What will the Bank of England do next?

This issue: What will the Bank of England do next?

Forecast: How likely is it that the Bank of England announces a rate increase of 1 percentage point or more in its Nov. 3 meeting?
Deadline: Forecasts must be made by 9am Wednesday 10/5.

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This is a wonky one... Enjoy.

Pity the Bank of England. It is fighting several fires—inflation, an energy crunch, a possible recession, and now a mini-financial crisis—while the UK government is in the other room playing with matches.

Friday before last, the Truss government outlined a “mini-budget” combining energy price caps with tax cuts, mostly for the rich. Markets ran the other way, causing the value of the pound to plummet and prompting a mini-financial crisis.

This is not the first time a central bank and a central government appeared to be at cross purposes. In 2014, in his final speech as outgoing Fed chair, Ben Bernanke called out the US Congress for failing to do its part to stimulate the economy in the wake of the financial crisis:

"To this list of reasons for the slow recovery… I would add one more significant factor—namely, fiscal policy… Excessively tight near-term fiscal policies have likely been counterproductive… [and so] the recovery is weaker than it otherwise would be."

Translated from ultra-conservative Fed speak, it was a bit like that Mark Wahlberg line from The Departed:

A picture of Ben Bernanke with meme text: "I'm the guy who does his job. You must be the other guy."

Central banks, for all their faults, have mostly spent the last 15 years trying to do their jobs. Legislators have frequently made those jobs harder, including by embracing austerity in the 2010s. But central banks can only do so much—to boost an economy, or even to fight inflation. At some point investors start to ask: What about the other guys?

Now the Bank of England has to weigh which challenge is most urgent. It reversed course this week and announced it would buy bonds to prevent a crisis involving private pension funds from spiraling out of control. Next it has to decide whether to hike rates faster than planned (to undo the efforts of the government it nominally works for) or to go slowly (for fear of exacerbating the financial chaos that the government helped to create).

Background

The UK has been experiencing high inflation—consumer prices were roughly 10% higher in August than the prior year. And while it doesn’t import much gas from Russia, it’s facing higher energy prices as a result of the invasion of Ukraine. The UK is also plagued by sluggish economic growth and low labor productivity relative to its peers.
Friday before last, the Truss government introduced a “mini-budget” containing energy price caps and tax cuts. The energy price caps are estimated to cost the government £100bn over two years (to reimburse energy producers) while the tax cuts will cost about £30 billion a year in lost revenue. No government forecast of the plan’s effects was provided.
Markets did not care for it. By Wednesday, the pound had fallen to a 37-year low (before recovering at the end of the week). And the price of UK government bonds dropped precipitously. Analysts mostly did not buy that the tax cuts would spur growth, and focused instead on the additional public debt and the potential for more inflation. The IMF even publicly criticized the plan.
Then private pension funds found themselves in a mini-financial crisis. The funds had used derivatives to hedge themselves and as long-term bond prices fell they needed to put up more collateral—which meant selling more long-term bonds, driving prices even lower. Things got so “close to imploding,” per the FT, that the Bank of England stepped in to buy government bonds to calm the market.
The central bank declined to make an emergency interest rate hike, but issued a statement about doing “as much as needed” to tame inflation. Its next meeting is November 3. One thing to know about UK interest rates: Most homeowners have floating rather than fixed-rate mortgages.

Perspectives

Against the mini-budget

“The rationale for this largesse is to stimulate growth. I concur with the Chancellor that this is our major problem. But tax cuts are just a quick-fix sugar-high – they do not deal with the UK’s fundamental problem of miserable productivity growth…I support protecting households from the soaring gas prices caused by Putin’s invasion of Ukraine. But the right policy would be to offset this cost with solidarity levies from better-off households and windfall taxes on energy-producing firms. Instead, we have huge unfunded tax cuts.” —John Van Reenen, LSE and MIT

A partial defense

“By no means is all or even most of it ‘stimulus.’ ...The energy price subsidies are the biggest part of this announced plan. I am against that policy, but it is trying to absorb a contractionary shock rather than being stimulus per se. The Truss plan is transferring much of that higher energy cost from the private sector to the public sector. The real cost involved is mostly the preexisting problem from the higher cost of energy, which now is on the government’s books to an increasing degree. Many people are speaking of that as “a cost of the Truss plan,” which it is in terms of nominal flows but not nearly as much in real resource terms.” —Tyler Cowen, George Mason University

On the financial reaction

“There is a fundamental macroeconomic conflict between the Truss government's so-called growth program of large-scale spending and the Bank's need to reduce trend inflation… The government's reckless budgetary statement is having consequences that will surely require higher interest rates… When a government's discretionary expansionary fiscal policy leads to a falling rather than a rising currency, despite rising rates, it is a clear signal that markets doubt the credibility of the government's economic competence or goals, in this case for good reason.” —Adam Posen, Peterson Institute

What happens next

“The Bank of England will be forced to raise interest rates higher and faster than planned, not just to cap inflation, but now to prop up the pound and keep convincing investors to buy British gilts (public debt).” —Robin Niblett, CSIS

“The really binding constraint here is financial stability… Between the balance between inflation and growth there’s a third thing we desperately want to preserve which is the stability of the financial system. And as interest rates are going up to square the circle between the tax cuts and the inflation imperative, they are breaking bits of the financial system.” —Adam Tooze, Columbia University

Indicators

Bank of England Official Rates

In August and September, the Bank of England raised rates 0.5% each meeting.

“Nineteen of the 36 economists surveyed said the Bank would add 75 basis points in November while 13 said it would go for a super-sized 100 bps lift. Only three said it would add 50 bps as it did in its last two meetings while one opted for a mega 125 bps increase.” —Reuters survey of economists

“Goldman Sachs Research now expects the BOE to deliver 100-basis-point hikes in both November and December (up from 75 basis points), taking the terminal Bank Rate — the U.K.'s most important interest rate — to 5%.”—Goldman Sachs Research

Good Judgment forecasters think there’s a 71% chance rates rise by at least a full percentage point in total over the Bank of England’s next two meetings (Nov. and Dec.)