Minouche Shafik: Small is beautiful but big is necessary
Speech by Ms Minouche Shafik, Deputy Governor for Markets and Banking of the Bank of
England, at the Bloomberg Markets Most Influential conference, London, 28 September
2016.
* * *
Accompanying charts can be found at the end of the speech or on the Bank of England's website.
The title of this speech is an expression used by Sir Fazle Abed, the founder of BRAC, the largest
nongovernmental organisation in the world. He was referring to the development community's fascination with small
projects rather than focussing on large scale systemic change. In response he built an organisation that reaches
over 100 million people, provides loans to five million poor women, and runs 40,000 schools.
I am especially grateful to Grellan McGrath, whose combination of creative challenge, analytical depth and
organisational skills greatly enhanced this speech. I would also like to thank Ben Morley, Lee Robinson and
Alastair Firrell for their assistance. I am grateful to other Bank of England staff and fellow members of the policy
committees on which I sit for helpful comments on an earlier draft. Nevertheless, the view expressed are my own
and not necessarily those of the Monetary Policy Committee, the Financial Policy Committee or the Board of the
Prudential Regulation Authority.
Introduction
Central banks are bigger than ever before. Gone is the pre-crisis ideal of minimalist central
banks with small balance sheets, narrowly defined objectives and tools, and a bias toward
non-intervention. Today, major central banks have greater responsibilities and a wider range
of tools at our disposal. Our balance sheets are larger and for the most part continuing to
increase (Chart 1). I'd like to use these remarks to offer a number of reflections on these
developments, using the Bank of England's recent experience by way of example, and
focussing on four themes.
My first theme is that the broadening of our responsibilities and range of tools at our disposal
has facilitated a more joined up approach to how we set monetary policy and pursue financial
stability - as I will illustrate using the example of our contingency planning around the
referendum. Second, the increase in size of our balance sheet has been a necessity of the
times we live in. Deep structural forces have combined to depress the level of interest rates
at which the economy would be in equilibrium, obliging us to rely evermore on monetary
policies that were once considered unconventional. This requires us to operate with multiple
instruments in multiple markets meaning that our impact on the financial system - the central
bank's footprint - is larger.
Third, we are aware that some of our policies have spillovers and side effects, but we take
steps to address them where feasible to do so within our mandate. We know that a bigger
footprint means we need to be mindful of our step. Finally, despite our bigger size, there are
some things central banks cannot do. To generate sustainably strong growth over the
medium term, monetary and financial stability policy must be part of a balanced package that
also includes the government's economic policies and, given strong global interconnections,
international policy co-ordination.
Joined up contingency planning
I'll start with our contingency planning prior to the referendum on the UK's membership of the
EU. We started from a position of strength thanks to changes made since the financial crisis,
including: reform of the regulatory capital and liquidity frameworks; a more robust supervisory
model; and increased access to our own liquidity facilities. Nevertheless, as we made clear in
the run up to the vote, the three statutory committees on which I sit - the Monetary Policy
Committee (MPC), the Financial Policy Committee (FPC), and the Prudential Regulation
Authority (PRA) Board - undertook extensive work to consider the implications of a vote to
leave the EU.
This contingency planning was the embodiment of joined up policymaking. The MPC and the
FPC met to exchange views on risks around the referendum for financial and economic
conditions; the FPC and the PRA Board both considered the potential for the referendum to
create financial instability; supervisory and market operations staff worked in tandem to
ensure that banks' liquidity needs could be met through a prudent combination of their own
buffers and Bank of England facilities; and we made sure to reach out to our international
partners in order to be able to present a co-ordinated response whatever the result of the
vote.
I am sure that everyone in this room could tell similar stories of detailed and co-ordinated
contingency planning in firms across the UK and indeed internationally. In part because of
this careful planning by all of us, the day after the referendum was remarkably orderly. Like
many of you, I arrived in a dealing room in the very early hours of the 24th of June to witness
astoundingly large volumes go through the foreign exchange market in a remarkably orderly
fashion as sterling found its new level - many banks and trading platforms reported turnover
that was up to ten times the typical daily amount. And, like many of you, I went through a
series of pre-scheduled conference calls and meetings with market participants and
counterparts in the international system which had an eerily calm atmosphere as the
immediate risks we had most feared - thankfully - did not materialise.
That is not to say there was nothing to do. Having raised the countercyclical capital buffer in
March, the FPC was in the welcome position of being able to reduce it once again and thus
send a strong signal that banks would be expected to support lending to the real economy.
And having already made clear that it would allow insurers to use the flexibility built into the
transition to Solvency II, the PRA was able to re-iterate publicly that firms could apply for
approval to re-calculate the Transitional Measures on Technical Provisions as at the end of
June - thus reducing the impact of the sharp decline in risk free interest rates on their
solvency positions.
