British economy is being hit by four policy shocks at the same time

The Telegraph has published a commentary arguing that fueled by the Bank's monetary death march, Britain is hurtling towards disaster. Caliber.Az reprints this article.

The monetary death march continues. The Bank of England’s fourteenth rise in interest rates is unscientific, unnecessary, and underestimates the powerful global forces washing over these islands. 

It pushes policy further beyond the safe or useful therapeutic dose for no clear purpose other than validating expectations on the futures market. Inflation is falling already for reasons that have almost nothing to do with the recent actions of Threadneedle Street.

The British economy is at stall-speed, and probably sliding into recession. That recession will now be deeper. The full impact of this rate squeeze on a private sector debt stock of 151pc of GDP (BIS data) will not be felt for another year, and probably later given the stretched maturities of debt contracts.

The Bank is the only big central bank that is actively selling bonds under its turbo-charged policy of quantitative tightening (QT), an experiment that has never been tried before and is much harder to calibrate than officials pretend.

There is a high risk that the Bank is incubating a full credit crunch that will bankrupt tens of thousands of viable businesses. Once such a process is allowed to happen, it can snowball into a destructive cascade that is extremely hard to stop and inflicts years of damage on society. 

Why is this being done? China is in deflation, and it is China that shapes global inflation. 

The producer price index is already negative in large parts of the global economy. The Drewry shipping index has collapsed by 80pc from its peak to $1,576 per container and is now below its long-term average. “Disinflationary forces are now arriving with a vengeance,” said Jan Hatzius from Goldman Sachs.

On a three-month basis, inflation in the US and much of Europe is barely higher today than it was when central banks were still holding interest rates at zero and were still injecting liquidity à outrance via QE. Even the lagging and near useless indicators of annual inflation are rolling over. 

The UK is being hit by four tightening shocks at the same time. The Bank of England pays serious attention to just two of them: its own rise in rates to 5.25pc; and fiscal drag from stealth taxes and bracket creep that will subtract 0.5pc from growth this year and roughly double that next year. 

The other two shocks are under-appreciated and may be leading the Bank into perilous waters.

When the US Federal Reserve tightens hard, the contractionary impulse moves through the entire international system of dollarised finance. 

“Europe is feeling the impact of its own tightening, and that of the US: global liquidity in dollars is shrinking,” said Philip Turner, a former top official at the Bank for International Settlements.

The BIS estimates that there are $12 trillion of offshore dollar credit contracts outside US jurisdiction. This is what lubricates global finance. Some credit is in the form of cross-border bank loans – ie, a Saudi bank lends to a Turkish company, or a French bank lends to property developers in China (via Hong Kong) – and some is in dollar bond issuance. 

Companies across the world borrow in dollars because the market is deep and borrowing costs are low, until the Fed turns off the spigot. At which point the whole global system shudders. 

It happened in an earlier form in 1928 when the Strong Fed cut off loans to Europe and set in motion the Great Depression. It happened in 1982 when the Volcker Fed triggered the Latin American debt crisis, and in 1998 when the Greenspan Fed set off the East Asia crisis. 

Is it happening now? We will find out. All we know is that the data on dollar liquidity is starting to track the pattern going into the global financial crisis.

Europe’s authorities were caught off-guard by that episode, imagining that the strong euro made them invincible. They had a rude awakening when the three-month dollar funding market in Europe froze, leaving eurozone banks unable to roll over liabilities. In the end it was the Fed that bailed out the European Central Bank with foreign exchange swaps. It was the eurozone, not the US, that slithered into an economic depression.

The ECB and the Bank of England profess to be more alert to this imported risk today, yet they are piling on their own scorched-earth tightening on top of the Fed’s tightening, inflicting a double blow on economies already in a stagnation trap.

The second under-estimated shock is slow-burn damage from quantitative tightening (QT). “The true scale of monetary tightening is not just the rise in the policy rate. It is also the shrinkage of the balance sheets,” said Professor Turner, now at the National Institute for Economic and Social Affairs.

The Bank of England has adopted an extreme New Keynesian position that bond sales do not really matter. In their model, QE and QT are just asset swaps. Buying bonds helps in a crisis by restoring confidence but selling them later is as dull as watching paint dry and has no tightening effect. 

Without wishing to rehearse the monetarist arguments for why this is arrant nonsense, Fed economists Andrew Lee Smith and Victor Valcarcel reached the opposite conclusion after studying America’s first, stormy, experiment with QT. 

They found that the liquidity effect of QT had twice the potency of the original QE. Asset sales played havoc with US money markets, but only after a beguiling lag. 

This was obvious at the time to anybody in the markets. QT led to a stock market crash. The Powell Fed was forced to retreat and ultimately revert to fresh QE. 

Professor Turner comes at the issue from the Wicksellian perspective of the BIS. In a joint paper with Marina Misev from the University of Basel, he argues that the current monetary squeeze is “too much, too late” and threatens to “destabilise a financial system already dangerously exposed.” Reliance on rear-view mirror indicators such as inflation and wages almost guarantee that “they will not see trouble until it is too late”.

The paper says central banks ought to be looking harder at credit data “which capture monetary policy in mid-transmission” before they send the economy into a tailspin.

That credit data is utterly dire. The ECB’s Bank Lending Survey shows that net demand for loans in the second quarter was down 42pc, the worst ever recorded. Net fixed investment demand in Italy fell by a calamitous 55pc. Credit to households is now contracting in absolute terms. 

The picture in the UK is scarcely better. The housing market is in the eye of the storm. The credit crunch is so far less severe but the money supply figures are in near melt-down. Simon Ward from Janus Henderson says real M1 money has contracted by 7.4pc over the last six months. “The latest rate rise just takes us further into overkill,” he said.

The Monetary Policy Committee does not look at money – despite its name – yet discerns signs that the long-feared feedback loop in wages and prices has begun to “crystallise”. That is not confirmed by falling inflation expectations. Services will take longer to deflate than manufacturing but the process is clearly underway. The PMI index for new service orders plunged in July. 

The MPC would serve us better if it stopped fretting about a non-existent wage-price spiral in services and started paying more attention to dollar liquidity and to the forward-looking indicators of credit and money that tell us where the British economy is going. As matters stand, it is going into a brick wall.