27th September 2010
Expectations of additional quantitative easing (QE) grew last week in the wake of the Bank of England's (BoE's) minutes of August meeting of its Monetary Policy Committee (MPC). The minutes showed MPC member Andrew Sentance remaining the lone hawk pushing for a rate rise, with an 8-1 vote to keep rates pegged at 0.5%.
The minutes also indicate that several MPC members feel additional QE action might well be needed to stimulate growth and keep inflation on track to hit the 2% target over the medium term. In the wake of the minutes markets looked to quickly price in QE, with yields on ten year gilts last Wednesday dropping below 3% in the biggest fall for over a year.
Azad Zangana, European economist at Schroders, is not impressed with arguments for further QE: " I fail to see how the BoE can justify QE at this stage, both in terms of how they went about calculating how much QE was needed originally, and the inflation they have managed to generate out of that. "
The original QE programme, launched in March 2009, comprised £200 billion on gilts and a few million on corporate bonds. The amount was calculated on the basis of the outlook for the UK ‘output gap', the difference between the actual level of national output and its potential level, in the wake of the financial crisis.
Clearly at the time of the original programme, the revision down of GDP and concerns about excessive slack in the economy formed the basis for justifying QE.
But Zangana is adamant that the argument for another round of QE now does not stack up. ‘If you look at the latest numbers, you cannot justify QE…we have just had 1.2% real growth coming in, inflation is running at over 3%, well above trend, so the output gap looks like it is closing by itself.'
The only rationale for more QE that Zangana can see now is if the target is to keep sterling weak and thereby generating further inflation as deflation remains a major concern among policymakers. The weaker currency would also help improve UK competitiveness, with export-oriented sectors like manufacturing benefiting.
Zangana is not alone in his views over QE. Earlier this month, a Reuters poll of City economists that coincided with the September MPC meeting found only five out of 36 economists expected QE to be resumed at some point in the near future.
And late last week former MPC member Kate Barker also gave the thumbs down for additional QE, saying it is "looking less certain". As the economy stands today, "it is an open question", she told Bloomberg.
Inflation is at the heart of considerations over QE. It currently remains well above its 2% target but the BoE's view is that this is more due to temporary factors such as a weaker sterling and VAT increases, and that these will eventually drop out of calculations and prices will fall.
"The bottom line is most of the policymakers feel there is still a lot of spare capacity and worry that further out, say 2012, 2013, inflation will be well below target rather than above," says Zangana.
The big fear though – and it must give BoE governor Mervyn King sleepless nights – is that there is a lot less capacity than the Bank is assuming. There seems to be some disagreement with the Office of Budget Responsibility and the BoE on this issue, with the former arguing there is less spare capacity than being assumed by the BoE, a view MPC's Andrew Sentance is known to be sympathetic to.
"The OBR's view is certainly the only way you can explain why companies are looking to invest and hire again, increase capacity," says Zangana.
In the final analysis, however, irrespective of whether there is additional QE or not, if the BoE misjudges the outlook for spare capacity and inflation becomes entrenched rather than abating over the medium term, it could prove disastrous for its rates policy.
Rates will eventually go up, for sure, but the consensus is for a very slow rise. Zangana for one is concerned inflation may begin to surprise on the upside such that the BoE finds, just as it approaches the point where it would have had to start hiking, that it is forced to raise them much faster:
"That would lose it credibility with the markets. If we go from 0.5% to 3% in just six months, for instance, I can easily see another recession."
For now though Zangana is looking for a slow, below trend recovery for the UK, weaker than any in the past, and is slightly more optimistic than consensus with his numbers.
He sees the first BoE rate rise from its current level of 0.5% coming next August, a tad later than consensus, starting with the quarter point hike, and totalling a rise of 75 basis points for 2011, giving 1.25%.
Longer term Zangana sees rates at 2.5% by the end of 2012, rising slowly thereafter to 3-3.5% – Zangana's new estimate for the ‘neutral rate' for the UK economy, the level at which the economy is neither being artificially stimulated nor growth constrained. This new neutral rate estimate compares with 4-4.5% in the past.
As for QE, he believes the mere threat of further action by the Bank on this front will be good enough to keep sterling weak and gilt yields low, if that is what the Bank is really trying to do.
"I think we would have seen stronger signals if they were seriously going to do it. Looking at the results of the last MPC meeting, my reading is that we had one person voting for a rate hike, nobody voting for QE, essentially. "
Another major drawback for a further round of QE is public opinion. The first round of £200 billion plus resulted in little more than UK banks shoring up their ragged balance sheets and meeting foreign obligations in the wake of financial crisis, with little filtering through into the real economy and households.
Zangana says: "I think it is safe to say the BoE was disappointed by how much of the first QE programme fed into the real economy. On both technical grounds and in terms of what that first programme achieved, it is debatable whether another round can be sold to the public."