- Interest rate increases are not transmitting to the real economy as expected
- BoE MPC member says there is “more to do” on rate hikes
The Bank of England’s (BoE) base rate is both hugely powerful and relatively powerless. Though the main tool of monetary policy, the base rate only directly affects a very narrow set of financial institutions: the BoE has to rely on financial markets to pass the policy movement through to households and firms.
This ‘transmission’ takes place through a number of channels, including mortgage rates, changes to the exchange rate and movements in asset prices. But the passthrough isn’t instantaneous, and these transmission channels work with long lags. According to received wisdom, the impacts of monetary policy accumulate over time, taking 18-24 months to feed through to the inflation rate.
Dario Perkins, managing director of global macro at TS Lombard, notes that the past 12 months have seen the fastest and broadest monetary tightening in history. Despite this, “the global economy still looks resilient and asset prices have not yet collapsed, contrary to what many permabear pundits were assuming”. Economies may be more resilient than we thought, but this strength may also be because some of these transmission channels might be clogged.
Take borrowing rates. Last week, a report from the Bank for International Settlements (BIS) noted that, in theory, today’s high levels of private debt should leave economic demand more sensitive to interest rate hikes. But over the past decade, the maturity of debt has generally lengthened, while the prevalence of variable rates has fallen. BIS economists think that this has shielded households from higher rates, meaning that “the impact of tighter monetary policy will take more time to be fully transmitted”.
Debt structure has even caught the Office for Budget Responsibility (OBR) off guard. In its November forecast, the OBR assumed that the effective interest rate on mortgages would jump to 3 per cent by the end of 2022 and 4.8 per cent by the start of 2024 as the impact of rate hikes filtered through. Economists at Pantheon Macroeconomics note that thanks to the prevalence of fixed-rate deals, the effective rate rose to just 2.4 per cent in Q4 last year.
The money and credit transmission channel isn’t the only one that looks gummed up – asset prices are behaving unusually, too. In theory, higher interest rates increase the discount factor on future earnings and signal a worsening economic outlook to financial markets. In a speech last week, the BoE monetary policy committee's (MPC) Catherine Mann – who thinks that transmission rates are faster than the 18-24 month assumption – noted among her points that “transmission from monetary policy to financial markets has been quick”. The problem is some of this speed may now be having a contrary effect.
Mann’s research suggests that strong equity performance has offset some of the MPC’s tightening efforts. She argues that forward-looking markets are already incorporating a policy pivot, and financial conditions have started to loosen as a result. Mann says that the MPC has “more to do”, and thinks that “monetary policy will have to stay tighter for longer to ensure that inflation returns sustainably back to the 2 per cent target”, as a result.
Not all policymakers are feeling so hawkish. In a briefing last week, TS Lombard’s Perkins went as far as to argue that “central banks are not nearly as obsessed with equity valuations as investors assume”. Perkins said that it made more sense for central bankers to watch how higher rates are impacting house prices, rather than engage in “a futile attempt to stop people buying meme stocks or trading monkey jpegs”. He notes that equity holdings are dominated by the top 1 per cent of households, whereas home ownership is far more widespread.
Following February’s Federal Open Market Committee (FOMC) meeting, US markets rallied after Fed chair Jerome Powell expressed his relative relaxation at easing financial conditions. BoE Governor Andrew Bailey also recently implied that further rate hikes are not a foregone conclusion, noting last week that “the economy is evolving much as we expected it to”. The Fed and the BoE are both meeting to set rates later this month; a more scolding tone on asset prices, should it emerge, is likely to prompt a jittery market reaction.
