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  • Dr Gerard Lyons

The case for gradual policy tightening

When assessing the economic and policy outlook it is always important to anticipate what lies ahead as well as being on top of current developments. It is necessary to emphasise this perhaps obvious comment at the present moment, as the economy emerges from an unprecedented situation.

Year-on-year comparisons of most economic statistics are producing dramatic figures, and in some cases triggering eye-catching headlines. Just take recent UK inflation figures: “Businesses are raising prices at the fastest pace in 22 years” was just one of many such headlines. Because of the collapse in the economy a year ago, as the pandemic triggered the first lockdown, and because of the strong rebound in many sectors now as the economy continues to reopen, all year-on-year comparisons need to be interpreted accordingly – with understanding. There will be dramatic changes. So it is important to focus on what will happen next, as well as present developments.

A sustainable rebound?

In many respects this very focus accounted for the reaction in financial markets globally, as well as in the UK, last week following the US Federal Reserve’s (the Fed) latest policy meeting. At that, the Fed signalled – sensibly in my view – that policy will need to be tightened. Not just yet. But the message was to recognise that it is not just a case of ‘if’ monetary policy tightens but ‘when’. The Fed was, naturally, focusing on the US, but it has relevance for how we should view prospects in the UK too, as well as impacting global markets. So what then are the key issues we should be looking ahead at? The UK and world economy are rebounding. This rebound reflects many factors – a return of confidence and a recovery in demand and output as the roll-out of vaccinations continues and as further unlocking either happens or is anticipated. The UK economy is now 3.7% below its pre-pandemic level.

While the recent delay of full opening up by the government has hit some sectors hard, the economy looks set to return to this pre-pandemic position – that is, its level of last spring – probably by August or September. This fits with the view we have held for some time of a strong economic rebound this year. But will this rebound be sustained and continue? This goes to the heart of the present financial market turbulence. It is not just the rebound from unlocking that is accounting for buoyant growth numbers but the huge policy stimulus, too. Thus, the Fed’s very hinting at future tightening was sufficient for markets to focus on when and by how much growth will slow.

Questions to answer for markets

The clear worry for markets is that economic recovery is dependent upon cheap money and that tightening will slow growth prospects. There are, it seems, three big inter-related questions that need to be answered for markets now: - after the strong rebound and recovery this year, how much of this will be sustained or will economic growth slow significantly? - inflation is rising. Is this really temporary or transitory as policy makers suggest? - as the balance of risks changes surely monetary policy needs to be tightened, but while inflation risks may merit a shift in central bank policy how can they get the balance right? Let’s focus on this latter issue here, as the approach to be taken encompasses the other two questions, too. Take the Bank of England (BOE). They are still implementing the same policy now as in February even though then they were worried about growth and in contrast now they expect a strong rebound. They seem to be behind the curve. The Bank should outline a gradual, predictable policy tightening beginning now. They should then indicate the approach they will take. Currently they are stimulating through both low interest rates and by printing money through Quantitative Easing (QE). They don’t need to reverse both at the same time. With policy rates at 0.1% and inflation at 2.1%, “real” interest rates (calculated by looking at rates minus inflation) are negative. This may be justified when growth is weakening and downside risks threaten, but it is not appropriate if recovery is underway. This may suggest the need to raise rates, but at the same time we are still seeing a huge stimulus through QE as the BOE continues to buy large amounts of gilts. So much so it is now the largest holder of government debt and by some distance. The sequencing and pace of tightening is key. Should it be via higher rates or via a halt to its QE policy? Such a halt to QE policy would be, initially, to stop further asset purchases. In February the BOE set a QE target of £895 billion, comprising £875 billion of gilts, in addition to £20 billion it already held in corporate bonds.

Last month, the Monetary Policy Committee voted 8-1 to continue with the QE policy, but the one objection was to reduce the target by £50 billion. Halting could then be a prelude to a reversal of the policy, via Quantitative Tightening (QT), with the BOE reducing the number of gilts on its balance sheet by not replacing when current holdings mature, or by selling gilts. The answer as to whether to tighten via rates or via the balance sheet is a policy choice although there are so many possible options, how either is managed or combined will impact the shape and level of the yield curve.

We should be wary of complacency

Even though the economy is rebounding, it is important not to be overconfident and complacent. If we look at China, which emerged from this crisis sooner, the rebound was strong, but growth has lost some momentum as credit conditions there have tightened. Perhaps that lesson needs to be borne in mind. For instance, the UK housing market, which has boomed recently, may already be cooling as a temporary tax boost ends. Also, there are areas of weakness or vulnerability in the UK economy. Many small firms nurse debts or government-backed loans that will need to be repaid. Meanwhile, 3.4 million people were still on furlough at the end of April. (It peaked at 5.1 million in January.) There is a similar situation in America, where payrolls are 7.6 million below their pre-crisis level (although the market is speculating upon a strong jobs bounce in data there soon). In the US, meanwhile, fiscal policy is being relaxed while here there is already much media focus on the need to tighten fiscal policy – with such talk perhaps being fuelled by the Treasury. Central banks still need to tread carefully in this environment. In recent weeks markets were worried about a taper-tantrum in the US, with sharply and perhaps violently higher yields on any talk of tightening via reducing asset purchases by the Fed. In the event, the Fed was able to change the focus to higher rates with its comments last week without such a market tantrum – a sign of good expectations management by the Fed and also that the market was already thinking this way, too. Such developments would likely make it easier for the Bank of England to go down this path, too, of policy signalling – here the sequence looks set to be QT first, with rate hikes to follow. But that could change. The speed of tightening is a function of economic and inflation prospects. We also need to be mindful of fiscal policy, too. The Treasury and the Bank of England are joined at the hip, with the Bank funding the deficit and helping to keep yields low. Policy coordination is critical. The best way to reduce the ratio of debt to GDP is via a sustained period of stronger economic growth. President Biden’s message at the recent G7 was for countries not to tighten policy prematurely. He clearly favours a ‘go for growth’ policy in the US, but the scale of policy stimulus there may be excessive and risks inflation rising. The UK may not face exactly the same issues but we are not that far away in some areas.

While we do not need to relax fiscal policy like the US we certainly don’t need to tighten, but we are also seeing inflation pick up as pent-up demand collides with supply bottlenecks and retailers and producers pass higher costs on and seek to boost margins, too. Hence the need to tighten monetary policy gradually and soon in a slow, predictable and phased way and to see how the economy responds.