MNI: Financial Tightening Complicates BOE Hike Calculations

Tighter financial conditions from increases in interest rates facing UK firms and households and surges in long rates, especially notable in gilt yields, are likely to weigh against a June hike for some Bank of England's Monetary Policy Committee members, though there is disagreement on the MPC over how to measure or interpret such effects.

The policy summary accompanying April’s eight-one vote to hold Bank Rate at 3.75% indicated that most members recognised "that the tightening in financial conditions would help to reduce inflation over time.” Since then, conditions may have tightened further, with 10-year government bond yields at 18-year highs near 5.2% on Monday.

Still, the MPC members’ judgement begs the question of how to quantify this tightening. One of them, Catherine Mann, has previously made the case for a financial conditions index to make her reaction function clearer, but not all of her colleagues agree. Signals from tightening caused by political uncertainty differ from those associated with yield moves due to rising inflation expectations, with weightings for the varying contributions to tightening also complicating factors, MPC members told MNI.

Chief Economist Huw Pill, who cast the sole vote for a hike in April, pointed to the difficulty of extracting a clear signal from disparate market indicators, particularly at a time when the rise in gilt yields coincides with internal Labour Party challenges to Prime Minister Keir Starmer. (See MNI INTERVIEW: Gilt Spikes Make Case To Slow QT - NIESR Head)

GILTS AND POLITICS

"I am sceptical, so therefore I'm not in favour of publishing [a financial conditions index],” Pill told MNI at a NatWest event last week, noting that this would require adding "the weighted average of something you control, maybe Bank Rate and something that is set in markets, for example, 10-year bond yields ... but crucially ... if the long rate has gone up because of higher inflation expectations, it shouldn't be that you offset that through lower Bank Rate, because actually, you need to have tighter financial conditions."

On the other hand, "if the long rate has gone up with a temporary, let's say, political premium being embedded that might be something that you do want to offset."

The 10-year gilt yield rose to its highest level since 2008 on Friday, as Greater Manchester Mayor Andy Burnham, who has previously said the government should not be "in hock to the bond markets," would stand for election to the Makerfield parliamentary constituency.

Mann, who has at times been at the hawkish end of the spectrum, gave a dovish twist to a speech at the Centre for Macroeconomics last week, pointing to the role of the shift in gilt holdings towards more price-sensitive investors, such as overseas hedge funds, in pushing up financing costs. 

"We have foreign investors exiting the holdings of gilts, that will lead to higher yields and ... that tightens financial conditions. Do I want to tighten more knowing that?" she said, adding in the question-and-answer session that financial conditions and spillovers were relevant for "the appropriate conduct of monetary policy." (See MNI INTERVIEW: Must Tackle Hedge Fund Debt Risk - BIS's Gelos).

FINANCIAL CONDITIONS INDEX

Mann has championed the use of financial conditions indices, though she noted that different weightings for the various components provide quite different results.

"Will there be an agreement about which index is the best one? I think it's an important question," she said in response to an MNI question.

One option could be to weight assets similarly to how they would be treated in an investment portfolio, she suggested.

"Or do you want the weights to be the how each of those asset classes affects real economic activity? As it turns out, those two different views ... [result in] a substantial difference in what those two indices look like and what they mean," she said.