Policies, pauses and politics

An independent central bank, so we are told, provides appropriate policy by being free from political interference. The premise is that the central bank provides price stability (low inflation) whereas the treasury provides infrastructure. Growth should then be a by-product of the business environment i.e. stable prices and reliable infrastructure. In recent years this has resulted in a tight fiscal/loose monetary policy mix for the UK.

“Foul!” cry conspiracy theorists who note that the Monetary Policy Committee (MPC) maintained loose monetary policy whilst consistently overshooting their inflationary target rate – evidence that the MPC is led by a political stooge, providing a lenient monetary backdrop for austere government policies. Pragmatists, on the other hand, believe the MPC merely responded sensibly to the fiscal tightening. The difference between whether monetary policy facilitated, or responded to, fiscal policy is semantic. Either way the Treasury and the MPC’s policies have been independent in only the loosest sense - and thankfully so.

Source: Datastream/Brewin Dolphin

A stricter interpretation of the mandate, the kind Mr King espoused when raising rates in 2007, would have kept policy tight with higher rates (or less quantitative easing). The pound would probably have appreciated, lowering the cost of imports like oil and many foods, which are meaningful contributors towards the headline consumer price index. This would be the kind of legacy which the more hawkish ECB (under Jean-Claude Trichet) and Bank of Japan have managed to leave. The ECB’s record is second to none in terms of effectively targeting inflation.

But the cost of such a policy however would be counted in terms of economic growth as the competitiveness of UK companies would have been undermined by the higher exchange rate.

Source: Barcap/Datastream

How will policy progress now? Well, as the Bank of England’s long-heralded prediction of falling headline inflation seems to be coming to fruition, policy ought to loosen further. But with the global economic environment improving (driven by the US) the MPC is expected to pause their stimulus – suggesting again they are more concerned about growth than inflation. Overseas the Federal Reserve are under even greater pressure to restrain their stimulus as the Republican leadership and presidential candidates have differed only in the extent of their disapproval of stimulative Federal Reserve policies.

Back in the UK all eyes are on the budget where speculation has been rife that the Chancellor’s progress in reducing borrowing requirements might prompt a fiscal giveaway. He has guided against such a path, instead suggesting that any new spending will be funded by tax or spending cuts elsewhere.  

A balanced budget stimulus could be achievable by increasing taxes and spending together and/or reducing the tax burden on the poor (who spend most of their income) and away from the rich (who save it). Whilst these types of big government policies are anathema to grass roots conservatives, they could help consumption. So measures like raising the minimum income tax threshold, funded by reductions in the tax benefits of pensions for higher rate tax payers, remain on the table. As does Nick Clegg’s Tycoon Tax, so his advisers insist – although it may be a table nobody else is sitting at.

Guy Foster, Head of Portfolio Strategy