What happens when the Bank of England runs out of interest rate ammunition?
"When interest rates get to the zero level, if we ever were to get to that level..., at that point there needs to be close coordination between government and the central bank because monetary policy is very close to government debt management" - Mervyn King (Governor of the Bank of England).
The UK entered this year with economic data continuing to disappoint but with precious little interest rate ammunition left. After lowering the rate by 50 basis points to 1.5 per cent last week, it is envisaged that interest rates will fall to just 0.25 per cent by February. But we should not be fooled into thinking that markets need only fret about when interest rates start to rise again. As the chairman of the Federal Reserve, Ben Bernanke has been quick to point out that when interest rates are at very low levels, monetary policy has far from run out of ammunition. Indeed, the unconventional measures, as they are collectively known, will have large implications for markets. This is what we expect from this year.
A commitment to keep rates low for a long time: Households and corporates will be more likely to go out and spend, in the knowledge that interest rates will remain low for some time.
Large amounts of government borrowing: The Chancellor of the Exchequer massively revised his plans for borrowing in the pre-budget report. But even these forecasts are likely to prove too optimistic. Assuming much weaker growth forecasts, and accounting for the fact that the housing and financial markets may not recover as quickly as the Chancellor envisages, it is estimated that the government will need to borrow an additional £54bn over the next four years, such that the Public Sector Net Borrowing will rise to 9.2 per cent of GDP.
But this increase could still be dwarfed by further sums of money that may be needed to be injected into the banking system. As Mervyn King recently admitted: "We may not have come to the end of recapitalisation. It may be that the banks need more capital, in which case that should be put in". This will entail that the governments net cash requirements will increase by an additional £50bn of injections for bank recapitalisation.
Significantly more "gilt-type" paper will be required: The Chancellor is clearly feeling the pressure of on-balance sheet lending, but needs to get more cash into the economy, and particularly into the banking system. He has already authorised the banking system to issue debt to cover maturing liabilities up to £250bn.
Like the Special Liquidity Scheme (where securities have to be repurchased back within three years) this is merely helping the banks fund old mortgage lending, rather than giving the banks access to the new cash for lending that the economy desperately needs. So widening the credit guarantee scheme looks likely. The Crosby Report advocated guaranteeing mortgage-back securities in the region of £100bn. But this suggestion met a frosty response from the Governor of the Bank of England who stated: "The proposal is very specifically aimed at guaranteeing mortgage-backed securities. I am all in favour of finding ways of encouraging a sustainable rate of mortgage lending but I am not entirely confident that the best way to do this is to resurrect an instrument which, for rather good reasons, has fallen out of favour".
The authorities may therefore simply decide to broaden the banks' capacity to issue new bonds, and the recent cut in fees for this facility is a clear step towards this possibility. The scale of such action is unclear. The government seems very keen to see lending return to 2007 levels. According to Bank of England data, net lending to households was £96bn in 2007 and net lending to corporates was £68bn. It might therefore be reasonable to assume that around £150bn of government guaranteed paper will also be available. There is also the potential that some corporates are allowed to use a government guarantee to issue new debt as we are starting to see on the continent with the car manufacturers.
Use of the Bank of England's balance sheet: Even excluding the Special Liquidity Scheme, the central bank's balance sheet has increased almost threefold since the start of the crisis, as banks have turned to the central bank in order to repo assets that the markets have lost appetite for. This in itself has little impact on markets other than to smooth some of the liquidity constraints that the banks could otherwise encounter and so ease the premium for counterparty risk. But the impact on markets would prove more potent should the Bank of England choose to purchase securities outright.
Should the markets start to find the government bond issuance too much to stomach, the Bank of England would start to purchase longer-term government bonds, to ensure that interest rates along the maturity spectrum remain low. The only clear implication is that government borrowing will balloon by even more than the Chancellor anticipates and this issuance will have to compete with the issuance of "gilt-type" paper from the banks, and potentially corporates.
Although such massive issuance could be met with rising interest rates, the threat of demand for this paper from the Bank of England should keep interest rate curves flat and low. But if markets are suspicious that the economy will not grow its way out of debt, and instead repayments will have to be met by printed money, this might have implications for the currency (assuming problems are not as large and being met with the same response elsewhere in the world). Overall, 2008 was a tumultuous year for the UK economy, and 2009 does not look any better.
