Despite attempts to rationalise the Bank of England’s decision to hold off utilising the remaining £25bn available to it under the existing £150bn quantitative easing package, we continue to admit to surprise at the move. We had thought that the recent Monetary Policy Committee (MPC) meeting would prove the catalyst for the remaining available funds ahead of the now eagerly awaited Quarterly Inflation Report, due in August.
We had thought that the MPC might use the publication of what we expect to be a downbeat Report, to call for a further tranche but confirm its desire to wait before making further bond purchases in order to gauge the effectiveness of QE 1, the equivalent of a full 9% of UK GDP. In the event the Bank has opted to hold off using the remainder of the facility, probably until the August MPC meeting, a move which will slow the level of gilt-edged purchases from the current £6.2bn per week run rate.
This may also imply that the Bank is trying to “tough it out” for the time being but given the parlous health of the UK economy, we continue to expect another letter from the governor to the Chancellor requesting further quantitative easing resources, but maybe not now until the Quarterly Report after next, due in November.
Why now?
By taking the decision not fully to utilise the existing quantitative easing facility the Bank may be sending a signal to investors in the gilt-edged market regarding what may lie in wait within the next Quarterly Report (August). It is possible that near-term growth and inflation forecasts may be revised upwards. Just as importantly, given the authorities’ increased confidence that the worst of the financial crisis may now be behind us (not a view we feel entirely comfortable in sharing), the official view is likely to be that the so-called “tail risks” are diminishing.
With regard to inflation, the Office for National Statistics has just released June inflation data which shows a marked fall in headline CPI from 2.2% y/y to just 1.8%, the first “below target” (referring to the middle of the 1-3% range over the medium term) figure since September 2007. We expect falling food price inflation to exert further negative pressure on headline CPI data through to September at which point we suspect that base effects will have troughed. For this reason we suspect that the Bank’s Quarterly will feature an upward revision to medium term inflation forecasts. Note that the 2.5% VAT reduction will likely be reversed at the November / December pre-Budget Report and were it to be included in existing inflation data the headline rate would still be at or above the 3% level commensurate with “letter writing” territory for the governor Mr Mervyn King.
UK economic output growth is, however, set to remain anaemic and well below the trend rate achieved over the past decade. The Bank may look to raise its growth forecast for 2010 but will need to tread carefully in our view as heralding the car scrappage scheme as “the Honda effect” looks hugely optimistic in the context of consumer spending which is likely to remain heavily circumscribed. Continually casting around for the best way to describe output’s cross-section over the next few years we stumbled across this one from our former colleague Stuart Thomson (now at Ignis) who describes the recovery as being “internet shaped” (i.e. a series of false dawns culminating in an ultimately overwhelming sense of disappointment!). As a well known technophobe the writer knows exactly what he means! We continue to believe that any recovery may prove short-lived, given huge and remorseless pressure on aggregate demand and that a “double dip” recession still looks a highly likely result going forward.
Ammunition to pause its quantitative easing process and a chance to reflect on the impact and long-term consequences of gigantic balance sheet expansion to date. From where we’re sitting the results so far are inconclusive. Quantitative easing set out with three aims. Firstly, to shock the financial markets when first announced. Secondly, to expand the money supply and thirdly, to reduce the term structure of interest rates. The first goal was comfortable. Markets were surprised and calmed by the provision of sufficient liquidity to erase the enormous pressure which had built up in the money markets. The second goal, to improve the term structure of interest rates has, so far, been partially successful, the spot gilt curve is higher now than when quantitative easing was first announced back in March but the forward gilt curve has indeed declined as a result of the Bank’s purchasing programme. The second part of the strategy for term structure has been the successful reduction in corporate bond spreads which has fallen due to investors overwhelming preference for corporate bonds.
However, the policy has failed in its most important objective, to stimulate that critical component of the money supply, bank lending to the non-financial corporate sector. Whilst bank reserves have soared, there remains precious little evidence of any increased willingness to pass on the additional funding. Recent press articles have highlighted the increase in popularity of two-year fixed mortgage rates, demonstrating the banks’ extreme liquidity preference and the continued impairment of their balance sheets reflected in speculation regarding a further possible £13bn write-offs / downs in commercial property loans.
It has been suggested, is some quarters, that the Bank’s decision not to pursue quantitative easing through to the end of the presently available package might be in some way down to its annoyance over the Treasury’s recent decision to provide further support to the Financial Services Authority (FSA) despite the latter’s role in the crisis of the past two years. Whilst we believe that the Bank was disappointed by the government’s decision, particularly so in the context of the US administration’s having chosen to beef up the Fed’s regulatory powers at the expense of the SEC regulator, we do not believe that the Bank would be so unprofessional as to allow such grievance to interfere with policy. In fact we believe that such rumours may have been started by those banks which would have preferred the UK central bank to have purchased their toxic waste off them, rather than simply buying government bonds and boosting reserves.
Conclusion
The pace at which the Bank pursues its quantitative easing programme has slowed. We suspect that the bank might be wishing to send a signal to the markets that, if the authorities are right and the worst of the financial and economic crisis is now behind us, that the programme is drawing to a close. Regular readers of this publication will know that there are significant risks to this relatively cosy interpretation of prospects. It may well be that consumers bring forward retail-related purchases in anticipation that the 2.5% VAT cut will be reversed in the late autumn and that this may stimulate near-term activity. We are not convinced that many consumers enjoy that luxury.
Our expectation, contrary to the strongly held view of senior officials on both sides of the Atlantic Ocean, is that the present economic revival represents little more than a hiatus and that the risk of a “double dip” recession actually looms very large indeed. The consequence of a dip back into recessionary territory would be a further widening in the output gap from already record levels and an intensification of near-term deflationary pressure. The most effective solution for deflation and eventual liquidity trap is quantitative easing and we believe that investors should not read too much into the Bank’s latest decision. More quantitative easing is on the way, although by pursuing this course significant, potentially hyper-inflationary pressures are being built up for the future.
• This article first appeared in Week in Preview, published by Charles Stanley stockbrokers.