The Bank of England’s Dilemma: Easing and Tightening at the Same Time
If and when something else goes badly wrong, central banks are likely to intervene. Can they do that while continuing to battle inflation?
The Bank of England is testing one of the most challenging problems facing central banks today: Can they ease and tighten at the same time?
On Tuesday the BOE had to intervene again in the country’s dysfunctional government bond markets, offering to buy up to £5 billion, equivalent to $5.5 billion, a day of inflation-linked bonds, just 24 hours after expanding its offer to buy conventional bonds. Inflation-linked prices rose a little in morning trading, but failed even to reverse Monday’s huge selloff.
The BOE insists its interventions are about financial stability, not monetary policy. But there is a fine line, and the instability is interfering with monetary policy. The turmoil in the bond market triggered by surprise tax cuts—since partially reversed—three weeks ago forced the BOE to delay a planned selloff of its vast holdings of government bonds that was designed to tighten monetary policy. On Tuesday, it delayed sales of corporate bonds that only began last month as another part of the monetary-policy plan.
Pressure is now growing for the BOE to extend its support of the bond markets beyond this week, when it says it will stop.
Where the Bank of England is leading, others may follow. Investors have begun to focus on the dangers of financial problems hitting elsewhere, encouraged by official warnings of the rising risks. Among other threats identified by the International Monetary Fund on Tuesday: high debt, overextended nonbank lenders, emerging-market banks, elevated house prices, weak sovereigns and hard-to-trade markets, made worse by rapidly-rising global interest rates and a strong dollar. On the plus side, the IMF says banks in developed countries are strong.
If and when something else goes badly wrong, central banks are likely to intervene. Can they do that while continuing to battle inflation?
The IMF says not only that they can, but that they must.
“To the extent possible, in a situation of financial crisis, financial instability, that should not change the commitment to lower inflation,” says Tobias Adrian, director of monetary and capital markets at the IMF. “Central banks have the ability to provide liquidity as a last resort and so in principle they can even purchase while they’re increasing interest rates.”
History isn’t supportive. In the past when financial crises hit, central banks ended their rate rises. It is such a regular pattern that the Federal Reserve policy is often described as “tightening until something breaks.”
Sometimes this is a serious problem for monetary policy, but often it isn’t, because financial crises typically weaken the economy and reduce inflation. One example: The turmoil in government bonds in the U.K. has already pushed up mortgage rates dramatically, which will leave homeowners with less to spend on other things, potentially helping to lower double-digit inflation.
Financial crises can conflict with monetary policy when inflation keeps rising anyway, but the central bank feels forced to stop tightening policy because the financial system is falling apart. In 1998, the implosion of hedge fund Long-Term Capital Management prompted the Fed to slash interest rates, which turned out to be unnecessary and helped inflate the dot-com bubble. In Britain, the 1973-1975 secondary banking crisis pushed the BOE to stay its hand on rates while rescuing the sector, even as inflation soared above 25% in 1975.
Many investors are skeptical that central banks can avoid falling into the same trap again. Yet, the BOE insists that its decisions about monetary policy are distinct from decisions to step in as market maker of last resort for government bonds. If that’s true, it might show up in even bigger interest-rate rises than previously planned to offset the easing effect of the financial stability interventions—traders are currently pricing a monster rate rise of above 1 percentage point at the next meeting, in early November.
I think the BOE will be reluctant to risk its tattered anti-inflation credentials at a time when international investors have been questioning the credibility of Britain’s institutions. Raising rates and buying bonds at the same time seems entirely plausible, if still weird.
Sometimes, though, it is the higher level of interest rates themselves that cause the problem.
In the U.K., it was the sudden jump in very long dated bond yields, not interest rates, that triggered margin calls at leveraged pension plans, threatening a self-fulfilling cycle of forced selling. But if higher overnight rates lead to higher long-bond yields, they risk restarting the cycle.
Luckily, higher short-term rates also raise the prospect of a weaker economy and lower inflation, which ought to push down long-dated yields. For this to happen, investors have to believe that the BOE can give priority to fighting inflation even after a recession hits, and they might doubt its ability to withstand political pressure.
The European Central Bank will face a similar issue if investors lose confidence in the new hard-right Italian government. The ECB has created a plan to allow it to buy Italian bonds, but if it keeps raising interest rates, Italy’s borrowing costs will keep going up, worsening the fundamental problem that worries investors. If a rescue is needed, the ECB might find it difficult to keep its foot on the monetary pedal.
Top Fed policy makers have been discussing the blowback to the U.S. of possible financial troubles elsewhere. But none have suggested they could act pre-emptively to head off a financial crisis created by tighter monetary policy. This is probably right, since they could never be sure serious problems were on the way, and failed to spot in advance major problems even in their core market of overnight dollar borrowing.
As the fastest rises in interest rates in a generation continue to batter global markets, investors face a triple uncertainty. Where will the next financial crisis appear? When it does, how long will it take for central banks to step in? And, the biggie, will the threat of financial meltdowns distract the Fed and other central banks from the inflation fight?
None have easy answers. But there’s a decent chance that other central banks will end up forced to follow the BOE and tighten policy even while offering bailouts elsewhere.