Central Bank Dilemma: Would You Vote to Hike Rates?

Many Happy Returns

The episode examines the divergent monetary policy responses from major central banks—the Fed, ECB, Bank of Japan, and Bank of England—follo

Key takeaways

• The Bank of England's recent decision was a 'hawkish hold,' with members split between immediate hikes and waiting for more data.
• Energy price surges caused by Middle East tensions act as a supply shock that interest rates cannot directly mitigate, only dampen via demand reduction.

Main topics

• Central Bank Monetary Policy
• Inflationary Second-Round Effects

Notable quotes

You can raise rates all you like, but that's not going to directly lower the price of oil.

Conclusion

The episode highlights the difficult balancing act central banks face

Transcript preview

Speaker 2 (0:00) Today's episode is brought to you by Lightyear, the investment platform I use for my stocks and shares ISA. Speaker 2 (0:09) Three hikes and a hold in eight days, all in answer to the same energy shock. So why did the Fed, the ECB and the Bank of Japan raise rates while the Bank of England sat tight, despite facing the Speaker 1 (0:22) worst inflation path of the four? This week, we put you on the committee. Same data, same fog and the same transitory scar tissue. Would you vote to hike? Speaker 1 (0:41) All right, let's get into it. So when the Monetary Policy Committee at the Bank of England meet to decide rates, they take a couple of days and probably a few bottles of wine to make their decision. We're going to do it in a much shorter time frame, I hope, Robin. Yeah, we're going to speed things up and we're going to do it Speaker 2 (0:57) for three different central banks. So that's our goal. So what we have Speaker 1 (1:02) here seems to be a textbook supply shock. The Iran war has led to energy prices surging. And that's exactly the kind of thing that when you go to central banker school, they say you should look through. Yet most of the central banks are tightening anyway. Yeah, so just stepping back a moment, the idea Speaker 2 (1:20) is that with a single rate, the policy rate, you can affect the entire economy. Now, that's a pretty crude handle in order to affect things like inflation and growth. It is very effective at the extremes. If we have zero-cost borrowing, well, happy days if you're a borrower. If you have 10%, 20 % interest rates, well, not such a good story. In between, though, they're always fine-tuning policy in reaction to economic data. But the gist is higher interest rates slows down the economy, reduces inflation by reducing demand. Of course, they can't affect supply. That's the government's job. And lowering interest rates makes borrowing cheaper and stimulates the economy and hopefully increases growth and pushes inflation up a bit. So that's the general gist of how this works. Speaker 1 (2:12) But right here, we seem to have a supply shock. So... You can raise rates all you like, but that's not going to directly lower the price of oil. All you can really do is squeeze the economy a bit to try and stop the second round effects. Speaker 2 (2:26) Yeah, and people describe monetary policy as pulling an elephant on roller skates or maybe steering a supertanker. The idea being... that there's a lot of momentum in the system. You start pulling, you start driving the supertanker, and it takes a long time to turn it around, which means you have to steer based on where the ship's already heading and take that momentum into account. Speaker 1 (2:49) I'm worried about how you'd stop the elephant on roller skates, though. If you're just pulling it with a rope, there's no tension, is there? Maybe that's the point. Maybe that's what happened in 2022. They let the elephant get out of control, and then they really had to yank on the rope. Well, that explains a lot. But it's difficult, Speaker 2 (3:07) right? Because you make a change in policy, and it takes six months, maybe a year to affect things. And you've also got this really muddy way of looking at the economy via all these economic indicators. And they all look at hundreds of indicators. The primary ones are the rate of inflation. And they can break that down into subcategories. And the secondary ones are things like employment and GDP growth. Now, the Fed has a dual mandate. The Bank of England, in theory, just has one mandate, which is inflation at target. But it does talk about growth as well, because that affects inflation. So what is it that keeps the elephant moving? Well, it's these second round effects. And if you read the minutes, certainly from the Bank of England, That's what they talk about a lot. And that's where the big disagreement is. Of course, everyone can see headline inflation's gone up. The big deal is what's going to happen next. In other words, if you're a trucking company and you see the price of diesel rise, are you going to pass that on to your customers? Will that increase food prices? All of these knock-on effects are what they call second round effects. Speaker 1 (4:13) If you read the MPC Minutes, they say there is, and I quote, little evidence so far of these second round effects. So