Yesterday was a day of wild swings in financial markets and one which makes me miss the days when I used to put on a trading jacket in the open outcry markets of LIFFE. Something about old warhorses and the sniff of battle I guess! However the moves in one area did highlight a fundamental issue which is rarely discussed either properly or in depth so I will explain it today. The issue can simply be expressed as who sets interest-rates? You may note the fact that I use a plural here. Also I guess you are already figuring that it is much wider than the conventional somewhat stereotypical answer which is that the interest-rate is set by the central bank of the respective country. This is particularly relevant at a time when central banks have intervened in so many areas and markets and are considered by some to be giants in a land reminiscent of Lilliput.
The Bank of England
Martin Weale gave a speech yesterday evening and as he is a voting member of the Monetary Policy Committee you might think that UK interest-rate markets would be hanging on his every word. So let us examine what he had to say.
An increase in Bank Rate of ¼ point would be unlikely to slow that process to a halt immediately but there is a risk that, if the increase were delayed, inflation would be pushed above target or a rather sharper increase in Bank Rate would be needed subsequently.
This represents his view that a nudge higher in UK Base Rates is required right now to combat future upside inflation risks. A bit awkward for a man who “looked through” rises in consumer inflation to over 5% you might think! He did briefly vote for a Base Rate rise then but changed his mind (something which may yet repeat). Also you may be intrigued by this bit.
The margin of spare capacity is shrinking rapidly and all logic suggests that that ought to lead to an increase in inflationary pressures over the two to three year horizon which concerns the Committee.
Whilst he is making his case he has nudged the policy horizon from 2 years to 2/3 years. I guess the vaguer you make it the easier it is to dodge responsibility when things go wrong as they so regularly have.
Let me add here a real problem for inflation targeting which is that right now seeing the future more than a few months ahead is as difficult as it has ever been. On those grounds alone lengthening the policy horizon is not a little dim.
What did the financial markets actually do?
As I have already hinted at yesterday was a day of big moves in interest-rate markets and also high volumes. For instance by I saw reports that the US Treasury market had passed the previous days total volume by 10 am. Let us examine some moves in the UK.
If we go to one of the UK’s longest dated conventional GIlts (2060) I note that it rallied more than 3 points and that its yield fell from 2.83% to 2.73%. Those with personal pensions will be grateful that it is no longer compulsory to buy an annuity because should such yields persist we will see even poorer value from conventional annuities. If we move down the maturity curve to the ten-year yield used as a benchmark then this fell below 2% (and is there as I type this) which contrasts significantly with the (just over) 3% with which 2014 began.
There are also interest-rate futures markets which for the UK are rather confusingly called short sterling. A price rise here indicates a lower path for expected interest-rates in the UK and prices have been rising. We do not have to look back very far to see quite a change as since the end of last week the December 2015 has priced in a future with interest-rates 0.24% lower and the March 2016 contract has priced in interest-rates some 0.29% lower. Just to confirm that these are lower interest-rates and not the higher ones Martin Weale is voting for.
The combination of all these factors will be felt in various areas as for example some mortgage rates (fixed ones in particular) and corporate borrowing rates will respond to the new situation should it remain like this. So the UK is seeing a monetary loosening of policy right now -especially if we also add in the recent decline of the value of the UK Pound- just as two members of the MPC are calling for higher Base Rates. Other countries have more direct formal relationships here as for example yesterday saw lower fixed rate mortgages being offered in the United States in response to the plunge in US Treasury Bond yields which took place.
What about Quantitative Easing?
This has been an attempt to reduce longer-term interest-rates via bond yields by several of the worlds major central banks. You would think that such large purchases (some £375 billion) would have an effect on the price. Except that yesterday UK Gilt prices surged and yields fell without there being any new QE purchases. The only action these days is the rolling over of maturing bonds (which just to be clear I would stop). Whilst there is a stock of UK QE we have to question if UK Gilt yields would have dropped anyway leading to the possibility of it being a waste of time and a failure.
As it did exist in the UK we need to look elsewhere for clues. Germany is currently an interesting test case as its bonds continue to surge with its five-year yield now a mere 0.11%. It does not have QE and yet if we move to Japan long considered the home of QE and currently deploying it with kamikaze enthusiasm we see a five year yield of 0.14%. The circumstances of the two countries are of course by no means exactly the same but the country without QE has lower shorter maturity bond yields. Also with longer-dated bonds surging in price in Germany again today they could not be catching up much faster.
Putting it another way QE is now generally expected in Italy for example and maybe rather soon. Yet its government bonds are falling in price and the ten-year yield is up by 0.34% to 2.74% today alone. It was not so long ago that the discussion was around Spanish yields were below the UK, er not now and by a fair margin and yet QE is expected there too….
What does the central bank control?
It controls the official interest-rate and these days there may be more than one occupying this mantle. Let us look at the UK Base Rate. This is an interest-rate that is for overnight borrowing only. if we are generous we might add that it usually holds for one month until the next MPC meeting.
Accordingly the impact is then implied onto a range of other interest-rates. Some are explicit as there are mortgage rates which are tied to the Base Rate. Others are not so explicit but are expected to respond. What if increasingly they did not? We have seen that sort of behaviour in parts of the Euro area.
I hope that this has clarified matters on this subject. As ever we do not have a laboratory and some test tubes to do a controlled experiment. But two members of the MPC are currently voting for Base Rate rises and Mark Carney has hinted at future rises. Yet right now the financial markets are apparently approving of the recent reforming of Fleetwood Mac.
You can go your own way
Go your own way
You can call it another lonely day
You can go your own way
Go your own way
The Royal Statistical Society
I raised the issue of the treatment of UK inflation with respect to rail fares ( CPI or RPI) with the RPICPI User Group. In response the Chairman has written to the head of the UK Statistics Authority requesting clarification. The details of the exchanges can be found below.