MNI: Calls For BOE To Be Clearer On Financial Conditions

The Bank of England risks muddling its guidance with its references to tighter financial conditions, and should make clear whether these result from possibly temporary external factors or largely reflect market expectations of the BOE’s own future tightening, Oxford Professor Michael McMahon and former BOE Deputy Governor Charles Bean told MNI.

In its April Monetary Policy Summary, the BOE’s Monetary Policy Committee said that "financial conditions have tightened since the [Middle East] conflict began.” Individual members also cited tighter conditions as a factor against raising rates, even though this tightening has included a move higher in expectations for Bank Rate. Overnight Index Swaps currently price in 46 basis points of hikes by December, though this is down from a peak of four expected 25bp increases over the rest of the year earlier in the Iran conflict.

 Both Bean and McMahon noted this approach begs important questions.

"If the market ... thinks there's a fair chance that inflation takes off, and that long-term rates go up because of that, that's not a good thing for the policymaker. They should absolutely be taking action," said McMahon, a widely-cited expert on monetary policy communication. "If the committee believes that a tightening of financial conditions is necessary to achieve the inflation target, the committee [should] make that clear in their policy." (See MNI: Financial Tightening Complicates BOE Hike Calculations)

McMahon likened the Bank’s current use of “tightening” to the episode before the last UK Budget, when reports of plans for a possible income tax hike led to a fall in projected debt interest costs which was used to justify not raising income tax.

"Circularity is just not sensible, clever, or conducive to good policy making, and I think there's an equivalence here, an equivalence here with regard to the monetary stuff," McMahon said.

Policymakers face the "reflection problem," of being seen to respond to their own image, he said.

"This is why I think being very clear on what decisions you're making and ... not looking like you're just being led by the market" is important, because a market move "may well have been a response to what they thought you were going to do, and then if you don't do it, you know we create a big mess of a problem."

“I certainly don't think linking non-action to tightened conditions is enough. I think you have to give a very clear narrative on what [is] behind that,” McMahon said. “There's no single movement in the yield curve or single movement in particular, asset prices that can capture the sense or narrative of what's going on. There's lots of things that can move yields the same way, one is good, one is bad,” 

PERSISTENCE OF CONDITIONS KEY

A key question is whether the tightening is expected to persist, according to Bean, deputy governor from 2008 to 2014 and before that BOE chief economist.

It "really depends on the precise nature of the volatility, in particular whether or not there is any tendency for financial conditions ... to revert to the status quo ante or not. If a worsening in conditions is likely to unwind soon, then it wouldn't seem very sensible for monetary policymakers to react to it," he said in an email exchange.

"But if you expect the worsened conditions to be maintained, then you should react -- there is no good reason for waiting in these circumstances," he added.

Bean, who was also on the steering committee of the official fiscal forecaster, the Office for Budget Responsibility, said both the Bank and the OBR should be flexible if necessary over the windows used in their projections to assess movements in asset prices.

"Be pragmatic ... the important thing is that the new assumption is clearly explained and justified," he said.

The Treasury, in setting the borrowing remit for the Debt Management Office, should also take a subtler view of risks around market curves for gilt prices rather than taking them at face value.

"It should look not only at expected cost but also consider the implications of gilt prices deviating from their expected path. For instance, a lower expected cost might well be associated with greater upside fiscal risks," Bean said. (See MNI INTERVIEW: Gilt Spikes Make Case To Slow QT - NIESR Head)