Bravo, Governor Bailey!

Is Powell Watching?

During a week when financial markets were dominated by developments in the United Kingdom, Bank of England Governor Andrew Bailey was the unsung hero for his efforts to restore independence to the central bank. Despite the continuing massive losses to British pension funds from the surge in long-dated gilt yields, Bailey announced on Tuesday that the BoE would not continue its emergency bond buying program beyond October 14.

Investors’ reaction can be summarized by “How can he do this now? Will that not lead to further sales of gilts, and take the pound sterling to a new low?” Yes, the Bailey announcement would have done that, but only if the misguided fiscal measures that Prime Minister Liz Truss and Chancellor of the Exchequer Kwasi Kwarteng introduced on September 23 were not reversed. Implicitly, the new “mini budget” increased the unfunded deficit by at least £45 billion, and left it to the BoE to clean up the adverse fallout on financial markets from the measures.

Bailey and his colleagues at the central bank did initially give in to the Treasury moves. Quantitative Tightening by the BoE — sale of bonds to reduce liquidity — was promptly replaced by Quantitative Easing to bring down bond yields after the turmoil in London markets began. The casualty was the BoE’s anti-inflation program at a time when consumer prices in July had risen by over 10% during the prior year. But since the bond purchases only made investors clamor for more, Bailey had to decide whether his institution would be permanently subordinated to the Treasury’s whims, or whether he had to chart his own course.

And the new course he chose is what brings kudos to the Governor. His decision to no longer support the fiscal stimulus program through emergency purchases of gilts is bringing fiscal rectitude to the British administration. At the same time, the Bailey decision emphasizes the independence of monetary policy — historically, a key factor that has been shown to keep inflation under control in various countries around the world.

With the BoE unwilling to pick up the pieces after them, the Prime Minister and her Chancellor canceled the tax cut at the highest income level, and dropped plans not to raise a corporation tax by £18 billion. Kwarteng was fired as Chancellor yesterday. Despite the initial positive market reaction to the partial U-turn on policy and the Chancellor’s dismissal, investors decided that the measures were insufficient. Yields on 10-year gilts and 5-year gilts rose by 18 basis points and 27 basis points respectively yesterday, reversing rallies earlier in the day.

The Prime Minister chose Jeremy Hunt, who lost out to her in the race to lead the government in an early round, and even though Hunt had ended up supporting the candidacy of her arch rival, Rishi Sunak. The new Chancellor will have to institute further cuts in spending, and raise taxes, in a hurry. Otherwise, markets will be no kinder to him than they were to Kwarteng. Hunt will have a free hand to institute market-friendly measures. In light of her unpopularity, Truss cannot fire him without at the same time bringing her own government down!

Bailey’s non-intervention announcement of Tuesday was made when he was in Washington, DC to attend the IMF - World Bank meetings. Was another central banker based in that city, Jerome Powell, listening? The Federal Reserve’s pursuit of zero interest rates and $120 billion of monthly bond purchases last year occurred despite a $1.9 trillion fiscal program introduced by the incoming Biden administration to follow $900 billion in new stimulus in the closing months of the Trump administration. The Chairman decided that any inflation would be “transitory” despite the immensity of the fiscal stimulus that had accompanied his monetary expansion.

Although the Chairman claimed that the persistence of high inflation was “unexpected” — he has never explicitly acknowledged the huge error in his forecast — it had been clear to some of us that the combination of expansionary policy from the Treasury and the Federal Reserve would end with the elevated inflation rates that we are witnessing.

We learned Thursday that the Fed’s error was costly. Despite three successive 75bp increases in the Federal Funds rate in June, July and September, the core consumer prices (which exclude food and energy) rose by 6.6% over the past year, the highest in 40 years. While that assures another 75bp increase at the next meeting of the Federal Open Markets Committee due to take place on November 1 and 2, the question is: What happens after that?

As the recession starts to bite during the coming year even as US inflation stays well above the central bank’s 2% target, it would be instructive to watch whether the Federal Reserve Chairman will resist political pressures to stimulate beyond levels appropriate to get to the 2% inflation rate. Campaigning for the 2024 presidential elections will become active from next year onward, and Powell will face pressure to go easy.

I shall leave it to you to guess how I would bet.

Dr. Komal Sri-Kumar

President

Sri-Kumar Global Strategies, Inc.

Santa Monica, California

srikumar@srikumarglobal.com

@SriKGlobal

October 15, 2022

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