Media reports have overhyped the new Term Funding Scheme (TFS), under which the Bank of England will supply medium-term funds to banks at Bank rate as long as they maintain or expand their lending.

Some reports have described the scheme as a “giveaway” or “subsidy” to banks. It is not. The Bank will fund the scheme by creating new bank reserves, which earn interest at Bank rate. The net cost of the scheme to the Bank (ignoring administrative expenses), therefore, will be zero. There is no “giveaway”.

Usage of the scheme, according to the Bank, “could reach around £100 billion”. Some reports have added this figure to the £70 billion of planned purchases of gilts and corporate bonds, claiming that the Bank has launched a £170 billion “money-printing package”. Usage, however, may fall well short of £100 billion, while the scheme will be used mainly to replace existing funding, not to finance new lending. It is not equivalent to QE.
 
Many banks are holding “excess” reserves at the Bank relative to their regulatory or operational needs. These banks could use these reserves, earning Bank rate, to exploit any profitable lending opportunities – they have no need or incentive to access the TFS. Their lending, therefore, is unlikely to be affected by the scheme.

The scheme is targeted at liquidity-short banks and building societies, which will be able to use it to replace more expensive wholesale and retail funding and, possibly, to increase lending*. The positive impact on the margins of these institutions, however, comes at the expense of not the Bank but rather their wholesale / retail depositors, whose funds will earn lower rates elsewhere.

Even these banks / building societies may have reservations about accessing the scheme, since Governor Carney has suggested that the Bank will expect to have a significant say over their loan pricing decisions. The banks, he said, have “no excuse” not to pass on the quarter-point Bank rate cut in full and the Bank “will be watching” to ensure that they do.

The combined impact of the Bank rate cut and TFS, therefore, may be negative for banks – margins of banks with excess reserves may be squeezed, while those accessing the scheme may lose autonomy over other decisions affecting their profitability. The scheme is unlikely to stimulate much additional lending. Its main effect will be to increase the pass-through of the Bank rate cut to borrowers and, particularly, depositors.

*To the extent that profitable lending opportunities exist that have not been exploited by banks with excess liquidity.

The MPC’s easing package exceeded expectations but falls short of representing a “sledgehammer”.

The MPC supplemented a quarter-point Bank rate cut with purchase programmes of £60 billion of gilts over six months and £10 billion of corporate bonds over 18 months. The implied monthly rate of buying of £10.6 billion, however, compares with £25 billion when QE was introduced in March 2009. The nominal size of the economy has grown by a quarter since 2009, so monthly buying as a percentage of GDP will be only one-third of the level in 2009.

The novelty in the package was the introduction of a Term Funding Scheme, which replaces the Funding for Lending Scheme and will allow banks to access medium-term funding at Bank rate as long as they maintain or expand their net lending. The purpose of the scheme, however, is to ensure that the Bank rate cut feeds through to lending rates by offsetting the negative impact on banks’ margins; it does not represent an additional stimulus measure.

The package also contained forward guidance that the MPC will cut rates to the lower bound, judged to be ”close to, but a little above, zero” if the economy evolves in line with the Inflation Report forecast, which envisages “little growth” in the second half of 2016. Governor Carney, however, stated that he is not in favour of a move to negative rates, and there was no discussion in the minutes of this possibility.

The judgement here is that there is insufficient evidence, in particular about post-referendum money and credit trends, to warrant additional easing at this stage. The MPC is playing fast and loose with the inflation target, launching stimulus despite forecasting that the annual CPI rise will be above the 2% target in 2018-19. If demand holds up better than expected, or the Brexit supply shock proves larger, a significant inflation overshoot may be in prospect.

A post in October 2015 argued that US economic growth would undershoot consensus expectations because 1) narrow money trends, which lead activity by six to 12 months, had weakened sharply and 2) the level and rate of change of inventories were elevated relative to sales / output, suggesting that the three to five year Kitchin stockbuilding cycle was about to turn down (having last bottomed in 2012).

These reasons for pessimism have now reversed. Six-month growth of real narrow money, defined as currency in circulation plus demand deposits divided by consumer prices, has risen from a low of 0.2% (not annualised) in October 2015 to 4.4% in June.

The rate of change of inventories, meanwhile, turned negative in the second quarter, a drawdown having last occurred in the third quarter of 2011. It would be premature to declare the Kitchin downswing over, since the level of stocks remains elevated relative to sales – see first chart. The large GDP growth drag from inventories during the first half, however, is unlikely to be repeated.


A further reason for optimism is an improving profits backdrop. Last week’s GDP release contained a significant upward revision to the level of profits in recent quarters, along with a stronger rebound in the first quarter. A second-quarter number is not yet available but a further increase is implied by faster growth of nominal GDP (3.5% annualised) than employee compensation (2.6%) – second chart. Together with lower corporate financing costs, this may contribute to a rebound in business investment.


What are the risks? One is that slow first-half growth feeds through to weaker near-term employment gains, undermining consumer spending, which has been a recent bright spot. July consumer surveys, however, do not suggest much pull-back: the expectations component of the Conference Board confidence measure, for example, remains consistent with solid spending expansion – third chart.


A second risk is that wages continue to pick up in response to a tight labour market, aborting the recent profits recovery. Annual growth in the wages and salaries component of the employment cost index rose to 2.5% in the first quarter, equalling a high reached in the first quarter of 2015. The latter was boosted by unusually large bonus / incentive payments: excluding incentive-paid occupations, wage growth is on a strong upward trend – fourth chart.


A probable rebound in GDP growth coupled with rising wage pressures argues for a central scenario in which the Federal Open Market Committee raises the target funds rate during the second half, with a September move still possible.