HyperNormalTimes

Written by our Director of Equity Advisory, Jeremy McKeown, the HyperNormalTimes provides in-depth and considered long-term commentary on major macroeconomic and market-shaping themes.

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June 5, 2021

DC on BoE indicates QE to become YCC – Welcome back to the 1940s

It was the case that the Bank of England, the senior officials in the Treasury, senior officials in the Cabinet Office were saying, you know, we have to think about the consequence of, if we do this lockdown, we’re going to have to borrow huge amounts of money. What if the bond markets suddenly spike and go crazy and refuse to lend [to] us. We’re going to then have to find emergency powers to tell the Bank of England to buy the debt, etc. etc. So there were conversations going on at the time about that possible problem. Dominic Cummings Select Committee Hearings, May 26th, 2021 

Curtain Raiser  -

The revelation from Dominic Cummings in his testimony to MPs that in the depths of the pandemic senior UK government officials were discussing whether to end the “independence” of the Bank of England attracted little media coverage. Westminster correspondents seem more interested in who paid for the Prime Minister’s wallpaper than how we will finance the lockdown. But maybe nobody believes central banks are independent, and it is a non-story.

Monetary Dominance -

The Bank of England was established in 1694 with £10 000 of capital to fund William and Mary’s wars with France. However, it wasn’t until 1946 that the UK government nationalised it. (The date is significant). The Bank’s activities were critical to the UK economy, and the government acquired it in the national interest. The Bank’s 17 000 shareholders received £14.6m of UK Government bonds by way of compensation. It remains wholly owned by the UK government. However, in 1997, the Blair Government granted it “independence” in some areas of its work because “they wanted its decisions to be free from party-political influence. It was a time of peak monetary policy dominance, and this move by the New Labour government helped to underline this point. Fed Chair Alan Greenspan was applying the lightest touch regulation to the banks, and UK Chancellor, Gordon Brown was basing his plans on what he later described as the “abolition of boom and bust economics”. Keynesian economics was at its cyclical low point.

Do What is Necessary -

How things change, the Global Financial Crisis was a wake-up call for Western governments. The policy response of choice became Quantitative Easing (QE), a previously obscure Japanese policy experiment. By the time Mario Draghi famously told sceptical markets that the ECB would do whatever it took to inject liquidity and confidence into markets and stave off the Euro crisis, monetary policy was in the final death throes of its policy pre-eminence. By the time we entered lockdown in early 2020, the world economy had been mending but insufficiently for central banks and government treasuries to repair their balance sheets and find a credible path to budgetary stability. The QE credit card was looking maxed out. Monetary policy had played itself out just as the UK government needed to finance the most significant increase in spending since World War Two. As with WWII, it was a time to do what was necessary. How to fund it was of secondary importance.

Ketchup Bottle Supply -

Today the world is opening up. We have daily stories of new variants and localised issues, but the world is becoming vaccinated to a greater or lesser extent. The vital economic signs are returning. Indeed, the FT referred to the ketchup bottle economy struggles to turn the supply back on in specific sectors such as semiconductors and lumber. But once the price mechanism shakes the bottle, things should unblock, possibly swamping stabilised demand. Either way, the economy is starting to rev its engines, which is good because a credit card bill needs paying.

Rates Can't Rise -

As with the mid-1940s, today, a political mood prevails set on rebalancing the economy to stave off the rise of populist tendencies. In 1946 the £14.6m nationalisation of the Bank of England was a footnote to a government programme of unprecedented welfare provision and economic intervention. The mid-1940s was peak Keynesianism. Food rationing introduced at the start of the war was not phased out until 1954. Notably, the government imposed credit rationing to cap interest rates (the main reason The Bank was deemed essential to the national interest). These we reinforced by exchange controls, also introduced at the outbreak of WW2, which incredibly were to last until the Thatcher Government in 1978. Just as today, the government could not allow rates to rise; they were too indebted. William Allen summed it up:

The large volume of liquid government debt outstanding at the end of the war, and its expansion during the ultra-cheap money period, facilitated the rapid expansion of money and credit. Bank credit expanded by more than 20% in both 1946 and 1947, and deposits increased by 16.2% in 1946. Inflation began to rise despite widespread price controls and rationing. The period 1945–47 was one in which debt management policy was indistinguishable from monetary policy, and the structure of interest rates throughout the yield curve was managed as a single enterprise. Moreover, the criteria for determining interest rates were clearly articulated. The experience showed, however, that pegging long-term bond yields at a level determined by the government, based on a mistaken economic forecast, and not endorsed by the market, was not a sustainable policy. William A Allen , Government debt management and monetary policy in Britain since 1919. 

Yield Cuve Control -

Allen is referring to the way the UK government managed to effect a policy of yield curve control (YCC). YCC is starting to be introduced by some central banks already. As with QE, the Bank of Japan has taken an early lead. While QE deals in quantities of bonds, YCC focuses on the price of bonds and is essentially a price cap on debt over the entirety of the yield curve. Belz and Wessel, at the Brookings Institute, have discussed YCC and raised the following warning:

The major risk associated with yield-curve policies is that they put the central bank’s credibility on the line. They require that the central bank commit to keep interest rates low over some future horizon; this is exactly why they can help encourage spending and investment, but it also means that the central bank runs the risk of letting inflation overheat while holding to its promise. Sage Belz and David Wessel, What is Yield Curve Control? 

Fiscal Dominance -

Our current position is closer to the 1940s than the 1970s. The government is re-asserting control, and we are in a period of full-on fiscal dominance. The monetary can has been kicked down the road so often that it is no longer fit for purpose. Central Bank independence is of secondary importance. We are all Keynesians now. But as we know, history doesn’t repeat itself. There are also notable differences to the 1940s. The world economy is far more interconnected. Goods, services, capital and people are more mobile, and we have technology that can send information around the world at a marginal cost of zero. Capital and exchange controls, interest rate caps and rationing are more complicated, arguably impossible, to effect. It is worthy of note that the move by the US for the G20 countries to agree to a minimum corporate tax rate is a step in the direction of coordinated fiscal policy response and an acceptance of the new fiscally dominant era.

Bond Wipe Out - 

Like in 1946, the Bank of England’s balance sheet is swollen from buying mainly government bonds in an “off-balance sheet” structure that makes Enron look amateurish. Austerity has ended in favour of levelling up. The Bank’s political masters need to keep borrowing, the Office of Debt Management has taken over from the Monetary Policy Committee. The work here is too important to bother with such niceties as central bank independence or credibility. When interest rates controlled in the 1940s, inflationary pressure built up. Initially thwarted by tightened monetary policy in the early 1950s, and after several ill-fated attempts at prices and incomes policies (direct control of the price mechanism in wages and consumer goods), consumer price inflation eventually ripped through the UK economy in the late 1960s and 1970s. In the 30 years from 1946 to 1976, the Bank’s previous shareholders’ 3% Treasury stock lost more than 80% of its nominal value. In real terms, their compensation was worthless.

Stay Positive -

The primary investment conclusions are that while the current bout of price spikes might well be transitory, that doesn’t mean the long term consequences of our heightened government debt levels won’t be inflationary. If the next few decades will provide challenges for equity investors, for bond investors things could prove terminal. The old notion of a balanced bond and equity portfolio needs an overhaul for the new era of fiscal dominance. Real assets need greater consideration. For the long term impact of inflation much rests on the supply-side’s ability to respond and the impact of technological change as an overarching deflationary force. On this, I agree with Churchill: I am an optimist. It does not seem too much use being anything else.

Jeremy

Ealing

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