Shadow MPC

The BoE and the Treasury need to exercise a little thinking out of the box as the MPC believes the economy needs additional stimulus but is unsure how it can be achieved

MS 4Mar Shadow

This month’s Monetary Policy Committee meeting promises to be the most interesting for several months.

The 6-3 vote at the February meeting for an extra £25bn of quantitative easing marked a change from MPC member David Miles being the lone voice calling for more QE, and the fact that outgoing Bank of England governor Sir Mervyn King was in the minority camp is particularly relevant.

The governor always votes last and so he was clearly trying to make a point by voting for a proposition he knew would be lost.

On two of the three previous occasions when King has voted with the minority the following month the MPC acquiesced with his view.

Furthermore, it was not just the closer vote on more QE that was notable from last month’s minutes but also the fact that the committee discussed cutting Bank base rate, before dismissing the idea for the same reasons as when it was considered last year.

There was clearly an increasing view on the MPC that the economy needed additional stimulus but the committee was in some difficulty in deciding exactly how it should be delivered.

It was also not convinced the timing was quite right for further action. A key question was should they use one of the existing policy tools or do something outside the box?

Plenty of outside box thinking is undoubtedly exercising brains at the Bank and the Treasury.

Some of the new ideas under consideration were aired in public for the first time at a recent meeting of the Treasury Select Committee, with three members of the MPC in the hot seat. Deputy governor Paul Tucker dropped the bombshell when he disclosed that one idea being considered was negative interest rates.

He made it clear that he was talking about the Bank charging negative interest on deposits with the central bank.

MS 4Mar MPC

However, it is difficult to see how Bank Rate could remain at 0.5% if such a policy was adopted, even if it didn’t actually go negative.

The main reason the MPC rejected cutting Bank Rate below 0.5% last time this was considered was the pressure it would put on the Balance Sheets of banks and building societies, especially those with a significant back book of tracker mortgages, or SVRs linked to a maximum margin over Bank Rate, written pre credit crunch at rates which are now either loss making or on very skinny margins.

The main rationale for considering negative interest rates appears to be to encourage banks and building societies to increase lending on the basis it will make more sense to lend money and earn some interest rather than pay The Bank of England for the privilege of having money on deposit with it.

A big problem with this is that after the regulatory failure in the run up to the credit crunch the various regulators, both supra national such as the Basle Committee and locally, i.e. currently the FSA, went from one extreme to the other and now require banks and building societies to hold far higher levels of liquidity, particularly for higher LTV lending as far as mortgages are concerned.

A large proportion of these liquid assets effectively have to be held on deposit at the Bank of England.

Thus on the one hand banks and building societies are required by regulators to hold substantial amounts on liquidity, which reduces their capacity to lend.

Then to address the problem of there not being enough lending, ideas such as negative interest rates surface to encourage more lending. Rather ironic and perhaps it would be simpler to engage in a bit of joined up thinking!

Funding for Lending has broadly worked as the Bank expected and been a particularly positive influence in the mortgage market. Building on this success, introducing FLS2 would be a less risky alternative to negative interest rates and avoid the serious risk of unintended consequences from the latter.

If the MPC decided further stimulus was needed prior to 31 January next year, the deadline for drawing down FLS funds, I can see no reason why a mark two version could not sit alongside the initial tranche, providing there were sufficient differences between what the two versions offered and hence sought to achieve.

For example, FLS is offered on a floating rate, with the price broadly linked to Bank Rate, on a 4 year term. FLS2 could be offered at a fixed rate over a longer term and without onerous early repayment charges. This would allow lenders to offer more competitive longer-term fixed-rate mortgages, thus encouraging borrowers, especially those who might struggle to meet their commitments if rates rose too far too quickly, to insure against rate rises beyond 5 years. It could also be targeted at specific sectors of the market, with the lowest rate being charged if, for example, at least X per cent of a lender’s new gross lending was at LTVs above a certain threshold.

The minutes of the last MPC meeting, combined with the comments from Paul Tucker and his two colleagues when they appeared in front of the Treasury Select Committee, open up a whole new area for debate about how best to stimulate the economy, but also suggest the MPC is likely to decide on some additional stimulus at its March meeting, which will be the fourth anniversary of the rate cut to 0.5 per cent. This is most likely to take the form of an additional £25bn of QE, with an outside bet of a Bank base rate cut to 0.25 per cent.