Monetary Policy and Financial Stability

by George Hatjoullis

Yesterday (29/06/2017) we saw a minor perturbation in the asset markets. It was a response to a series of coincident but somewhat ‘hawkish’ statements from central bankers. Hawkish, for the uninitiated, is market-speak for inclined to tighten monetary policy and raise official interest rates. There was, as many noted, a whiff of coordination about the statements. This is unlikely in the strict sense but central bankers do talk to each other. Moreover, they all play from the same rule book and tend to react in much the same way to environmental stimuli. The implication is that they all see the same environment. If they are coincidentally all talking hawkish the environment that they perceive has changed. This is the interesting take from this otherwise small perturbation.

Cheap money has been the rule since 2009. It has not however necessarily been easy money. The central banks have flooded the system with liquidity but this has not led to a credit explosion. This is because banks have tightened credit requirements in response to the 2008 crisis. In part they were required to do so but it has also been a prudential response. Those deemed a good credit have had access to plenty of cheap credit. This has channeled the liquidity through specific routes and had some very noticeable outcomes. Those with capital, the already rich, have been able to expand and get richer.The expansion of pay-day lending, charging usurious interest rates, car loans, and mortgages, are all symptoms of a distorted credit structure. In the UK we have also had huge expansion in peer-to-peer lending and challenger banks. Things are not what they were.

The challenger banks are particularly interesting. They need a banking licence and as such must come within the FSCS compensation scheme. This has expanded the availability of risk free assets. Each separately licensed bank offers a secure deposit facility up to £85k. One of the consequences of the 2008 crisis was to focus attention on the fact that deposits above the protected amount (it varies) are not secure. They are not the same as cash in hand. The deposits may be easy to access but they are no more secure than the bank and the willingness of the state to bail it out. After 2008 bank credit worthiness has become an issue and the willingness of the state to bail out banks has diminished somewhat. The only case of unsecured depositors being ‘bailed-in’ (losing their deposits) is Cyprus in 2013 and this was in exceptional circumstances (the state could not bail-out the banks) but the principle that bail-ins are possible is now well understood. Leaving more than £85k in a bank is risky. The proliferation of challenger banks has increased the number of the £85k deposits that is possible.

It has been my contention that the newly perceived insecurity of large deposits effectively reduced the money supply and contributed to the deflationary forces evident since 2008. The demand for risk free or near risk free assets such as government debt has grown dramatically just as states were working hard to contract supply through tighter fiscal rules (aka austerity). The central banks exacerbated this excess demand by buying large quantities of government debt in the open market as part of the so-called quantitative easing programmes. This has increased liquidity (cash) at a time when what was required was (risk free) assets. The result was that risk free interest rates fell to zero (or negative). Cash has sought a return and a safe home and has typically found it in property.

Property values have exploded since 2008. The idea that inflation has been low is nonsensical. The cost of accommodation, the largest single cost in any household budget, has risen dramatically. The owners of accommodation have done well. The users have done less well. The monetary policy has had distributional effects. It has increased wealth inequality. A small two bed-room flat in a shoddy ex-council estate in Islington might set you back £19200 per annum. The median gross annual wage in inner london is circa £34k. Take home pay after tax and national insurance is £26,334. This means two sharing are paying 36.5% of disposable income each in rent alone. Not everyone earns the median and those living in this kind of accommodation typically earn much less. How does one save for a mortgage in these circumstances? The cost of credit to those on low insecure income and with little capital is also much higher than the headline interest rates. Someone is doing well and it is the already wealthy.

Another group that has been disadvantaged by the low yields and low-interest rates is the retired. Those in defined benefit schemes are arguably much better off because they have secured pension incomes, typically index linked. The transfer values of these pension benefits are very large. The problem is that, outside of the public sector, these schemes are the liability of corporate entities. The low yield has made it very expensive to fund the benefits. This has led to a threat to the continued provision of such benefits. Those in defined contribution schemes understand the issue very well because they have to generate the income themselves just like the corporate plan sponsors. Low yields have made annuity levels pitiful and forced retirees into risky assets, or property, to generate an income. But many have simply sat in cash in order to preserve capital. This has not been too serious as this group typically have homes and the cost of living has been contained through low goods price inflation. But this has changed.

Inflation has picked up. In the UK this has been exacerbated by the Brexit induced decline in sterling. The phenomenon is however more widespread and relates in part to some bounce in oil and commodity prices. It is unclear how far this bounce can go and it has recently reversed somewhat. The central bankers have the capacity to look through such cyclical events so it is surprising how much the pickup in inflation seems to have shaken their easy money resolve. The implication is that there is more going on. Employment has increased sharply though wages have yet to follow suit. It may be the expectation that wages will pick up that is being signalled. This has some validity as, with increased barriers to labour movement, the flow of cheap labour to high demand areas may abruptly cease. Mexico walls, Brexit, and increased resistance to refugees in Greece and Italy speak to this.

It may also be that central bankers speak with false bravado. They speak of looking through inflation trends but when confronted with higher inflation they become unsure of themselves. It may be that in all the years that they have claimed to adopt easy money to return inflation to target what they were really doing was pursuing easy money for other reasons and could do because goods price inflation was below target.  Now they must either move the goal posts or back-off the easy money. Maybe the other objective was financial stability and restoration of the capital adequacy of banks. This, it seems, has largely been achieved and with goods price inflation now a little uncomfortable they are getting nervous. They were quite happy to see asset price inflation when bank stability was in question and this has had consequences for the standard of living of many (distributional effects). I surmise that the coincident hawkish tone of central bankers is signalling that financial stability is no longer an issue. Expect the more conventional reaction function of central banks to return.

If financial stability was the central issue and is no longer sensitive then we should expect monetary policy to be tightened more quickly than might be expected simply from observable macro variables. Central bankers are not comfortable with low nominal interest rates. Expect the word ‘normalisation’ to increase in incidence. It has already had a good outing in the US. Expect such ideas as ‘preemptive’ to pop up more often. The financial markets may continuously be surprised by monetary policy developments and this could shake asset prices some. There will be real economy effects. They may not all be negative though. The easy money era made the rich richer and the poor poorer. If this is reversed it may actually boost aggregate demand. Nothing is ever quite what it seems when partial static analysis is applied to general dynamic equilibrium systems.  But I may be wrong…