The Bank of England has made it clear that policy action to cushion the economy from the coronavirus is on its way, the only questions are what, how much and when. In the face of today’s meltdown in the financial markets, the Bank may be forced to act soon. We think that in the coming days or weeks, the Bank will unveil a 25bps interest rate cut, support for supply-chain financing and cheap financing for banks lending to the most affected sectors.
- The Bank of England has made it clear that policy action to cushion the economy from the coronavirus is on its way, the only questions are what, how much and when. In the face of today’s meltdown in the financial markets, the Bank may be forced to act soon. We think that in the coming days or weeks, the Bank will unveil a 25bps interest rate cut, support for supply-chain financing and cheap financing for banks lending to the most affected sectors.
- Should the Bank of England act? The economic shock caused by the coronavirus will affect both the supply-side of the economy (via shortages of imported components and travel restrictions) and the demand-side of the domestic economy (via less spending on discretionary items such as cinemas and restaurants). There’s not much the Bank can do to address the supply-side effects. There’s probably not much it can do to support demand in the very near term either, given it usually takes 12-18 months for lower interest rates to boost the real economy.
- Yet under the current circumstances looser monetary policy is probably the right decision. After all, the Bank has a role to play in countering the fallout in financial markets given the risk that the slump in UK equity prices or a widening in credit spreads feeds through to weaker demand. And by introducing measures that prevent firms from going out of business, the Bank can help to ensure that any impact on the economy’s supply capacity is temporary rather than permanent.
- What could it do and why? The Bank will almost certainly cut interest rates from 0.75% to try to stem the fallout in the markets and to support demand. It could follow in the footsteps of the Fed and lower Bank Rate by 50bps. But we suspect that with the additional fiscal stimulus in the pipeline at Wednesday’s Budget, the Bank’s limited room for manoeuvre before it hits 0% (it is starting from 0.75% while the Fed started at 1.50-1.75%) and its desire for a more targeted response will tip the balance towards a 25bps cut.
- But that will probably be supported by other measures. First, working with the Treasury, it may put in place some form of supply-chain finance to keep small and medium-sized businesses afloat. This could involve loans to businesses affected by supply shortages to tide them over until the disruption ends.
- Second, the Bank may also extend its Term Funding Scheme, which ran from 2016-2018. That initially allowed banks to borrow £75bn in total from the Bank at a rate close to Bank Rate for up to four years, with the fee banks paid lower if this increase was lent to households and businesses. This time the Bank could target banks’ lending to the most affected sectors, such as air transportation and accommodation.
- Third, it could reduce the so-called Counter Cyclical Capital Buffer, which specifies an amount of capital that banks must hold over and above the minimum requirement, from 2% to perhaps 0%. That would enable banks to roll over/extend credit facilities to more households and businesses for longer than usual.
- When will it act? With the equity markets seemingly in freefall, the Bank may feel unable to wait another two weeks until its next scheduled meeting on 26th March. The Bank might want to wait until after Wednesday’s Budget. Or it might want to wait until Andrew Bailey takes the helm on 16th March. Even so, it is perfectly possible that the MPC acts sooner rather than later.
- Will it work? Clearly the Bank can’t prevent the spread of the virus. But it can mitigate some of the economic effects. If we are talking about a couple of quarters of stagnant GDP, then this policy response, in conjunction with the 0.2% of GDP fiscal stimulus that we expect in the Budget (see here) is likely to be enough to prompt the economy to rebound later in the year. This is broadly in line with our current forecasts, so we think that the markets may have gone too far by pricing in a 50bps rate cut to 0.25% by May. However, if the economic effects are worse and there is a recession in the UK in Q2/Q3, or weak GDP growth lasts for longer, then the Bank may do more. It could cut rates to 0.25% and as it is not keen on negative interest rates, it could contemplate more QE.
- Overall, we think that the Bank of England will act soon, although perhaps by less than the markets are currently anticipating.
Ruth Gregory, Senior UK Economist, +44 20 7811 3913, email@example.com