What's Up With British Interest Rates?
and what does it mean for the U.S.? We will discuss tonight
James Mackintosh writes (WSJ),
In the short run, is the U.K. a special case, or just the first victim of the newly-awakened bond vigilantes (investors who punish spendthrift governments with higher borrowing costs)? In the long run, is the U.K. once again taking to an extreme an approach—loose fiscal policy, and so more inflationary pressure—that is set to become the new new normal?
…The most apocalyptic risk is that Britain is merely the first major victim of higher rates. Previous Fed tightening cycles often created financial problems, most obviously the global financial crisis that began with the subprime implosion of 2007, but also repeated emerging-market crises, the blowup of hedge fund Long-Term Capital Management in 1998, and the implosion of the overnight borrowing market in September 2019. When easy money goes away, bad things happen.
How bad? It is always hard to predict, since we don’t know what hidden risks we don’t know. The banks are in much better shape than in 2007, but the Bank of England just had to step in to prevent problems in fully-hedged pension funds, a deeply dull sector few would have expected to implode.
Most of the financial rules, regulations, and norms of the last 15 years have only existed during a regime of extremely low interest rates and large central bank balance sheets. Throughout the last decade, there has been a consistent pattern whereby a catastrophic or near-catastrophic event exposes a risk in the financial system that policymakers then rush to cover—and those financial mishaps tend to happen more when the modern financial-regulatory regime enters new territory. Rapidly rising rates and shrinking balance sheets are, in many ways, new territory.
…The nuanced argument for “QE has to continue forever” rests not on the idea that central banks are subsumed by fiscal dominance and must “fund” yawning budget deficits, inflation be damned. Instead it rests on the idea that, for a variety of bank regulatory and financial stability reasons, the lowest comfortable level of reserves (or, what BoE policymakers define as the Preferred Minimum Range of Reserves) in the banking system might be much higher than anticipated. If commercial banks need more reserves than expected, central banks would have to revise down their estimates for Quantitative Tightening.
Economists and others see the central bank as responsible for controlling inflation. But central banks also feel a great responsibility for averting financial panics. Quite often, conflicts arise between these two objectives.
In his 1972 book Supermoney, George J. W. Goodman (aka ‘Adam Smith’) has a selection called “The Banks June 1970.” Back then, the Fed was in one of its inflation-fighting periods, but Penn Central Railroad went bankrupt late one Friday afternoon. Because Penn Central had borrowed a lot in the commercial paper market, there was a fear that creditors of other firms would rethink their willingness to hold commercial paper.
The Fed took the view that a collapse of the commercial paper market would be catastrophic. As Goodman describes it, the Fed spent the weekend calling up commercial bankers and telling them to lend money generously—the Fed would provide as much reserves as were needed. It put off inflation-fighting for another day.
The actions of the British central bank to buy long-term government bonds (gilts) is quite reminiscent of that. It puts off inflation-fighting for another day.
This weekend, there was financial news. It is never good to have financial news on a weekend. I presume that markets will be jittery this morning. You should have bought T-bill options Friday.
Also, over the weekend, three MIT-trained economists, who otherwise have little in common with one another, wondered out loud whether interest rates have overshot on the up side. Those economists were Paul Krugman, Greg Mankiw, and myself.
One question that arises, as Mackintosh and Politano point out, is whether central banks today are hamstrung in the efforts to fight inflation. Somewhere in the financial system, there may lurk important institutions that are unable to withstand higher interest rates. When these weak links are exposed, the central bank may feel compelled to backtrack.
Speaking of links, paid subscribers can find the link below to our Zoom discussion of the inflation outlook, at 8 PM New York time. The UK happenings factor in. Also, the state of the housing market. And for the latter, I am delighted to say that Kevin Erdmann will be joining us to share his perspective.