Central Banks, Cost of Credit and Credit Controls

by George Hatjoullis

Today is Non-Farm Payroll day in the US. From the outset I should say I do not much care. The Federal Reserve will initiate an interest rate increase in December come what may. The signals have come thick and fast that the present rate structure was elected in an emergency and there is no longer an emergency. A ‘normal’ rate structure needs to be re-instated. albeit at a steady pace. Quite what a ‘normal’ rate structure might be I do not know and I suspect nor does any voting member of the Fed. We all agree, however, that it is not down here! There is an important difference between the attitude of the US and the UK that I only noticed this morning and it is not simply the sensitivity to international economic conditions.

In the US there is a laissez-faire view  of central banking. The CB sets the cost of credit and allows the credit system to deliver credit to those sectors that are willing to pay the price. Only those sectors that can profitably use the credit will pay the price. This is a market based policy. In the UK this is not the case. According to the FT, the Bank of England combines monetary policy with macro-prudential policy. I did not know this! It seems the cheap credit policy being pursued by the BoE, and reaffirmed yesterday, is being combined with selected credit controls on specific sectors. Credit is cheap but you may not be able to get it. It does not matter which sectors can most profitably use credit. Only those sectors that the BoE deems suitable should receive credit. This is not a market based policy. This is an interventionist policy presumably justified because of externalities.

The externality is perceived to arise through market bubbles and consequent financial instability. Hence, although mortgages are cheap, the criteria for getting one are pretty stiff. The same stiffness is to be extended to other sectors such as buy-to-let. Extending credit to Small and Medium businesses is probably not going to be restricted. The government seems keen to encourage this sector and the BoE seems to think this is a good way to boost inflation. Really? Making cheap credit available to SMEs means that more marginal projects and enterprises will come into being. These enterprises, already typically over-reliant on short-term debt, will use debt financing where maybe equity is more appropriate. If and when interest rates rise they will be exposed and start squealing. Failures will accelerate unless product price inflation bails them out of the debt. They need inflation but expanding this sector artificially does not logically bring the inflation about. The BoE selective credit policy could create a debt problem in the SME sector. An unintended but no less serious problem with respect to financial stability.

In the US framework entrepreneurs make their own decisions. The interest rate framework is not artificially set to meet some macro-prudential goal. If they think they can make a profit at the going rate they can borrow. All and any sector can borrow. Credit grows where entrepreneurs think it can most profitably be used. It could well lead to a bubble in some sectors and create financial instability risk. However, it is not one the Federal Reserve has created. It is market determined and need not have systemic implications. Neither system is flawless. However, the idea that a CB can induce greater financial stability through cheap credit diverted to favoured sectors is patently not demonstrated. I do not trust markets but I trust CBs, NGOs and Governments even less.

From a monetary policy point of view it is clear US interest rates will rise faster than UK interest rates. This may have implications for the GBPUSD rate. The UK is using credit controls to micro-manage the economy, albeit for ostensibly macro-prudential reasons. The US framework is simpler and cleaner. There are few unknown unintended consequences. The UK system is messy and there are potentially many unknown unintended consequences. Cheap credit loaned to one favoured sector has a habit of leaking into other sectors that can use it, and in uncontrolled ways. Neither framework avoids the risk of systemic financial crises.