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The writer is an external member of the Bank of England’s Monetary Policy Committee

Major central banks have tended to move in lockstep over the past few decades in the face of big, global shocks like the financial crisis and Covid-19 pandemic. This lends weight to the conventional wisdom that the central bank of the world’s biggest economy — the Federal Reserve — sets a course for policy and other central banks must “follow the Fed”. But looking at the spillovers of Fed policy to UK growth and inflation, I think there’s a strong case for the Bank of England doing exactly the opposite.

My interest isn’t why the Fed might choose a particular course for monetary policy. Instead it’s what the implications would be for the UK economy and inflation.

Foreign monetary policy tends to wash up on our shores via two main channels: trade and financial markets. The impact via trade on UK growth and inflation is ambiguous. Let’s say the Fed cuts interest rates while the BoE does not. Other things being equal, US aggregate demand would rise, and with it demand for UK exports. This would push upwards on UK growth and inflation.

But this explicit demand channel is only part of the picture. When the US cuts rates, investors hunting for yield might redirect capital away from the country. All else being equal, this would push the US dollar down relative to sterling. UK exports to the US would be more expensive, sapping UK demand. And UK imports from the US would become cheaper, dragging on inflation.

The impact of surprise Fed rate cuts on the UK via financial markets is much clearer. As sterling appreciates relative to the dollar, capital inflows to the UK would push up UK bond and equity prices. An easing in financial conditions in the US is likely to buoy risky assets elsewhere. Looser financial conditions would push UK activity and inflation up. 

Understanding these various channels is nice but insufficient. We have to aggregate them to determine the overall impact on the UK economy. One way to do this is to use a top-down approach to look at how surprises in Fed policy have moved US borrowing costs and spilled over to the UK economy.

Using historical data from 1997-2019, I’ve looked at how moves in two- and 10-year US Treasury yields happening in the wake of Fed decisions have affected UK GDP growth and inflation. Two-year yields are highly relevant for borrowing in the real economy and incorporate shifts at the very short end of the curve. As such they are a decent proxy for changes in the US central bank’s benchmark federal funds rate.

Ten-year yields reflect surprises in unconventional monetary policy such as quantitative easing, which impact the long end of the curve. I’ve considered a 1 percentage point drop in both, not because either is likely but because it’s a round number with a clear directional impact.

A 1 percentage point fall in two-year Treasury rates initially pushes UK GDP and inflation up. This likely reflects a loosening in financial conditions. But subsequently UK growth and inflation fall as a result of the exchange rate channel. As sterling appreciates against the dollar, UK exports are less competitive and UK imports are less expensive.

Still we have to consider moves across the entire yield curve to understand the impact of Fed policy on the UK overall. A 1 percentage point drop in 10-year Treasury yields very clearly pushes both activity and inflation up in the UK. Moves in two- and 10-year Treasury yields together suggest a surprise Fed loosening might put upward pressure on UK growth and inflation.

What does this mean for my policy views? At the moment, very little. It doesn’t make sense to set domestic monetary policy based on the risk that another central bank might surprise us.

And all of this must be placed within the greater context of the UK’s domestic economy. The Monetary Policy Committee expects inflation to fall back to target this year, but it has been above 2 per cent for the best part of five years now.

There are two-sided risks to the underlying disinflationary process. Surprise rate cuts by the Fed could tip these risks towards greater inflation persistence and necessitate a more restrictive policy stance.

However Fed policy evolves, the BoE must focus on the forces shaping the outlook for UK inflation and set policy on that basis.