A tale of two central banks
As a policymaker, what should you do if faced with an economy with a huge current account deficit, a currency that's under pressure, a housing market that's hit a brick wall, a banking system that's in crisis, a mortgage lender that might be on the...
As a policymaker, what should you do if faced with an economy with a huge current account deficit, a currency that's under pressure, a housing market that's hit a brick wall, a banking system that's in crisis, a mortgage lender that might be on the verge of bankruptcy and a budget deficit that's larger than it once was?
Oddly enough, the answer seems to depend on which side of the Atlantic Ocean you are. If you are in America, you cut interest rates, you promise lots more interest rate cuts to come, you allow the currency to find its own level, you use implicit government guarantees to shore up the mortgage market, and you have a serious debate about providing fiscal help both to reduce housing foreclosures and to stave off the risk of a deep and long-lasting recession.
If you are in England or Scotland, you refuse to cut interest rates because you worry about an unwelcome currency collapse, you're unable to do much to help the mortgage market because you never got round to creating a quasi-government agency to offer protection when things go wrong, you fail to find a solution for Northern Rock despite having had months to sort the problem out, and you certainly refuse to provide any fiscal help because you're in danger of breaching the golden rule.
These differing approaches have been seen recently. The Bank of England chose not to cut UK interest rates when it had the opportunity to do so. The US Federal Reserve, in contrast, provided the clearest of messages that interest rates in the US might fall quite a lot further. In fact, in a surprise more just a few days ago, the Fed slashed interest rates by 0.75 per cent to per cent, its biggest in 25 years.
It must be kept in mind that the Federal Reserve has lowered policy rates from a peak of 5.25 per cent to whereas the Bank of England has, so far, offered only an insubstantial reduction from 5.75 per cent to 5.5 per cent.
Are these two central banks living on different planets? Are America's economic problems really much worse than those in the UK? Or, alternatively, is one of these central banks about to make a monumental policy error?
Admittedly, economic conditions on either side of the Atlantic are not perfectly aligned. The US housing market has been in free-fall for about two years now, whereas the UK housing boom has only recently shown signs of coming to an end. The right policy for the US now may prove to be the right policy for the UK in, say, a year's time.
America's economic problems may have begun in the housing market but the biggest difficulty now lies at the heart of the financial system. The money market crisis last summer has evolved into a major tightening of credit conditions. Banks and other financial institutions are less willing to extend credit on favourable terms. Borrowers can no longer easily get access to loans. And, with a big spike upwards in US unemployment last month, the broader economy is now beginning to suffer.
Much of this, though, is also true of the UK. The money market crisis was, after all, a transatlantic event. The Bank of England's own surveys show a severe restriction of credit availability not dissimilar to the American experience. And while there's been no obvious sign of a deterioration in labour market conditions, retailers appear to have had less business than anticipated over the Christmas period, while financial institutions are licking their ever-increasing wounds. Moreover, if the US is heading towards recession, the UK should brace itself for a chill westerly wind.
Given these similarities, why is there such a reluctance to act in the UK? There has been one rate cut, and sterling has fallen a reasonable way but beyond this there is little sign of action on the policy front as being seen in the US.
The obvious answer is that the UK has not yet had that single statistic suggesting recession might be around the corner. It's notable, for example, that the Fed's tune appears to have changed in response to the sudden, and shocking, rise in US unemployment. Beyond this, though, there are other, institutional, reasons for the contrasting policy approaches.
First, the Federal Reserve sets policy with "collective cabinet responsibility". Although, theoretically, the Federal Open Markets Committee has "one member, one vote", in reality, public disagreements have been rare and the Chairman's views have tended to dominate.
The Bank of England's Monetary Policy Committee is a very different beast. The bank makes a virtue out of disagreement, with each member of the MPC encouraged to express his or her own views. In times of uncertainty, though, this may simply lead to discord and a lack of policy leadership.
Second, although Chairman of the Federal Reserve, Ben Bernanke, is sympathetic towards inflation targeting, the Federal Reserve enjoys a so-called "dual mandate". It has responsibility not only for price stability but also for high employment and, hence, the avoidance of recession. In fact, the recent interest rate cut and promise of emergency economic measures have been done for this very reason. Admittedly this leads to a lack of clarity and the need for continuous judgement calls but it also suggests that the Federal Reserve will be quicker than the Bank of England to react to signs of economic weakness. In the UK, the Governor of the Bank of England might end up later this year writing another letter to the Chancellor explaining why inflation is so high even in the midst of a recessionary downswing.
Third, the US does not bother to tie its hands with publicly-stated fiscal rules. Arguably, this reflects the dollar's role as the world's reserve currency. In the UK, however, the current government has made an explicit commitment to limited borrowing and its rules are already in serious danger of being breached. It would be embarrassing if the golden rule were to all-too-quickly turn to base metal.
The biggest single difference, though, is philosophical. The Federal Reserve is prepared to act quickly because the institution still blames itself for its failure to deal properly with the onset of the Great Depression in the 1930s. The Bank of England's approach, in contrast, is focused more on the desire to avoid the inflationary excesses of the 1970s.
