The Bank of England's (BOE) powerbase is expected to expand to the highest level in its 316-year history, as the UK's first coalition government since World War II works through the details of an emergency budget focused on cutting government spending to reduce its deficit from 11 percent of GDP down to 2.1 percent by 2015.
Change is Coming
Over the summer, newly appointed Chancellor of the Exchequer George Osborne met with BOE's governor Mervyn King to discuss a proposal to overhaul the central bank's core responsibilities. Along with its traditional role of setting monetary policy via interest rates, the bank would also have direct authority over the country's banks, insurance companies and investment firms. These proposed responsibilities will make King the country's financial point man as the BOE struggles to tame current inflation risks while reviving the same institutions that have been blamed for creating the global financial crisis now in its third year.
A major step toward that goal has been to transfer the regulatory powers of the Financial Services Authority (FSA) — the government agency created in 1997 to oversee the financial industry — over to the BOE. The FSA will split into two separate entities, with most of its regulatory powers moving to the BOE under Hector Sants, the current FSA chief executive officer,and soon to become one of King's deputies. A separate entity, the Consumer Protection and Markets Authority will also be created to directly protect customers. King himself believes expanding the central bank's regulatory authority will be crucial for it to succeed at managing its traditional role of monetary policy. In a June 16 speech in London he said, "Monetary stability and financial stability are two sides of the same coin. During the crisis, the former was threatened by the failure to secure the latter."
King's Peers Struggle as Well
As King enters his second five-year term as head of the BOE, the proposed structural changes will elevate him above some of his esteemed central bank colleagues. European Central Bank President Jean-Claude Trichet's recent attempt to navigate the 16-nation euro zone collectively out of its sovereign-debt crisis has been seen as severely constrained by the constitutional requirement to defer to the individual domestic bank regulators and associated bank oversight agencies concurrently. In the U.S., even though Fed chairman Bernanke will soon get increased power over non-bank financial firms, he too will be required to coordinate his efforts with various government agencies that regulate securities firms and the insurance industry.
Not Everyone's Onboard
Growing concern over the BOE's expanded authority also has some politicians questioning whether this new path will actually return the UK's financial system back to health. Unlike the Fed, the BOE's initial response was seen as anemic at best as the scale of the growing crisis eventually caused the global credit markets to seize. King's view was not centered on the lack of liquidity because he believed simply pumping cash into the system wouldn't be the right tool to stabilize the markets. His ultimate answer was centered on solvency and stabilizing the quality of bank's balance sheets as seen in late 2008 when the BOE spent as much as GBP 50 billion, buying equity in two of Britain's biggest and potentially weakest banks, the Royal Bank of Scotland Group Plc and HBOS Plc.
Unfortunately, King's refusal to boost liquidity when the crisis began also had unintended consequences. Soon after sending his written testimony to Parliament insisting that the "moral hazard" of bailing out troubled institutions would only encourage risky behavior, the King-led BOE turned down a request from Lloyds TSB Group Plc for a GBP 30 billion bridge loan to help fund the takeover of troubled Newcastle-based mortgage lender Northern Rock Plc. By the middle of September, news of the troubled bank triggered the first run on a British bank in more than 140 years. Soon after, the government stepped in and guaranteed all deposits, as Northern Rock became the poster child for the evolving financial crisis that quickly swept through the country.
Monetary Policy Still Matters
Although the U.K.'s economy is slowly recovering after six consecutive quarters of contraction, the risk of a double-dip recession still lingers. The economy recently recorded its strongest quarter-on-quarter GDP growth rate in nine years, posting 1.1 percent in Q2 2010, up from 0.3 percent in Q1 2010. Unfortunately, inflation, the BOE's number one priority, continues to stay well above its 2.0 percent target rate, as seen in May when it jumped to a 3.4 percent annual rate. Oil prices have also risen 35 percent in the past year, fueling much of the current inflation pressures. Adding to the problem has also been the weakening pound, nearly 13 percent against the euro, the UK's biggest trading partner, and almost 16 percent versus the U.S. dollar this year.
King has few tools left to spur continued growth. With interest rates currently at 0.5 percent since March 2009, King's strategy of choice continues to be utilizing a quantitative easing (QE) program, which involves the central bank flooding the economy with money via massive government bond purchases. Since early 2009, the BOE has purchased nearly GBP 200 billion of bonds. If the economy does in fact falter in the face of the upcoming government spending cuts, King has made it very clear that he will inject more money into the system via QE part II. Debate on whether more QE is the right path continues as the primary fear of runaway inflation has many worried politicians, economists, and media speaking out against the policy. The depressed pound is also linked to the "near-zero" interest rate environment, which reinforces the argument for a more hawkish stance on interest rate policy to address the current inflation problems.
In the End, Better Times are Coming
Given the massive scale of the U.K.'s unsustainable fiscal obligations and the government's plans to drastically cut the budget deficit at an accelerated pace, the real possibility of a double-dip recession in the next couple of quarters persists. With the BOE potentially armed with its expanded powers, Governor King should have the ability to not only shield the financial system from misbehaving financial institutions, but better navigate the U.K.'s economy through these uncharted economic waters.
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