The Old Lady of Threadneedle Street Mislays Her Spectacles

Bernanke’s Verdict

Dr Ben Bernanke, a Nobel laureate who was Chairman of the Federal Reserve from 2006 to 2024, was asked last year by the Court (board of directors) to conduct a review of the Bank of England’s forecasting models. His conclusions were published last Friday (12 April) – and they are damning.

“Significant shortcomings” in its methodology contributed to the failure of the Bank to foresee the inflationary surge that gathered pace at the end of 2021 and allowed inflation to reach 11.1 percent by October 2022 – higher than in the USA or the eurozone. It seems that the Bank’s approach to forecasting has hardly changed at all since Gordon Brown, then Chancellor, made the UK’s central bank “independent” and free to set interest rates in 1997.

According to Dr Bernanke and his team, the Bank’s software systems are outdated and its economic model, Compass, is unfit for purpose. His 12 recommendations entail radical change at the 330-year old central bank in order to adapt to a more uncertain and volatile world. Bank of England Governor, Andrew Bailey, welcomed the review, describing it as a “once in a generation opportunity”.

Bernanke & Co. have diagnosed “material under-investment” in the Bank’s forecasting tools which do not adequately track labour market productivity and the interaction between prices and wages. BoE economists often have to input data manually, thus damaging the Bank’s own productivity. The review opines that the nine-member Monetary Policy Committee (MPC), which sets UK interest rates, is overly reliant on its central economic forecast. This forecast is based on market expectations – mainly as expressed in the futures markets – of how interest rates will evolve over time. The bank no longer even reports estimates of monetary aggregates – that is now considered a throwback to the ascendancy of monetary economics in the 1980s.

And yet Mr Bernanke concluded that recent forecasting errors were no more egregious than those of other independent central banks. One of the recommendations is that “staff should be charged with highlighting significant forecast errors and their sources”. In other words, staffers should understand why their forecasts were wrong before they rush to make their next policy decision. It is tempting to ask why it was necessary to consult a Nobel laureate to embrace something so basically common sensical. Unfortunately, the review leaves one more sceptical than ever before about the healthy functioning of UK monetary policy and indeed economic policy in general.

Andrew Bailey’s term as Governor is set to run until March 2028. The recently-appointed Deputy Governor, Clare Lombardelli, was until February the Chief Economist at the Organisation for Economic Cooperation and Development (OECD), based in Paris. She was previously the principal private secretary to George Osborne when he was Chancellor (2010-16). Ms Lombardelli will succeed Ben Broadbent as an MPC member when his term expires in June of this year. At that point the MPC will for the first time count women in a majority, although the key positions of Governor and Chief Economist will still be held by men.

Kwasi and I…

In a round of interviews to mark the launch of her new book, Ten Years To Save the West, former prime minister Liz Truss has been insinuating that the Bank of England in general and that Andrew Bailey in particular let her down during her brief premiership. In her memoir, Ms Truss says that she and her Chancellor, Kwasi Kwarteng, had been in constant contact with the Bank of England prior to the kamikaze “mini-budget” of 23 September 2022, and that Andrew Bailey’s claim that he had been “blindsided” by it was inexplicable.

In fact, the mini-budget was unveiled the day after the Bank of England had raised interest rates – by much less than the markets had been expecting – and had announced a new round of quantitative tightening by selling off a tranche of gilts that it held on its balance sheet. As a result, the value of the pound was already on the slide. Ms Truss says in her book that the Bank of England Governor was clearly aghast that, during her leadership campaign, she had questioned the Bank’s mandate and had pledged to review it. Ms Truss claims that the Bank of England cut her adrift by announcing that it would make a full assessment of the mini-budget at its next meeting.

Ms Truss further says in her book that she was “astonished” that no one at the Bank or the Treasury had flagged the issue of liability-driven investment vehicles (LDIs) in which major UK pension fund managers were heavily invested. Those pension funds had bet the farm on rates remaining at rock bottom just as they began to rise. In the event, The Bank’s decision to buy £65 billion of gilts in the open market saved the day and the explosion in gilt yields was arrested. Then the Bank withdrew from the markets, leaving the Truss government exposed to the political fallout from the hike in mortgage rates.

