Monetary Policy’s Big Week Continues

One day after the Fed doubled the pace of its reduction to its “quantitative easing” (QE) monthly asset purchases, the Bank of England (BoE) and European Central Bank (ECB) made some moves of their own. Amusingly, most coverage interpreted the BoE’s teensy rate hike and the ECB’s fresh QE taper as curiously “divergent” monetary policy, which suggests the ECB’s attempt to camouflage another taper worked. We wouldn’t make much of either move, as neither will have much impact on inflation and growth—something stocks already know, even if people broadly don’t.

Of the two, the BoE’s move is more straightforward. In an 8 – 1 decision, the Monetary Policy Committee (MPC) voted to raise the Bank Rate from … 0.10% to 0.25%. Headlines couched this as the end of stimulus and a new era of inflation fighting, which we find just mildly hilarious. In any other known universe, after all, a 0.25% policy rate might as well be zero. Actually, when the US Fed was employing “zero interest rate policy,” 0.25% was the upper end of the targeted range. It was also the BoE’s lower bound in its extraordinary “stimulus” after 2016’s Brexit vote. But evidently, the direction of rates matters more to onlookers than the level.

In all seriousness, we fail to see how raising short-term interest rates by 0.15 percentage point will do, well, anything—and not just because supply shortages, energy prices and post-reopening distortions are the primary culprits for UK inflation. Even if excess money supply were to blame, a 0.15 percentage point hike wouldn’t exactly address it. Money creation and circulation aren’t functions of short-term interest rates alone. They depend on the yield curve and how much higher the long end is than the short end. In modern financial systems, banks create most new money through lending. Their business model is simple: borrow at short-term rates, lend at long-term rates, and pencil in the difference between those rates as their profit margin on the next loan. They are also for-profit entities, so as a general rule, wider spreads will encourage more lending.

Rate hikes directly affect the short end of the yield curve only. Long rates, which are set in the marketplace, tend to have a mind of their own. A rate hike is technically “tightening” policy only if long rates don’t also rise. But gilt yields didn’t totally play nice with the BoE on Thursday. They crept up a bit across the entire yield curve. Therefore, the gap between the Bank Rate and 10-year gilt yields narrowed just ever so slightly, from 0.63 ppt on Wednesday to 0.523 ppt.^[i] In other words, from flat to a whisker flatter.

The extent of this flattening is basically a rounding error, and it isn’t likely to change banks’ behavior much. Variable-rate mortgages won’t suddenly become unaffordable for current homeowners. Savings accounts won’t suddenly start compensating for inflation. Loan growth, which hit an anemic 1.6% y/y in October, probably stays anemic.^[ii] The economy, already slowing from the post-reopening boom, probably keeps slowing. And if you are worried about the latest COVID restrictions taking a toll, well, keeping the Bank Rate at 0.10% wasn’t going to help businesses suffering from reduced foot traffic, so we doubt today’s move makes things markedly worse. It is a symbolic nod to inflation, in our view, and nothing more.

The ECB’s move is odder but probably similarly feckless. It announced its pandemic-era “emergency” QE program will end in March, as scheduled. But it also decided to increase the total size of its longer-term QE in April. Together, the moves amount to a reduction of monthly ECB QE from €80 billion to €40 billion in four months. That is a 50% taper! But headlines are couching the increased total size of the longer program as stimulus, suggesting ECB chief Christine Lagarde’s Jedi mind trick worked. The ECB has long been the master of the non-taper taper, and they have done it again, congrats.

This, too, likely changes very little. Buying long-term bonds isn’t stimulus, in our view, because it reduces long rates and flattens the yield curve. Buying fewer bonds theoretically exerts less pressure on long rates, but such a well-telegraphed reduction likely has scant impact.

One could argue that reduced asset purchases give banks less new money to lend, but they already had more than they could handle. As The Wall Street Journal highlighted earlier this week, the interest rate on some dollar swaps is in negative territory because eurozone banks have parked a mountain of spare cash at the Fed’s reverse repo facility, where they can earn a 0.05% interest payment instead of paying the ECB’s negative rate on deposits.^[iii] If the ECB force-feeds banks less cash, so much the better, we guess. But there, too, yield curves are quite flat, so the likelihood any of this translates to aggressive lending seems low. It won’t stimulate the eurozone’s economy any more than the BoE’s tiny move will tighten the UK’s.

Monetary policy isn’t unimportant, but tiny moves rarely do much. To see monetary moves that actually pack a punch, look at Turkey, where the central bank just once again cut rates by a full percentage point even though inflation is officially 21.3% (and observers suspect the actual rate is double that).^[iv] Turkey’s policy rate is now down from 19% in mid-September to 15%, and given the central bank governor and President Recep Tayyip Erdogan share the (unorthodox) belief that high interest rates cause inflation, most expect rates to go lower still. The lira has tanked, people are struggling to make ends meet, and no one expects things to get better any time soon. That, folks, is a monetary earthquake. The ECB and BoE’s tweaks? Even if we did analogies, there wouldn’t be any good ones to illustrate how tiny they are.

We have said it before and will say it again: Don’t overrate small monetary moves. Like the Fed, the BoE and ECB are pushing on a string. Save your sanity—and your energy—for when they actually make a move with real consequences.