Carney Warned of the Risks of Brexit. Then He Ignored Them.
(Bloomberg Opinion) -- Could Bank of England Governor Mark Carney be the new Jean-Claude Trichet? The former President of the European Central Bank is still lambasted in markets for mistakenly raising rates in 2011.
Investors are particularly unforgiving of the sort of ungainly U-turn that Trichet’s ECB was forced to execute, hiking twice only to have to reverse course and cut twice before year-end. The Bank of England has raised rates twice in the past year and may soon be forced to do a U-turn of its own, in which case Carney will probably receive the same treatment.
You only have to look at the latest growth data to understand why the market is questioning the bank’s decision to hike rates this month. Central banks don’t usually raise rates when the national statisticians are reporting that the underlying trend in growth is slowing. But the real reason to question Carney’s thinking is not the bank’s assessment of the current state of the economy but its failure to take out insurance against the risks looming on the horizon.
There are two considerations that should have weighed heavily on Carney’s mind in August: the uncertainty created by Brexit and the BOE's limited capacity to respond in a crisis.
First, the uncertainty: There is clearly a risk that the U.K. and the European Union will fail to reach a withdrawal agreement. The economy might need major monetary stimulus in the event of a ‘no deal’ outcome.
Second, the BOE’s capacity to respond in the event of a no-deal outcome is limited. The BOE entered the financial crisis with a monetary bazooka -- that is, it had the room to cut interest rates by multiple percentage points and the scope to buy bonds on an industrial scale. The next time around, the bank may be armed with a pea-shooter, with little scope to cut rates and less room to buy more bonds.
The central bank playbook gives very clear advice under these circumstances: When there is an obvious risk that bad things might happen, and a limited capacity to respond to that risk should it materialize, then you do not raise rates. Remember: Monetary policy affects the economy with a lag – hike rates today and you will slow the economy tomorrow.
This is why prudent central bankers since at least as far back as Alan Greenspan have followed a so-called "risk management" strategy. They take out insurance against risks like a no-deal Brexit by keeping interest rates lower than would be normally appropriate. That insurance comes at a price; growth and inflation will probably be a little too high if there is a deal. But the price is well worth paying to make sure that the economy can better withstand an adverse scenario.
Carney went out of his way to note that he was ignoring the central bank playbook. He claimed that the bank cannot be handicapped or tied by the range of Brexit possibilities and can always cut rates later. However, he neglected to explain why that is the right thing to do given the inevitable delay before those cuts could take effect. The risk management argument for leaving rates on hold until Brexit day in March 2019, or a deal is done, should have been overwhelming.
Brexit is largely the bank of England’s problem but other central banks will be in the same boat as the BOE if there is another recession in the near future; they, too, need to consider the merits of the risk-management approach. If Carney has to reverse his rate hike, it will be another reminder that it makes sense to err on the side of keeping rates lower -- especially if you only have access to a pea-shooter.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Richard Barwell is a senior economist at BNP Paribas Asset Management.
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