MNI INTERVIEW: Financial Conditions Back BOE Easing - Aikman

Tightening UK financial conditions in the wake of U.S.-driven trade shocks bolsters the case for easing monetary policy while also raising concerns over whether the Bank of England has the tools to deal with stability risks in the non-bank financial sector, finance professor and director at King's Business School David Aikman told MNI.

Sterling appreciation and higher risk premia suggest the BOE should ease more than it would otherwise have done, although the Bank's sensitivity over potentially de-anchoring inflation expectations, in light of the post-pandemic price surge, is steering it towards a more gradual approach to easing, said Aikman, a former senior BOE official.

"You should be thinking about current financial conditions as a key part of the transmission mechanism, and all else equal, if they tighten, there should be some kind of monetary response to that," he said in an interview.

"That's one of the lessons we took from the 2008 crisis. The Bank's models didn't have a big role for those types of factors up until then, and now they do.”

SEPARATION PRINCIPLE

While BOE Monetary Policy Committee member Catherine Mann has cited financial conditions as a factor behind her vote for an “activist” 50-basis-point cut in February, the MPC has tended not to highlight them in its policy communication.

Instead the BOE has worked on a separation principle, with the Financial Policy Committee identifying tail risks and trying to set macro-prudential policy to ensure systemic resilience, while the Monetary Policy Committee focus on financial conditions has been largely limited to their effect on its macroeconomic projections.

But this arrangement comes under strain in times like this, Aikman said, pointing to recent influential academic work from MIT's Ricardo Caballero and others, which made the case that central banks should seek to stabilise financial conditions beyond their direct impact on prices.

"The [macropru] tools are mainly focused on the banks ...where is the risk? It's in non-banks. Maybe it's in hedge fund leverage ...maybe around private credit as well. So it's in this area where the Bank probably has quite limited data and quite limited macro prudential tools that it could actually unilaterally use," Aikman said.

REASONS FOR CAUTION

While there were early fears U.S. trade policy could lead to stagflation, the impact elsewhere increasingly appears to be disinflationary, with market turbulence and an appreciation of sterling supporting the case for further easing, he said. (See MNI INTERVIEW: CenBank Balance Sheets Key To Tariff Response)

"Volatility itself should lead to higher risk premiums as well ... You'd expect that to translate as a higher equity risk premium, higher corporate bond spreads and so on. So I'd be surprised that the net effect of all of this wasn't a tightening." Aikman said.

While a 25-basis-point rate cut in May, taking Bank Rate to 4.25%, is now fully priced in, the Bank is nonetheless wary.

"The reason the Bank has been cautious, I think ... is quite sensible, that we had such a rise in inflation. The concern is, sure you can get away with that once, without inflation expectations de-anchoring, if it happens again, the whole framework, I think, would be in a much more precarious position," Aikman said.