Given my responsibility for the Bank of England's market operations, one success story I will
draw particular attention to is the resilience of banks' liquidity positions. By way of context, in
the period since the financial crisis banks have increased their liquid asset buffers fourfold,
and increased fourfold the lendable value of collateral pre-positioned for use in the Bank of
England's normal liquidity facilities. In recent years we have made much of these facilities
and how they have been overhauled since the crisis to provide access to a broader range of
counterparties, and to provide liquidity against a broader range of collateral.
But in truth this was one of the first times these new facilities had truly been put to the test,
and I am pleased to say they performed admirably. The flexibility we were able to show by
increasing the frequency of our regular operations gave added reassurance to banks that
they would indeed be able to rely on us. Our ability to send the message to the wider public
on the day of the referendum that we stood ready to lend more than £250bn to the banking
system helped head off any concern about the health of our banks. And the fact that the
facilities were used in moderate size proved they are an effective form of insurance - over
the month of June banks borrowed about £9bn of central bank reserves from us through our
regular operations in exchange for pre-positioned collateral as they prudently maintained
very high levels of liquidity around the referendum result.
Navigating through uncertainty
Once it became clear that the immediate financial stability risks had either not materialised or
been effectively mitigated, our attention turned to the macroeconomy. In setting monetary
policy after the referendum result, we faced two challenges. The first was that there was little
data on which to base an assessment of how the outlook had changed; the second was that
we started from the unusual position of Bank Rate already being at a record low. I'll take
each of these challenges in turn.
It is vital that monetary policy is set in a forward looking manner, given the lags in the
transmission mechanism, and this means taking decisions even when the data cycle is at an
early stage. That was very much the case in August. Although we had little hard economic
data covering the period since the referendum, we did have some forward looking surveys
and leading indicators of GDP growth at our disposal. Now these leading indicators are of
varying quality - some have a high predictive content for GDP growth, others very little, so it
can be difficult to know what signal to take.
One simple way of organising this information is illustrated in this "radar" of economic
indicators which I found helpful to navigate through the data (Chart 2). Its cells are coloured
green when the indicators are above their long run average; amber when they are below,
which is cause for concern; and red when they are well below, which is even more worrying.
The cells in the centre represent the data which have historically had the highest correlation
with GDP growth, while those in the outer circles have a lower correlation with GDP growth
and are less reliable.
The first radar dates from early 2014, a year in which GDP growth was 3.5%, so it is not
surprising that its cells are predominantly green. The intervening years remained mostly
green, though some amber spots began to appear as the initial recovery slowed to a more
normal rate of expansion. In the wake of the referendum result, at the time of our decision in
August, the most reliable indicators - those at the centre - were for the most part flashing
amber or red (Chart 3). Since then, of course, the data have turned out more positively than
expected, and the radar has become a little less red, a little more amber, though it mostly
remains below average levels (Chart 4).
Now, this is just a way of organising the data. Formally extracting a signal from it requires
much by way of econometrics - there is a rich literature devoted to data uncertainty and
nowcasting, to which the Bank has contributed significantly1. Forward looking indicators are
prone to overreaction and in some cases are outright misleading. Moreover, their predictive
power is limited to the very near term outlook. Given that monetary policy has its greatest
effect one to two years ahead, this means we must combine our assessment of the near
term indicators with a view of the underlying shocks which will drive the economy over the
coming years.
There is no doubt in my mind that the UK is experiencing a sizeable economic shock in the
wake of the referendum. Any reduction in openness or need to reallocate resources will
necessarily imply a slower rate of potential growth for the economy. Moreover, the reality of
the protracted process of withdrawing from the EU means we still know very little about the
nature of our future trading arrangements, and this uncertainty is weighing on prospects for
business investment. Our agents around the country report that some new projects are being
scaled back or deferred until the outlook becomes clearer. There are signs that foreign
companies have become more cautious about investing in the United Kingdom, and we know
that some of those who rely on the European Union as a destination for their exports are
beginning to make contingency plans in case they have to move some of their business
elsewhere.
All of this reflects the unavoidable economic reality of a period of transition. The depreciation
of the sterling exchange rate is certainly helping the economy find a new equilibrium. While
the flexible nature of the UK economy means it will ultimately adjust to its new
circumstances, the process of adjustment can sometimes be painful. That's where monetary
policy can help, and it seems likely to me that further monetary stimulus will be required at
some point in order to help ensure that a slowdown in economic activity doesn't turn into
something more pernicious.
However, the likely timing of that stimulus will depend on the continued evolution of the data
over the coming weeks and months. Thus far, the welcome improvement in the forward
looking indicators suggests that the slowdown may not be as sharp or as sudden as we
might have feared. For example, Bank staff have revised up their forecast for the mature
estimate of GDP growth in Q3 to 0.3% from 0.1% at the time of the August Inflation Report.
