is taking place in the wider financial system.
One example makes the point. Total assets on the balance sheet of one UK bank, RBS, shrank from £2.2trn in 2008 to around £1trn at end 2013. The UK financial system has shrunk dramatically in the past five years. Without counteracting action from the central bank the potential disinflationary impact of this process could have been much worse that it has been.
Long awaited pick-up
In the aftermath of the 2007-2008 financial crisis policy makers were faced with lesser of evil options. Very low interest rates and large scale asset purchases have created winners and losers. Savers have been hurt borrowers and owners of equities and real estate have been rewarded. This may be distasteful to some but this ignores the "one big thing" – without such action a much more damaging deflationary downward spiral could have occurred.
The UK economy is now showing impressive signs of recovery. Employment growth has been stronger than the Bank of England expected and business surveys suggest a positive outlook. The composite PMI (a measure of activity in the service, manufacturing and construction sectors) is at levels that would have been consistent with tightening by the Bank of England in previous economic cycles.
The recently revised GDP data also point to a better balance of growth with business investment starting to show a long-awaited pick-up. Despite all this, the market does not price the first rise in Bank Rate until Q1 2015. We do not disagree with this pricing for the following reason – the Bank of England now has a range of macro-prudential tools which could be used to tighten credit conditions before looking to raise Bank Rate.
Potential future tools were outlined in the Financial Stability Report published in November last year. The Financial Policy Committee, which is chaired by Governor Mark Carney, could recommend changes to the Help to Buy scheme; could make recommendations to the Prudential Regulatory Authority on bank capital requirements on residential real estate lending; or make recommendations on maximum loan-to-value ratios.
Mark Carney has emphasised the sensitivity of the U.K. economy to changes in Bank Rate. He has also said that a rise in Bank Rate will be the "last line of defence". Macro-prudential policies are potentially powerful tools and some of these are likely to be used before Bank Rate is raised.
For the gilt market this leaves some of the same challenges that have existed for some time. The tendency will be for 5-10yr dated gilt yields to rise. However, being short duration at all times will not be a viable strategy. With short-end rates likely to stay low the negative carry in short 5yr and 10yr positions will be punishing in a sideways market. The long-end of the market is likely to fare relatively better. An improved pension funding position will lead to ongoing derisking which will see sales of equities and buying of long-dated nominal and index-linked gilts. There will be a flattening pressure on the yield curve between 10yr and 30yrs.