This report was compiled by the marketing department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.
The UK entered this year with economic data continuing to disappoint but with precious little interest rate ammunition left. After lowering the rate by 50 basis points to 1.5 per cent last week, it is envisaged that interest rates will fall to just 0.25 per cent by February. But we should not be fooled into thinking that markets need only fret about when interest rates start to rise again. As the chairman of the Federal Reserve, Ben Bernanke has been quick to point out that when interest rates are at very low levels, monetary policy has far from run out of ammunition. Indeed, the unconventional measures, as they are collectively known, will have large implications for markets. This is what we expect from this year.
A commitment to keep rates low for a long time: Households and corporates will be more likely to go out and spend, in the knowledge that interest rates will remain low for some time.
Large amounts of government borrowing: The Chancellor of the Exchequer massively revised his plans for borrowing in the pre-budget report. But even these forecasts are likely to prove too optimistic. Assuming much weaker growth forecasts, and accounting for the fact that the housing and financial markets may not recover as quickly as the Chancellor envisages, it is estimated that the government will need to borrow an additional £54bn over the next four years, such that the Public Sector Net Borrowing will rise to 9.2 per cent of GDP.
But this increase could still be dwarfed by further sums of money that may be needed to be injected into the banking system. As Mervyn King recently admitted: "We may not have come to the end of recapitalisation. It may be that the banks need more capital, in which case that should be put in". This will entail that the governments net cash requirements will increase by an additional £50bn of injections for bank recapitalisation.
Significantly more "gilt-type" paper will be required: The Chancellor is clearly feeling the pressure of on-balance sheet lending, but needs to get more cash into the economy, and particularly into the banking system. He has already authorised the banking system to issue debt to cover maturing liabilities up to £250bn.
Like the Special Liquidity Scheme (where securities have to be repurchased back within three years) this is merely helping the banks fund old mortgage lending, rather than giving the banks access to the new cash for lending that the economy desperately needs. So widening the credit guarantee scheme looks likely. The Crosby Report advocated guaranteeing mortgage-back securities in the region of £100bn. But this suggestion met a frosty response from the Governor of the Bank of England who stated: "The proposal is very specifically aimed at guaranteeing mortgage-backed securities. I am all in favour of finding ways of encouraging a sustainable rate of mortgage lending but I am not entirely confident that the best way to do this is to resurrect an instrument which, for rather good reasons, has fallen out of favour".
The authorities may therefore simply decide to broaden the banks' capacity to issue new bonds, and the recent cut in fees for this facility is a clear step towards this possibility. The scale of such action is unclear. The government seems very keen to see lending return to 2007 levels. According to Bank of England data, net lending to households was £96bn in 2007 and net lending to corporates was £68bn. It might therefore be reasonable to assume that around £150bn of government guaranteed paper will also be available. There is also the potential that some corporates are allowed to use a government guarantee to issue new debt as we are starting to see on the continent with the car manufacturers.
Use of the Bank of England's balance sheet: Even excluding the Special Liquidity Scheme, the central bank's balance sheet has increased almost threefold since the start of the crisis, as banks have turned to the central bank in order to repo assets that the markets have lost appetite for. This in itself has little impact on markets other than to smooth some of the liquidity constraints that the banks could otherwise encounter and so ease the premium for counterparty risk. But the impact on markets would prove more potent should the Bank of England choose to purchase securities outright.
Should the markets start to find the government bond issuance too much to stomach, the Bank of England would start to purchase longer-term government bonds, to ensure that interest rates along the maturity spectrum remain low. The only clear implication is that government borrowing will balloon by even more than the Chancellor anticipates and this issuance will have to compete with the issuance of "gilt-type" paper from the banks, and potentially corporates.
Although such massive issuance could be met with rising interest rates, the threat of demand for this paper from the Bank of England should keep interest rate curves flat and low. But if markets are suspicious that the economy will not grow its way out of debt, and instead repayments will have to be met by printed money, this might have implications for the currency (assuming problems are not as large and being met with the same response elsewhere in the world). Overall, 2008 was a tumultuous year for the UK economy, and 2009 does not look any better.
This report was compiled by the marketing department of HSBC Bank Malta plc on the basis of economic research and financial information produced by HSBC International Bank.
Advert
Popular Stories
In Discussion
Advert
0 Comments
Post comment
Please sign in or create your Account to post comments.