Tuesday, 23 April 2013

To QE or not to QE that is the question


I have just moved jobs and this has prompted me to think about the challenges that Mark Carney the in-coming Governor of the Bank of England (BoE), will face.  He arrives with stellar credentials and a reputation as one of the world most expert central bankers.  He became the central banker for his own country Canada in 2008 and has taken credit for Canada’s OK performance since the financial meltdown following Lehman’s failure in the summer of 2008. He has used a mixture of monetary measures to help the Canadian economy recover, quantitative easing, and monetary tightening have both been deployed more readily than in other economies. 
Mark Carney - Magician or Muppet?
His arrival in Threadneedle Street  is vitally important for the British chancellor, George Osborne, who has run out of ideas for getting our economy growing again
Mr carney must be wishing that he had been appointed a little earlier as the BoE as the current governor has already blown £375bn on quantitative easing – but the firepower may be drying up.  The main issues he faces are:

    1.      Springing the liquidity trap in private consumption and getting the banks lending again
    2.      Managing inflation that has be stubbornly high unlike in japan and other advanced    economies where deflation is a major concern
    3.      Re-structuring the banks and dealing with the debt over hand in the private equity business
    4.      Implementing a new regulatory regime for the banks without killing off this vital sector
     Getting the economy to grow after 5 years of flat lining, with other major economies using QE and monetary policy to improve competitiveness (currency devaluation) we need action that supports the real economy.  
For some time the markets have been convinced that more monetary activism is on the way and this has had the pound plunging, along with yields on UK government bonds. Abenomics  being unleashed by Haruhiko Kuroda, the new Bank of Japan governor, have only stirred expectations of exceptionally aggressive easing with Mr Carney in charge.

Last week Mr Carney acknowledged on that the UK was one of the economies which the International Monetary Fund has said is in “crisis”. Like any in-coming manager he will want to paint the current situation as black as possible; so having talked the UK economy down what room for manoeuvre will Mark Carney have?

He created excitement in December when he mooted the idea that central banks could set targets for the overall size of the economy, or nominal gross domestic product, rather than inflation. But in the budgets Mr Osborne opted for relatively minor changes to the Bank of England’s remit as he kept the 2 per cent inflation target but clarified that policy makers could prioritise growth, provided inflation remained under control.  Economists called the new remit a “damp squib” after all the hype.

So what might change?

     One area of policy that will clearly change under Mr Carney is what is known in central bank speak as “forward guidance”. The idea is that private consumers make spending decision their view on forward interest rates,  if they believe interest rates will remain at ultra-low levels for an extended period they may be less inclined to save. Under Mr Carney’s stewardship, the Bank of Canada became the first central bank in the Group of Seven leading industrialised nations to promise to keep interest rates low a long way into the future. The US Federal Reserve has since gone further, committing to keep interest rates low until unemployment falls below 6.5 per cent. With the UK’s poor record on inflation such a commitment might be more difficult

     He may well consider more quantitative easing, but after our £375bn binge he maybe less include or able to continue the asset purchase scheme.  He could however be a little more radical than the current regime at the BoE and contemplate more structural measures.  He could look at more proactive restructuring of RBS and Lloyds Banking group and some of the private equity funds.  The UK economy is suffering from a large number of zombie companies weighed down by debt but hanging on due to ultra low interest rates.  Rather than raise interest rates, which would damage the housing market and consumers Mr Carney could insist the banks take more proactive steps to restructure debts that will never be paid off.  This might cause some short term unemployment pain but a clear out of Zombie companies would clear the way for more vibrant private sector growth.  Any return to large scale QE and continued negative real interest rates would be a firm signal that both the government and the Bank of England think that bank creditors (savers) should continue pick up the tab for the wild over spending between 2000-2009.    

     Mr Carney could also build on the Funding for Lending Scheme (FFLS), unveiled by the Treasury and the Bank of England last summer, has had some success in easing borrowing constraints on would-be homeowners. But, while conditions in the mortgage market have improved, lending to small and medium sized businesses remains constrained.  Revamping Funding for Lending is an easy win for Mr Carney, who indicated this year that he was willing to use the scheme to boost credit creation.  The problem with FFLS is that it is essentially a mechanism for civil servants to pick winners - a role they are very badly suited to.

If I was in his shoes I would consider a contrary approach, which would mean raising interest rates.  The medicine of ultra-low interest rates in the advanced world has proved a failure in Japan over 10 -15 years and has not worked in the US, UK or Europe in the last 5 years.  Where aging populations comprise a substantial part of the total private consumption and where companies turn cash into share buy backs low interest rates are a killer blow.  We need to move to a world where there are real positive interest rates on 2-3% rather than the current negative real interest rates.  This would also have the benefit of dealing with Zombie companies and force the banks to restructure quickly.  There would definitely be more pain in the short term but we surely benefit in the medium term with a more dynamic and health real economy.
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