Market Thinking

making sense of the narrative

The New BoE governor needs to be a technocrat.

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The UK press are once again discussing the candidates for the next Governor of the Bank of England, focussing primarily on the political ‘suitability’, but I would put in a plea that we need to see a technocrat rather than an academic or would be politician. I mean no offence to Mervyn, Lord King who I greatly admire and respect, but we need to go back to someone like Sir Eddie George, a technocrat who understands the importance of ensuring liquidity gets to where it needs to go and when it needs to go there. We don’t need vast numbers of academic economists trying to predict whether GDP will be 1.6% higher or 1.65% next year and we certainly don’t need anybody else who thinks the role is about grandstanding at Davos about the global economy and climate change. There are more than enough people doing that already thank you very much. 

At any time there are three different sectors of the economy – the Consumer, the producer and the Financial sector itself (plus of course government) and they all have different balance sheets and a different set of sensitivities to interest rates. The role of the central bank in setting interest rates is to try and balance these three competing needs. For many years, the dominant balance sheet in the UK was the Consumer, with a large and mainly floating rate mortgage book. UK interest rates were set against this background, and worked largely like fiscal policy as a result. A rise in rates sucked liquidity out of the economy to meet mortgage payments and vice versa. The BoE therefore was an important determinant of aggregate demand rather than just a supplier of liquidity and as such, the announcement by Gordon Brown in the first Blair government that the BoE would be ‘independent’  was a major event. 

The UK insurance and pension system meant that unlike Europe, the UK corporate sector was largely equity funded, which caused its own problems as large corporations with seemingly ‘free’ money were able to outcompete and dominate smaller business, the retail sector being probably the most obvious example. Meanwhile,  the banking sector was primarily focussed on asset backed floating rate lending to households sourced from short term borrowing in financial markets. It was this latter duration and liquidity mismatch that triggered the UK banking crisis around the time of the GFC and the response – a shift in interest rate policy to meet the needs of the Financial sector – that has left consumers facing negative real interest rates. For borrowers this has been a great benefit – and arguably inflated a dangerous bubble in credit, especially in autos – but for savers, used to an interest rate set for households, this lower rate set for the financial sector has been disastrous. 

But we are where we are. The UK household still has unsustainably high levels of debt and would collapse if the cost were adjusted to the ‘correct level’ (the US is similar, though its mortgage debt is more often fixed rate and refinanceable), while the financial sector remains the ‘price setter’ in terms of official rates. As such, the traditional focus on GDP and inflation, like the US with its Taylor Rule, is largely a waste of time. The role of central banks right now is to protect their financial systems and nurse them back to health without killing them or the rest of the economy. 

As the recent events with the Fed temporarily losing control over the US money markets demonstrate, the key role at the moment for central banks is to ensure adequate liquidity to the series of vastly inflated balance sheets that have emerged post the GFC. The next governor of the Bank of England needs to be someone who understands that.

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