Is the UK set for inflation?
- April 20, 2020
SummaryIndependent central banks exist to protect politicians from one of the oldest temptations of government: increasing their own money supply during times of economic stress.
For at least the last two thousand years, political leaders in control of their own money supply have looked to increase it during times of economic stress. The Roman Emperor Aurelian reduced the amount of silver in the Antoninianus coin, allowing him to mint more of them. Henry VIII took a similar approach, painting a thin layer of silver on to copper coins and earning himself the nickname “Old Coppernose”. From the fifteenth to the seventeenth centuries, the Spanish Empire flooded the market with newly minted coins from South America’s silver mines. And in the twentieth century, Weimar Germany and Mugabe’s Zimbabwe simply printed more notes.
In the best of the cases above, the results included inflation, currency devaluation, and increased borrowing costs. In the worst ones, printing money led to a vicious cycle that spiralled into hyperinflation.
The present-day version of printing money is known as monetary financing—meaning the permanent creation of new central bank reserves, in order to directly finance government spending. Understandably, given the warning from history, it is a process that independent central banks are reluctant to engage in. Only two weeks ago, the Bank of England’s governor wrote in the Financial Times that monetary financing was “incompatible with the pursuit of an inflation target by an independent central bank”. He noted that such activity would erode the operational independence of the Bank, and that in other countries it had led to runaway inflation. Four days later, the Treasury announced that the UK government’s bank account at the Bank of England will be expanded to an unlimited extent in order to fund its response to COVID-19. This will be achieved by the creation of new central bank reserves.
It is important to pause and note two points. First, almost no one doubts that massive government spending is required to support the economy through the current crisis—and that money has to come from somewhere. Second, the creation of new central bank reserves does not inevitably lead to runaway inflation. Much of the developed world has been engaged in quantitative easing (yet another name for printing money) for the last decade, and inflation has remained subdued.
The risk here is not monetary financing per se, but around who controls its extent and duration. Historically, the worst cases have arisen when governments themselves have been in control. Expanding the money supply appears to be addictive and, at least in the short term, vastly preferable to facing harsh economic realities. For exactly this reason, more recent experiments in money printing have remained firmly under the jurisdiction of independent central banks that are obliged by law to target low levels of inflation. By and large, both financial markets and the wider public seem to have faith in this approach. In the UK, for example, the Bank of England currently owns more than 25% of government debt (having printed money to purchase it) and yet inflation expectations remain low and manageable.
So, is UK inflation about to take off or not? In the absence of other factors, the answer depends on how quickly the government is prepared to give up its unlimited bank account and hand control back to the Bank of England. At the height of the 2008 financial crisis, government drawings on the Bank of England account briefly hit £20 billion before the Treasury handed control back to the Bank and resumed borrowing in the bond market. Those who are concerned by inflation should watch closely to see whether that level is breached this time round. History has another warning here: governments are quick to assume emergency powers during a crisis, but slow to relinquish them afterwards.
Should you have any questions on the above, or other market impacts of the recent movements, we are here to assist in any way we can.
Chatham Hedging Advisors, LLC (CHA) is a subsidiary of Chatham Financial Corp. and provides hedge advisory, accounting and execution services related to swap transactions in the United States. CHA is registered with the Commodity Futures Trading Commission (CFTC) as a commodity trading advisor and is a member of the National Futures Association (NFA); however, neither the CFTC nor the NFA have passed upon the merits of participating in any advisory services offered by CHA. For further information, please visit chathamfinancial.com/legal-notices.
Transactions in over-the-counter derivatives (or “swaps”) have significant risks, including, but not limited to, substantial risk of loss. You should consult your own business, legal, tax and accounting advisers with respect to proposed swap transaction and you should refrain from entering into any swap transaction unless you have fully understood the terms and risks of the transaction, including the extent of your potential risk of loss. This material has been prepared by a sales or trading employee or agent of Chatham Hedging Advisors and could be deemed a solicitation for entering into a derivatives transaction. This material is not a research report prepared by Chatham Hedging Advisors. If you are not an experienced user of the derivatives markets, capable of making independent trading decisions, then you should not rely solely on this communication in making trading decisions. All rights reserved.20-0126
Our featured insights
A tour of Europe — an update on interest rates
A brief update on the EUR, SEK, and GBP interest rate conditions, putting the recent year-to-date movements into the context of the last 12 months.
The hairy chart: Historical accuracy of LIBOR forward curves
These hairy chart graphs plot past LIBOR forward curves against the actual path LIBOR followed, showing that the forward curve has been a somewhat accurate predictor over the next six months or so...
Request your interest rate cap execution checklist
Understanding the tactical steps involved in executing on an interest rate cap can help CRE investors plan and use their time efficiently prior to closing on a loan. Request your interest rate cap execution checklist here.
Thought leadership for housing associations: Embedded swaps and SONIA
There is emerging evidence that the way the housing association sector hedges its interest risk will change in the coming year. Currently, most are able to fix the debt through an embedded swap (a fixed-rate loan or “FRL”). FRLs account for the majority of fixed-rate borrowing for most small to...
Steepening yield curve increases cost of GBP interest rate hedging
A series of government bond selloffs have jolted financial markets since the start of 2021. In the UK, one consequence is a sharp rise in the cost of hedging GBP interest rate exposures. Having started the year at 0.08%, the five-year swap rate on 3-month GBP LIBOR hit 0.52% at the end of...
LIBOR transition timing update — the regulators have spoken
This piece summarizes a series of public announcements on March 5 regarding the timing of LIBOR cessation. Most notably, one- and three-month USD LIBOR will be published through June 30, 2023, while all non-USD LIBOR settings (GBP, EUR, CHF, JPY) will be published through December 31, 2021....
U.S. real estate market update—February 26, 2021
Markets are pricing in the first 25 basis points of Fed rate hikes to occur mid-2023 versus early-2024. Benchmark Treasury yields hit their highest points since the start of the COVID-19 pandemic and the levels strained liquidity in U.S. interest rate markets.
Rising yields and a steepening curve — U.S.
Longer-duration yields have risen and the yield curve has steepened in a hurry. 10-year yield touched 1.55% on February 25. The last time it crossed 1.50% was a year ago before the COVID-19 pandemic. The 10-year yield fell below 0.60% on March 9, stayed around 0.60-0.70% for months till...