Government bond yields were rising anyway in late September 2022 as US interest rates rose to combat inflation. But because the Bank was tardy in raising UK rates, domestic inflation expectations worsened, driving up market expectations of future interest rate rises which then drove up long term bond yields. Hence the “doom loop” which finally obliged Ms Truss to abandon the budget completely and to dismiss her friend and colleague, Mr Kwarteng. (Reportedly, the two have not spoken since).

While Ms Truss is right that the Bank was unsupportive, she should admit that the timing of a major change in UK fiscal policy was reckless. She and Mr Kwarteng sought radical change in fiscal policy at precisely the moment when inflation was peaking, and rates were about to spike in order to combat it. The markets took fright.

But despite the mockery to which Liz Truss is routinely subjected, given that she became the shortest-serving prime minister ever, her defence of her economic agenda is to be welcomed. Even Labour politicians who have castigated her now chant the mantra of the need for growth, even if they have little idea of how to achieve it. She is also right that the Bank has become a kind of parallel state with its own economic agenda – as has the Treasury.

If the role of the Bank of England is now a subject of controversy, the Treasury is also a matter of contention. Australia, New Zealand and Canada do not have a single ministry of finance. Rather, they have separate departments responsible for government spending and for taxation. For now, prime minister Sunak has ruled out a fundamental restructuring of the Treasury, but this issue might well come to the fore under a Labour government.

Interest Rate Outlook

At the start of the year the markets expected UK rates to be cut by up to six times this year: they anticipated the base rate would be 3.75 percent by Christmas. Now, that looks more like just two cuts. Or even just one. As I warned in these pages in early January, interest rate expectations were unrealistic because there was a misunderstanding of how entrenched inflation had become. Just as the central bankers dismissed inflation as a “transitory” phenomenon in 2021, so they underestimated how difficult it would be to dislodge it thereafter.

In the UK, inflation is now down to 3.2 percent – the most recent figure for March was released on Wednesday (17 April). That was a two-and-a-half year low, although somewhat higher than the expected 3.1 percent. Food prices have ceased to increase while services are still costing more – note the rocketing cost of insurance premia. Next month’s figure (that is the number for April to be released in mid-May) will reflect the cut in the Ofgem energy price cap this time last year. That might be tantalisingly closer to the two percent mark. On the other hand, there are fears that the significant recent increase in the National Living Wage (now £11.44 per hour) may put upward pressure on the UK inflation rate.

On Wednesday evening Andrew Bailey predicted a “strong drop” in inflation next month. He said inflation was “on track” to fall to two percent within months, driven by cheaper household bills as the energy price cap falls. But Mr Bailey’s predictions are now widely taken with a pinch of salt. On Thursday, Megan Greene, an external member of the MPC, speaking at an event hosted by the IMF in Washington, said the last mile of slowing down the pace of inflation would be the hardest. Ms Greene warned that the world could be returning to a period of greater “volatility and uncertainty,” which could push prices higher. She added: “Actually, rates will need to be a bit higher than we thought before.”

Later today, we shall get the latest retail sales figures which will be a guide to how things are going on the high street. The mood music here is varied.

Across the Pond, in March, the US CPI registered its third successive monthly increase. The headline annual inflation rate rebounded from 3.2 percent to 3.5 percent, with the core rate stuck at 3.8 percent. In both the UK and the USA, the official target rate of inflation is just two percent. On Tuesday (16 April) the Federal Reserve Chairman Jay Powell said that it was taking “longer than expected” to bring the US inflation rate in line with the official target. At least, unlike the UK and much of Europe including the industrial powerhouse Germany, the USA is enjoying robust economic growth.

