Was the UK’s crisis unique?

The recent political situation in the UK has left markets in disarray. The Bank of England (BoE) needs to fight inflation pressure and stabilise the country’s currency, yet the previous leader of the governing Conservative Party actively put those efforts in a tight spot. Unfunded fiscal packages entail much higher rates when central banks give up on quantitative easing, as markets need to get used to less accommodation. There is a risk that investors will see this as a one-off, catch-22 UK situation in which the pragmatism of the BoE prevented the worst of all the outcomes – a crash in the liability-driven-investment system used by many pension funds – for now. But we argue otherwise.

History shows that this policy conflict between the UK central bank and government was not unique. Here, we look at previous episodes to consider what scenarios may unfold during this winter’s energy crisis.

 

Back to the future: fiscal vs monetary policy

The past decade has left us with the impression that central-banks and government policies are often cohesive. This has driven some market observers to think that central banks have lost their independence and are under the yoke of governments and ready to fund any fiscal plan. That may have seemed the case in 2020, but 2022 presents a very different relationship.

The Federal Reserve (Fed) appears wilfully ignorant of the US Treasury’s calls for caution, not to mention the International Monetary Fund and United Nations calls for the central bank to recognise that the dollar is a significant risk factor for the rest of the world. With its attitude of ‘our currency, your problem’, the Fed’s benign neglect is a reminder of how it has traditionally been oblivious to the shockwaves caused by a US currency scarcity. From a historical perspective, this behaviour is normal – and 2020 was the exception.

Here, a closer look at history is in order. Did central banks and governments collaborate during the last period extensive global tightening: the early 1980s? Not in the US, France and West Germany (see figure 1). In 1979, the shift in central bank policy to jugulate inflation by increasing rates was a collective move. It is often attributed to Paul Volcker, Chair of the Fed during that period, but most G10 countries followed suit. The textbook methodology was clear even back then: high rates will slow down an economy and create unemployment, which will end inflation as wages stop rising with inflation.

Back then, wage increases as a function of inflation were far more entrenched than they are today – largely explaining the need to push the brakes harder – and rates surged to about 20% in the US. The rational behaviour for governments would have been to let the central banks do their job and allow unemployment to rise enough for inflation to become deflation. Yet, what is rational from an economic standpoint is sometimes ignored in political circles. Mounting unemployment forced many countries around the world to deploy fiscal spending to counteract the goals being engineered by the central banks. In the US, the fiscal deficit reached 6% of GDP (during a Republican presidency), and in France, the deficit increased to 2.8% and the country’s presidency moved from centre-right to left. Even in Germany, a very conservative country when it comes to inflation, a fiscal deficit of about 1% occurred under Helmut Kohl, a conservative leader from an economic standpoint.

 

FIG 1. Interest rates, inflation and primary budget deficits in the US, France and Germany, from 1979 to 1989

Source: Bloomberg, LOIM as at October 2022.

 

Is the UK a harbinger of more to come?

As figure 1 shows, the recent UK episode is the latest in a historical series. Similar scenarios could happen again in the next six months as the pressures exerted by central banks turns roaring economies into deflating ones. With unemployment rising, as demand is not only slowed by higher rates but also by entrenched inflation remaining stubbornly higher than wage growth, the temptation for governments to cushion the scale of any upcoming shocks will be strong.

Investors tend to forget the historical flexibility of monetary policy in the UK. The ‘stop-and-go’ mantra of the BoE – which describes its conduct of hiking rates over short periods of time before cutting them (or vice versa), as opposed to committing to a rate trajectory as part of ‘forward guidance’ – has made its way into economics textbooks, which says a lot about the influence of the institution’s policies. This is not the case for the Fed, and even less so for the European Central Bank (ECB). What will the ECB do if one of the Eurozone countries announces a large and unfunded plan to protect its citizens from higher gas prices? It is hard to suggest that nothing will be done, but it is also unlikely that the ECB will disrupt its attempt to fight inflation. What we do know is that during the era of the European Monetary System, European central banks had a hard time coordinating policies with each other, so the question is: how will the current governance of the ECB cope with such pitfalls? 

Also, remember that LDI is not solely a UK strategy: its use among pension funds in the Netherlands, the US and Australia could equally challenge unfolding monetary-policy actions in these economies. In our view, central-bank dogmatism could lead to a difficult situation outside the UK, if central banks and governments fail to collaborate smoothly.

Simply put, the clash between the UK’s central bank and government is not a historical oddity. A lack of flexibility from other central banks, compared to the quick actions of the BoE during the gilt-market turmoil, could exacerbate the risks higher rates are already creating for investors.

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Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises are designed to keep track of the latest macro drivers making markets tick. Along with it, we wrap up the macro news of the week.

Our nowcasting indicators currently point to:

• Worldwide growth is clearly declining. The US and Eurozone are showing signs of decelerating growth momentum while the most recent data shows that this deterioration still has room to go. The US is increasingly showing indications that it is entering into a recession. 
• Inflation surprises will remain positive for the Eurozone but are declining elsewhere and are now non-existent in the US. 
• Monetary policy is set to remain on the hawkish side: central bankers are likely to be more hawkish than expected.

World growth nowcaster: long-term (left) and recent evolution (right)

 

World inflation nowcaster: long-term (left) and recent evolution (right)

 

World monetary policy nowcaster: long-term (left) and recent evolution (right)

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).