But we will learn a lot from the arrival of more official data for the post-referendum period,
and that will allow us to navigate by looking out the window as well as down at our radar.
A package tailored to our starting point
What is unusual about this particular loosening relative to previous cycles is its starting point.
Despite many real economic variables having returned to around normal levels following the
financial crisis the absence of any signs of overheating or inflationary pressure meant that at
the time of the referendum Bank Rate was already at an all-time low of 0.5% and we held a
stock of £375bn gilts on our balance sheet.
The global decline in market-based measures of long run real interest rates - which have
fallen by more than 5 percentage points since the 1980s (Chart 5) - suggests that the neutral
rate of interest is now far lower than any time in the past.2 The drivers behind this move are
deep structural shifts in trend growth rates, demographics and risk appetite. Taken together,
they have changed the global balance of savings and investment, thus depressing the level
of interest rates which will bring the economy into equilibrium.
These structural factors are beyond the influence of monetary policy. We can only respond
by setting Bank Rate lower than in past economic cycles - to do otherwise would result in an
unwarranted slowing of the economy. It means we must consider carefully where we think
the effective lower bound in our policy rate is - taking into account financial stability
considerations. It also means that we must be ready to use monetary policy instruments
other than Bank Rate - what was once unconventional is increasingly becoming
conventional.
With that in mind, the MPC had actively considered in the run up to the referendum how we
would go about loosening if it was necessary. Working closely with supervisors in the PRA
we confirmed that we had room to lower Bank Rate to a small positive number without
endangering the banking system. Based on our continuous dialogue with the Debt
Management Office and market participants, we knew there was scope to buy more gilts. We
also confirmed that there were a number of additional tools that we could use to generate
economic stimulus. In fact our creativity was limited only by the number of combinations and
calibrations the nine members of the MPC could come up with - making the voting process a
bit like trying to solve a Rubik's cube.
The package the MPC ultimately chose had five elements: a cut in Bank Rate to 0.25%; the
launch of a Term Funding Scheme (TFS) to reinforce the pass through of that cut; the
purchase of up to £10bn of corporate bonds; the purchase of an additional £60bn of gilts;
and forward guidance that should the data prove to be broadly consistent with the August
Inflation Report forecast, a majority of members expected to support a further cut in Bank
Rate during the course of the year. A sixth element was added by the FPC, who in parallel
approved a change to the definition of the leverage ratio to exclude central bank reserves,
thus making our monetary policy package more effective.
This package involved several pieces of innovation for the Bank of England. It brought our
official policy rate to a new record low in the Bank's 322 year history. It will bring the stock of
government bonds on our balance sheet up to £435bn, representing 23% of nominal GDP, a
new high. For the first time, we will purchase private sector assets for monetary policy
purposes3. And we will lend central bank reserves to the banking system, at a rate close to
Bank Rate, for a longer term than ever before.
Mindful of our step
The reason the MPC took these actions is because they will benefit the economy and, by
delivering monetary stability, contribute to prosperity. Our initial assessment of the impact so
far has been positive. But we are very aware that all monetary policy has spillovers and side
effects, and that we have a duty to minimise those where it is possible to do so without
jeopardising the overall beneficial impact. With that in mind, I would like to discuss three
criticisms frequently levelled at monetary policy of this kind, and to illustrate how the MPC
tried to take them into account.
1. Ultra low interest rates are self-defeating because banks are unable to pass them
through to customers. This criticism has its genesis in the fact that once household
and business deposit rates have reached a very low level, it becomes difficult for
banks to reduce them further. They face a choice between not passing the change
in Bank Rate through to borrowers, or having their net interest margins squeezed.
In light of the mixed experience of pass-through of very low levels of policy rates by
other central banks, this was something the MPC was acutely aware of in deciding
how far it should reduce Bank Rate. Using the intelligence and analysis of bank
supervisors in the PRA, we were able to establish that net interest margins on
banks' UK retail business were sufficient to comfortably withstand a cut in our policy
rate to a small positive number. UK banks' Net Interest Margin were around 230bps
in 2015 on average (Chart 6).
However, we still faced the risk that banks would choose to preserve these existing
margins, dampening the pass through of our change to rates faced by households
and consumers. The TFS is explicitly designed to counter that risk to the
transmission mechanism by tethering banks term funding costs more closely to our
policy rate. It gives them the ability to borrow from us for up to four years at Bank
Rate so long as they maintain their lending to the real economy. The initial signs are
good - standard variable rates have already been or, we expect, shortly will be
reduced on the vast majority of existing mortgages, and the rates available on new
5
lifetime tracker mortgages are on average 25bps lower.4, Though it is of course
difficult to say how much of this is directly attributable to the TFS.
