BoE, grudgingly, will “tolerate” above target inflation projections: money stays tight

A James Alexander post

The BoE of surprised markets by not only doing the 25bps rate cut expected but by unexpectedly restarting the QE programme. An addtional £60bn of bonds will be bought, taking the total up to £425bn.

The currency fell at least 1.5% against most currencies. However, purer domestic stocks only rose between 0.5% and 1.0%. The FTSE 100 rose 1.5% reflecting the drop in GBP. Gilt yields responded with shock to the extra buying as the 10 year gilt yield plunged back to post-Brexit lows.

The drop in gilt yields further flattened the interest rate curve and the short to medium term end remained inverted out to 4 years. This bond action is not a good sign. And the gilt moves were contrary to the BoE’s expectations:

In addition to cutting Bank Rate, supported by the introduction of the TFS, the MPC has voted to expand its asset purchase programme for UK government bonds, financed by the issuance of central bank reserves. This will trigger portfolio rebalancing into riskier assets, lowering the real cost of borrowing for households and companies. 

Inflation expectations will have moved very little. This is probably because of the very grudging nature of the BoE “toleration” of above-target inflation. It is actually not even that, it is only toleration of above-target projected inflation:

Thus, in tolerating a temporary period of above-target inflation, the Committee expects the eventual return of inflation to the target to be more sustainable.

Carney’s monetary tightening of 2015 did for Osborne, Hammond should watch out

The toleration of below target inflation has been so pervasive that the BoE was perversely threatening to raise rates for most of 2015 and so consistently tightening monetary policy. The complacency of George Osborne, the previous Chancellor of the Exchequer, towards this policy probably contributed more than anything to his downfall.

I expect Philip Hammond the new Chancellor wanted more, but has not got it. He needs to make sure he doesn’t just leave the BoE to make such disastrous mistakes. His letter to Mark Carney hints at more flexibility than the BoE likes to use. He needs to alter this wording to make it clearer that nominal economic growth has a higher priority than CPI targeting:

As set out in the MPC’s remit, active monetary policy has a critical role to play in supporting

the economy. In these uncertain times clarity about our macroeconomic framework is vital.

I confirm that the government’s commitment to the current regime of flexible inflation

targeting, with an operational target of 2% CPI inflation, remains absolute. The target is

symmetric: deviations below the target are treated the same way as deviations above the

target. Symmetric targets help to ensure that inflation expectations remain anchored and

that monetary policy can play its role fully. 

The BoE can’t control CPI but invents a projected CPI to control and thus is free to do anything

The problem is that the BoE targets a fiction which, as its author, it closely controls: the central projection for CPI 2-3yr out. Several times over the last 18 months it has modelled an upside breach of the central 2% projection. Sometimes it has threatened to tighten as a result, sometimes it hasn’t – but always promises vigilance and a bias to tighten. It is inconceivable the BoE would ever project a downside miss to the target in 2-3 years’ time.

By continually overestimating current but not future inflation, monetary policy remains tight forever. Remember that CPI inflation has been consistently below 2% for several years yet Carney has been tightening for nearly 18 months with his threats of rate rises, and only rate rises, sooner or later.

Brexit: a convenient excuse for the BoE’s failed projections

The result of this focus on projected and not actual CPI has been a slow strangulation of real and especially nominal economic growth. By ignoring the terribly weak NGDP growth of the last 12 months Carney is now almost happy to have something else to blame other than the BoE’s own failure to not only act to boost aggregate demand earlier –  but for contributing to the slowdown.

Much of this revision [to RGDP forecasts] reflects a downward adjustment to potential supply that monetary policy cannot offset. However, monetary policy can provide support as the economy adjusts. 

The Bank’s excessively strong negative views on the future trade policy of the UK remain notable and are a continuation of the anti-Brexit campaigning we saw during the referendum debate. The BoE has been so wrong about so much when it comes to forecasting, that it really should show more humility, and stop targeting its own “fiction” of future inflation.

The bond markets clearly do not believe the BoE inflation projections. Carney should be a worried man. The BoE expected investors to flee UK bonds post-Brexit. They flocked to them. The BoE expected its corporate bond QE to lead to investors fleeing UK government bonds. They flocked to them instead. Carney stated that the bank had done huge amounts of thinking about this package. Clearly perspiration is no substitute for inspiration.

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