Wednesday, June 27, 2012

BOE FOCUS-Solar Panels Shine Light on UK Policy Dilemma

A Bank of England-sponsored solar panel for every roof in Britain to jump-start the stagnant UK economy?

The suggestion, at an alternative economics conference a few weeks ago, brought a frown to the face of the BoE policymaker present, Adam Posen.

But it nonetheless underlined a dilemma facing the Bank as it presides over an economy that has responded at best mildly to record low interest rates and a flood of bond buying.

What now?

Since the solar panel idea was mooted, even bastions of economic orthodoxy such as the International Monetary Fund have urged the British central bank to find a better way to boost growth than what they have been doing.

Cut rates more, perhaps. Or buy slightly more exotic assets.

However, these proposals have a problem. Either they represent one-off boosts with little lasting impact, or they risk harbouring unpleasant side effects.

"From a very narrow monetary policy perspective something might make the world a better place, but from a financial stability perspective it might look lousy," said Richard Barwell, an economist at Royal Bank of Scotland.

The pressure is on the central bank to do something, however, because the government has little room to add stimulus via tax cuts or spending as it tries to bring down a huge budget deficit with economic output is still 4 percent below its peak.

Buying British government bonds with newly created money - so called quantitative easing, or QE - was a radical policy when the BoE started in March 2009, but 325 billion pounds later critics argue that it has lost the power to spur growth by cutting the cost of private-sector borrowing.

"They should be thinking outside the box," said Alan Clarke, an economist at Scotiabank who argues that QE has failed to stop an upward drift in mortgage costs faced by households and in firms' borrowing costs.

BoE figures show the average interest rate on a typical two-year fixed-rate mortgage has risen to 3.66 percent, up from 3.00 percent when the BoE started its latest round of QE in October.

Most business borrowing costs show similar rises - despite the fact that the cost of two-year government borrowing recently hit a record low of 0.2 percent, in part due to BoE gilt buying.


So far BoE policymakers insist there is not enough evidence to suggest the 125 billion pound round of QE conducted between October 2011 and May 2012 is less effective than the 200 billion pounds done between March 2009 and February 2010.

Governor Mervyn King has also rejected buying large quantities of assets other than government bonds unless the government indemnifies it. Nor has he asked the finance ministry to approve any more adventurous schemes.

One stimulus option recommended by the IMF is a cut to interest rates, which may be more feasible than in the past as banks now have greater scope to cut the deposit rates they pay to savers, allowing them to preserve their margins while cutting rates to borrowers.

But this was again rejected by BoE policymaker Ben Broadbent last week, and in any event would only have a one-off impact.

Moreover, while a rate cut might reduce the cost of borrowing, it would not necessarily increase the availability of credit - something many businesses argue is a bigger problem.

One proposal to tackle this is for the BoE to extend the small volume of corporate bonds it purchases to include those issued by British banks. A related idea is to buy assets held on banks' balance sheets in the form of asset-backed securities.

In theory this should give the banks plenty of new funds to lend to businesses and households, something the BoE says it is ill-equipped to do itself.

However, this approach has serious flaws, says RBS's Barwell. The BoE's financial stability statements suggest it believes high bank funding costs represent genuine credit risks, and Broadbent argued the lack of bank lending may be a rational response to the risk of a euro zone break-up.

Subsidising banks' finance costs in these circumstances would be too risky, Barwell said.

"Once the authorities start to accumulate huge sums of unsecured claims on the UK banks it will not take long before the market reaches the conclusion that the banks cannot be allowed to fail because taxpayers would realise a massive loss."

Buying secured assets would not solve the problem either, Barwell added. First, there is the danger that, unknown to the BoE, banks would offer their riskiest assets as collateral. And second, the BoE is already concerned about "encumbrance" - the danger that banks set aside so many assets for secured lending that unsecured lenders worry there is little left for them.

Ultimately, alternative assets for the BoE to purchase may be more likely to come in the form of government-backed infrastructure bonds - an announcement which in theory could come as soon as next week, when finance minister George Osborne delivers an annual speech to London's financial community in the presence of King, the governor.

These plans are constrained by the accounting sleight-of-hand needed to ensure they are also consistent with the government's political commitment to see its headline debt-to-GDP ratio falling by the time of national elections in 2015.

But if they went through, who knows, maybe indirectly the Bank of England would be buying everyone solar panels.


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