they talk about things like private sector wage growth is around three and a half percent, which is not far off being consistent with a two percent inflation target. And if you look at surveys, firms don't expect wage growth to pick up that much in the year ahead. You could also look at what the man in the street says. about where they think inflation is going. So these are inflation expectations. And that has picked up a little bit, but not to any sort of concerning degree. But are these the things everyone on the committee is watching? Oh, definitely. Speaker 2 (4:52) I think they're very focused on these second round effects. And of course, on the primary effects as well. Now, another thing which is factored into these equations that the Bank of England looks at, and the other central banks too, is something called crack spreads. which sounds slightly rude, but it actually just means the difference between the price of the refined product from crude oil and the crude oil price. So yes, if there's a crisis in the Middle East, crude oil prices go up. But if there is a lack of refining capacity, or the refining capacity is trapped behind a strait in the Middle East, then what actually happens is the price of the refined stuff goes up even more than the price of the crude stuff. And that's the crack spread. So what we've seen is a crack spread blow out. And there isn't much evidence that that's going to tighten anytime soon. So even if crude prices come down, it may be that the refined prices stay high for some time. And of course, that affects monetary policy because it affects inflation. So Speaker 1 (5:56) it's the basic story here that the people who make petrol and jet fuel and diesel, things like that, there's less capacity there. So they can make a bigger margin. Those refiners that are still online are printing money. That's less good for us at the pump. Now, these higher energy costs, we can kind of predict the effect of those to some degree in the UK specifically, because we have this off-gen price cap when it comes to, you know, gas in the home, electricity. And the projections seem to suggest that that cap is going to rise around 25 % at the start of 2027. So there's a big jump coming. Speaker 2 (6:32) Yeah, and we can decompose the components of inflation. Currently it's 3.1%. The Bank of England expects it to be above 4 % by early 2027. And they've broken it down. So they think that two thirds of that is due to energy prices increasing. Speaker 1 (6:50) But don't we always say central banks should look at core inflation? They should strip out food and energy. These things are volatile. Let's look at what inflation is doing domestically. And core inflation is lower. It's just 2.6 % in the UK. And it's a similar story in the US, where core is 2.4%, whereas headline inflation, including everything, is 3.4%. Now, on the Bank of England, there's a split, isn't there? Six members thought it's best to sit tight, whereas three members wanted a hike straight away. Are those doves, the six people thinking, now's not the time, just wanting to see more of a feed-through? of inflation into the broader economy before they start hiking. Speaker 2 (7:32) Yeah, that's exactly right. And you can actually read their comments in the minutes, which is great. You see each of the different opinions and what they think is important. Generally, I'd say that the Doves, Bailey, Breedon, Dhingra, Lombardelli, Ramsden, Taylor. Sounds like the batting order for England, doesn't it? I think the hike camp is better because they're all monosyllabic. Green, Mann and Pill. Sounds like... Camberwick Green, if you remember that. You probably don't. I don't, but you've got distracted by the names. What do these people think? Yeah, so it's all about second round effects. The people who want to hold are saying, okay, we don't see the immediate effect of having these second round effects yet in the data. So it's not a good idea to crush growth in the UK economy, given it's so weak anyway, by raising interest rates. But we are watching the data really carefully. And I just get the feeling that they were just one whisker away. from changing their opinion. So it's very likely, I think, in the next meeting, if the data does show an upward trajectory that Speaker 1 (8:32) continues, they're going to raise rates. Yeah, that was my take reading the minutes too, was that everyone, the doves and the hawks, agree that the risks to inflation are to the upside. But I do think there's a bit of a split in the hold camp, where someone like Andrew Bailey, the governor, is saying it's likely that policy may have to tighten soon. And Lombardelli says... The case for raising bank rate is building the longer the Iran war continues. Speaker 2 (8:58) Whereas there are a Speaker 1 (8:59) couple of members, Taylor and Dhingra, who seem to be more principled holds to me. They're more worried about growth and are making the point that financial conditions might already be tight when you look at the gilt curve. And Taylor says his estimate of the neutral rate is 3%, which are already well above. Speaker 2 (9:20) Yeah, what's weird is the Bank