While inflation is trending downwards across Europe and North America, in recent weeks it has become less likely that the Fed will cut rates appreciably in the immediate future. This leaves the Bank of England with a dilemma. If it cuts the UK base rate ahead of the Fed cutting the Fed funds rate then the pound will come under pressure – indeed, it already is. Further depreciation of the pound would be inflationary as the cost of imports, especially foodstuffs and energy, would increase in sterling terms.

The Europeans have a similar conundrum. Inflation in the eurozone is now down to 2.4 percent but it is widely though that if the European Central Bank (ECB) cuts rates before the Fed does, then the dollar and the euro could reach parity. On Thursday last week (11 April) the ECB left its benchmark deposit rate unchanged at 4.0 percent while signalling that a rate cut was likely in June.

Yellow Gold And Black Gold

Given the heightened levels of geopolitical risk, with no end in sight to the war in Ukraine and the incipient escalation of the Israel-Hamas war into a major conflagration across the Middle East, it is not surprising that gold is on the up. Gold is the asset that investors seek when they are scared. As I write this morning, gold is trading at $2,391 per ounce which is just a tad below its all-time high on 11 April of $2,431. China’s central bank has been adding to its known gold reserves for 17 consecutive months, reflecting a shift away from holdings of US Treasuries and European bonds. It seems that the Chinese middle classes are also buying gold as they reduce their exposure to property.

Gold is the ultimate hedge against inflation. Therefore, the price of gold tends to increase when inflation rages. The idea may have gained traction that Western governments want inflation to persist because that will whittle down the value of their colossal debt piles in real terms. That could become a self-fulfilling prophecy and could keep the gold price high.

The major central banks all maintain a large part of their reserves in gold. The US has the largest stock of gold, with 8,133 tonnes according to the World Gold Council. Next comes Germany with 3,353 tonnes, followed by Italy with 2,452 tonnes, then France with 2,437 tonnes, Russia with 2,333 tonnes and China with 2,235 tonnes. It is to be noted that collectively the eurozone countries have larger holdings of gold than the USA. The United Kingdom has a measly 310 tonnes – in large part because of Gordon Brown’s decision in 1999 to sell off half of the Bank of England’s gold reserves when gold was trading at just $280 an ounce.

Despite the geopolitical and interest rate uncertainty, the New York equity markets are trading at near their all-time highs. Those investors who fear that the markets have over-reached themselves and that the hysteria around “AI” has distorted valuations may also consider diversifying part of their portfolio into the yellow metal.

Oil has also been trading higher given the very real prospect of war in the Middle East. Last night, Brent crude was trading at just under $90 per barrel – up from around $80 one month ago – but the fear is that if Israel retaliates against Iran for its 13-14 April drone strike (which has just been confirmed this morning), then that could take oil to $100 per barrel. That itself would be inflationary and would make rate cuts less likely.

Afterword: The Elephant in the Room

It seems almost indecent to say it after the lull of the Easter break (and I have just returned from a pleasant spring séjour in Alsace). Ahem, but here goes.

We seem to be on the brink of World War Three. But nobody wants to talk about it.

Last weekend, the regime of the mullahs (who I distinguish from the great people of Iran) attacked Israel. It is a tribute to their incompetence and the capability of the collective Western alliance (the RAF played a key role, I am told) that the mullahs inflicted little damage. But the Israelis have now responded – they regard it as their duty. They have not heeded President Biden’s, still less Lord Cameron’s, plea to “take the win”. (Translation: not to retaliate).

There will be many in America who will say: If Donald Trump were in the White House now he would assemble an alliance – to include Saudi Arabia and other key Arab states – and use American military power to put a stop to Iran’s nuclear weapons programme once and for all. Of course, that might induce a wider conflict with Russia and China (and their weird little friend, North Korea). But it would not be the current policy of appeasement of a regime that will never settle down and become a responsible member of international community.

Meanwhile, the frontline in Ukraine is crumbling, with potentially momentous consequences…

That is why the US presidential election in November will be fought out on foreign policy, not domestic, issues.

Assuming we make it to November, that is.