• This report was compiled by Peter Calleya, manager for corporate strategy and research at HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.
Oddly enough, the answer seems to depend on which side of the Atlantic Ocean you are. If you are in America, you cut interest rates, you promise lots more interest rate cuts to come, you allow the currency to find its own level, you use implicit government guarantees to shore up the mortgage market, and you have a serious debate about providing fiscal help both to reduce housing foreclosures and to stave off the risk of a deep and long-lasting recession.
If you are in England or Scotland, you refuse to cut interest rates because you worry about an unwelcome currency collapse, you're unable to do much to help the mortgage market because you never got round to creating a quasi-government agency to offer protection when things go wrong, you fail to find a solution for Northern Rock despite having had months to sort the problem out, and you certainly refuse to provide any fiscal help because you're in danger of breaching the golden rule.
These differing approaches have been seen recently. The Bank of England chose not to cut UK interest rates when it had the opportunity to do so. The US Federal Reserve, in contrast, provided the clearest of messages that interest rates in the US might fall quite a lot further. In fact, in a surprise more just a few days ago, the Fed slashed interest rates by 0.75 per cent to per cent, its biggest in 25 years.
It must be kept in mind that the Federal Reserve has lowered policy rates from a peak of 5.25 per cent to whereas the Bank of England has, so far, offered only an insubstantial reduction from 5.75 per cent to 5.5 per cent.
Are these two central banks living on different planets? Are America's economic problems really much worse than those in the UK? Or, alternatively, is one of these central banks about to make a monumental policy error?
Admittedly, economic conditions on either side of the Atlantic are not perfectly aligned. The US housing market has been in free-fall for about two years now, whereas the UK housing boom has only recently shown signs of coming to an end. The right policy for the US now may prove to be the right policy for the UK in, say, a year's time.
America's economic problems may have begun in the housing market but the biggest difficulty now lies at the heart of the financial system. The money market crisis last summer has evolved into a major tightening of credit conditions. Banks and other financial institutions are less willing to extend credit on favourable terms. Borrowers can no longer easily get access to loans. And, with a big spike upwards in US unemployment last month, the broader economy is now beginning to suffer.
Much of this, though, is also true of the UK. The money market crisis was, after all, a transatlantic event. The Bank of England's own surveys show a severe restriction of credit availability not dissimilar to the American experience. And while there's been no obvious sign of a deterioration in labour market conditions, retailers appear to have had less business than anticipated over the Christmas period, while financial institutions are licking their ever-increasing wounds. Moreover, if the US is heading towards recession, the UK should brace itself for a chill westerly wind.
Given these similarities, why is there such a reluctance to act in the UK? There has been one rate cut, and sterling has fallen a reasonable way but beyond this there is little sign of action on the policy front as being seen in the US.
The obvious answer is that the UK has not yet had that single statistic suggesting recession might be around the corner. It's notable, for example, that the Fed's tune appears to have changed in response to the sudden, and shocking, rise in US unemployment. Beyond this, though, there are other, institutional, reasons for the contrasting policy approaches.
First, the Federal Reserve sets policy with "collective cabinet responsibility". Although, theoretically, the Federal Open Markets Committee has "one member, one vote", in reality, public disagreements have been rare and the Chairman's views have tended to dominate.
The Bank of England's Monetary Policy Committee is a very different beast. The bank makes a virtue out of disagreement, with each member of the MPC encouraged to express his or her own views. In times of uncertainty, though, this may simply lead to discord and a lack of policy leadership.
Second, although Chairman of the Federal Reserve, Ben Bernanke, is sympathetic towards inflation targeting, the Federal Reserve enjoys a so-called "dual mandate". It has responsibility not only for price stability but also for high employment and, hence, the avoidance of recession. In fact, the recent interest rate cut and promise of emergency economic measures have been done for this very reason. Admittedly this leads to a lack of clarity and the need for continuous judgement calls but it also suggests that the Federal Reserve will be quicker than the Bank of England to react to signs of economic weakness. In the UK, the Governor of the Bank of England might end up later this year writing another letter to the Chancellor explaining why inflation is so high even in the midst of a recessionary downswing.
Third, the US does not bother to tie its hands with publicly-stated fiscal rules. Arguably, this reflects the dollar's role as the world's reserve currency. In the UK, however, the current government has made an explicit commitment to limited borrowing and its rules are already in serious danger of being breached. It would be embarrassing if the golden rule were to all-too-quickly turn to base metal.
The biggest single difference, though, is philosophical. The Federal Reserve is prepared to act quickly because the institution still blames itself for its failure to deal properly with the onset of the Great Depression in the 1930s. The Bank of England's approach, in contrast, is focused more on the desire to avoid the inflationary excesses of the 1970s.
• This report was compiled by Peter Calleya, manager for corporate strategy and research at HSBC Bank Malta plc, on the basis of economic research and financial information produced by HSBC International Bank.