2. Quantitative Easing has adverse consequences for pension funds and insurance
companies. The MPC is very aware that the marginal impact of low long term risk
free interest rates is - all else equal - to increase the present value of pension fund
liabilities, and to increase the margin that insurers must set aside to cover the
present value of otherwise unhedgeable risks. This is something we hear frequently
through our Market Intelligence, from businesses we meet, in conversations with the
Pensions Regulator, and of course through the PRA's prudential supervision of
insurers. It is also an international concern since long rates are low globally.
Ultimately, the way the MPC can most effectively contribute to generating the stable
return on assets that these investors need to meet their long term liabilities is by
supporting stable economic growth and by pursuing its inflation target. The boost to
economic activity that will come with lower interest rates should increase the profits
of companies across the country, and boost the value of financial assets more
generally. Indeed for a pension scheme that starts off in balance, the increase in
value of assets can be expected to offset the increase in liabilities.6 The problem
arises for pension funds that already start from a deficit, who will find it more costly
to acquire the assets to match their future liabilities.
In making our policy decisions we must bear in mind we are uncertain about the
magnitude of both the impact of QE on the economy and its side effects. Indeed that
was one of the key motivations in working to develop a broad range of tools. At the
margin, our determination to use a range of easing options - rather than relying
solely on the purchase of gilts - likely reduced the marginal impact on long term risk
free rates. Our package spread the transmission of monetary policy more evenly
across short-term interest rates, corporate credit and bank funding markets, as well
as long rates. Conscious of the structural changes in market liquidity over recent
years7, we are also purchasing at a slow pace compared to previous rounds of
quantitative easing to minimise any impact on market liquidity (Chart 7).
3. The central bank should not take the place of private markets in allocating credit.
The need to avoid unduly affecting the allocation of credit was paramount in our
design of the corporate bond purchase scheme. As a result, we have deliberately
chosen criteria for purchases that will give us a broad and representative range of
issuers and sectors. Those companies who have an investment grade rating,
subject to assessment by our risk management staff, and who make a material
contribution to the UK economy can expect their bonds to be eligible.8 Purchases
began yesterday, and at the end of each month we will publish our holdings in each
of 9 sectors, and how that compares to the corresponding market share. Over time,
we will adjust our purchases with the aim of achieving a sectoral balance across our
portfolio that matches that of the market as a whole.
Things a central bank cannot do
I hope I have by now convinced you of three things: (i) that the benefit of gathering a broad
range of responsibilities under one roof allows us to practice more effective joined up
planning and policymaking (ii) that the expanding size of the Bank of England's balance
sheet is a necessary response to the circumstances we find ourselves in (iii) that in making
decisions we are conscious of the spillovers of our actions.
Let me end on a note of humility. If I were to be granted one wish as a central banker it would
be to increase the neutral rate of interest toward a more historically normal level. That would
hasten our return to a simpler world in which Bank Rate would be our only monetary policy
tool, and allow us to reduce our footprint in other financial markets accordingly and return to
a "small is beautiful" world.
However, despite the broadening of our responsibilities and the increase in tools at our
disposal, the Bank of England does not set the neutral rate of interest - that is set by the
economy. Over the long run, it is determined by deep structural forces, including
demography, the flexibility of our labour and product markets, the quality of our institutions
and infrastructure, and the balance of savings and investment in the world economy. Policies
that affect those forces can increase the potential growth rate of the economy, and lead to a
general improvement in the underlying appetite for investment, thereby driving up interest
rates.
So monetary policy is just one part of the story alongside government's fiscal and structural
policies and the degree of international policy co-ordination. A good balance between them
can put us on a more prosperous and stable path. But for now, even if we might wish for the
time when small was beautiful, big is necessary.
References
Bean (2012) "Pension Funds and Quantitative Easing," Speech given to the National
Association of Pension Funds' Local Authority Conference.
Carney (2013) "The Spirit of the Season," Speech given to the Economic Club of New York.
Cunliffe (2015) "Market Liquidity and Market-Based Financing," speech given at the British
Bankers Association International Banking Conference, London.
Haldane (2015) "Stuck," Speech given at the Open University, Milton Keynes.
Rachel, L. and Smith, T. (2015) "Secular Drivers of the Global Real Interest Rate," Bank of
England Staff Working Paper No. 571.
Shafik, M (2015a) "Interpreting the Yield Curve: Warning or Opportunity?" Speech given at
the Association of Corporate Treasurers Annual Conference, Manchester.
Shafik, M (2015b) "Dealing with change - Liquidity in Evolving Market Structures," Speech
given at AQR Asset Management Institute, London Business School.
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