Credibility problems

The UK macro mess

On Monday the Bank of England upped the daily limit on its gilt purchases. On Tuesday morning it expanded the scope of its programme to include index linked securities. On Tuesday evening the Governor hit wires with a reiteration that the interventions would be coming to end within three days. And this morning, at about 5.30am, the FT reported that the Bank has been signalling the counterparties that, actually, the intervention might continue after Friday.

So what, other than the Bank slowly destroying its credibility, on earth is going on?

It is worth briefing recapping how we got into this mess:

Between December last year and September this year the Bank increased interest rates from 0.1% to 2.25%. It also telegraphed that quantitative tightening – the unwinding of QE – would be beginning as it sought to shrink its balance sheet. Markets expected, until the mini-budget, Bank Rate to rise to around 4.5% by next summer.

With the jobs market looking exceptionally tight the MPC had concluded that tighter policy – even at the cost of a recession – was required to bring inflation down to target in the medium term. Painful and unpleasant, but at least understandable.

Then we got the mini-budget.

Markets, correctly, recognised that that the largest tax cuts since 1972, coupled with a large energy price intervention, would both increase the supply of gilts in the months ahead and – more importantly – add to demand (relative to the no tax cuts/energy intervention scenario) and hence inflation. That all implies a faster pace of tightening from the Bank to offset the actions of the Treasury. Expectations of Bank Rate hitting 4.5% next summer quickly became expectations of Bank Rate at 6% next summer.

Higher supply and a more hawkish path of rate hikes form the Bank all required a readjustment in gilt pricing with prices falling and yields rising.

This was all textbook stuff.

And then the gilt market broke.

This is not the place to go over, again, the LDI meltdown. FT Alphaville’s coverage has been superb.

But by Wednesday the 28th September, five days after the mini budget, the gilt market – especially at the longer end – was becoming dysfunctional. The speed of the readjustment in prices was triggering margin calls at leveraged LDI vehicles which were dumping gilts to raise cash and adding to downward price pressure.

Pricing in a core UK asset market was no longer being driven by economic fundamentals but by margin clerks and technical factors.

That prompted the Bank to intervene on financial stability grounds.

And that is the background to the communications mess-up of the past 24 hours. The found itself intervening in the gilt market with purchases to help maintain financial stability whilst at the same time saying that rates were heading up and gilt sales would soon begin to maintain monetary stability and bring inflation down.

It is not the job of the Bank of England to target any particular level of yield on gilts. And it is certainly not the job of the Bank to prevent investors losing money in the gilt market.

But it most definitely is the job of the Bank to prevent a disorderly breakdown in a core UK asset market which would lead to a unnecessary tightening in financial conditions that would hammer the real economy as borrowing costs rose by more than required to return inflation to target.

What is really happening here is a crisis of credibility.

The Bank is clearly worried that continuing interventions in the gilt market – even on legitimate financial stability grounds – might look and feel like an attempt to mop up the government’s mess and help out by lowering funding costs. In other words, the Bank’s fear is that the longer it continues to act the more fretting their will be about fiscal dominance (a situation in which the central bank plays a subservient role to the finance minister and is seen as taking its eye of inflation). In the longer run a loss of inflation fighting credibility could unanchor inflation expectations.

But promising to do incredible things is a ridiculous way to look credible.

Central banking is usually about a balance of risks approach. The risk of appearing fiscally dominated has to be weighed against the risk of an immediate and unwarranted tightening of financial conditions as borrowing costs spike with serious implications for the economic outlook.

The Bank cannot allow worries about its credibility on monetary policy to force it to discard its mandate for financial stability. Such an action would be self-defeating anyway as real financial stability problems would quickly impact on the conduct and transmission mechanism of monetary policy.

It is simply not credible to warn of “self-reinforcing fire sale dynamics” that “pose a material risk to UK financial stability” on Tuesday morning and then hope that that problem will have sorted itself out by Friday. The end game here is some form of further intervention in the weeks ahead – perhaps a liquidity facility for non-banks. Worries about fiscal dominance can be dealt with by delivering a large hike in Bank Rate in November.

This is a mess. And not one that any part of the British macro authorities come out of looking well. The Treasury started a fire in the gilt market. The Bank has tied itself up in knots trying to deal with that fire. And it looks like the regulators in general totally dropped the ball on LDI over the last decade.

The pressure on the chancellor to deliver a credible fiscal plan on Halloween just became even more intense.

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