U.K.: QE2 likely to set sail, but it’s no panacea

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This post is a guest contribution by Jonathan Ashworth of Morgan Stanley.

The vote on quantitative easing (QE) at the September meeting remained 8-1, but the tone of the minutes signalled an increased likelihood that the Bank of England (BoE) will resume asset purchases over the coming months. According to the minutes, “For most members, the decision of whether to embark on further monetary easing at this meeting was finely balanced since the weakness and stresses of the past month had significantly strengthened the case for an immediate resumption of asset purchases”. Moreover, “Most of these members (read: apart from Adam Posen) thought that it was increasingly probable that further asset purchases to loosen monetary conditions would become warranted at some point.”

We think there is at least a 50-50 chance that QE resumes in November, with a significant risk of an October move. Some members suggested that “a continuation of the conditions seen over the past month would probably be sufficient to justify an expansion of the asset purchase programme at a subsequent meeting”. In light of the bearish economic and market newsflow over recent weeks, we suspect that the vote could be 6-3 or even 5-4 at the October meeting.

By November, much will hinge on developments in the eurozone and in the domestic economic data (particularly the business confidence surveys). At the current juncture, our European Economics team believes we are some way from a comprehensive solution to the crisis; hence, the negative feedback loop should continue to buffet the UK banking sector and economy. While statistical effects should flatter 3Q GDP growth (2Q GDP was artificially depressed by the fallout from Japan and the loss of a working day for the Royal Wedding), the underlying picture is much more subdued. The latest Purchasing Mangers surveys are pointing to very little growth at the present time, and the more forward-looking components point to further weakening. As a result, we are downgrading our GDP forecasts to 1% for 2011 and 1.1% for 2012.

Set against this deteriorating backdrop (and given the recent pullback in commodity price futures), in its November Inflation Report the BoE may forecast a decent (although not huge) undershooting of inflation at its two-year time horizon, assuming unchanged interest rates (on the same basis in August it forecast inflation around the target level, but it now expects materially weaker second half growth). This, together with the growing uncertainty and downside risks around the economic outlook, should be enough to persuade a majority of members to vote for asset purchases, with £50 billion the most likely amount. Recent speeches from policy-makers suggest that they will be primarily targeted at longer maturities. As a result of the increased likelihood of doing QE, we have pushed our rate hike forecast to February 2013 at the earliest.

That said, we are not totally convinced that QE is a done deal just yet. With inflation likely to rise towards 5% in October, a number of members remain concerned about easing policy during a sustained period of above-target inflation and amid concerns over how quickly it will fall back. These fears will not have been assuaged by recent Financial Times analysis, using the Office for Budget Responsibility’s (OBR) methodology, which suggested the economy’s spare capacity may be significantly less than the OBR previously forecast. Recent speeches from MPC members Dale and Broadbent suggesting that the economy’s trend growth may be lower than previously thought will have reinforced this message. Meanwhile, the BoE’s own analysis in the 3Q Quarterly Bulletin suggests that the impact on inflation from further QE is not insignificant. So, it is not totally inconceivable that if, by the end of October, European policy-makers have confounded expectations and started to get a grip on the situation, the MPC (if growth was soft but not collapsing) may wish to eschew further easing, allowing time to assess developments in the global economy.

We Don’t Think QE Will Be Much of a Panacea

While we think that, on balance, QE will be beneficial to the economy, we are somewhat less sanguine about its impact than the BoE. In its 3Q Quarterly Bulletin, it discusses the design, operation and impact of QE, with the range of estimates for GDP and inflation under different modeling methods.

Below we list the main mechanisms through which the BoE suggests that asset purchases will boost the economy, and we discuss the likely efficacy of each.

Policy signaling effects: With markets already expecting no change in interest rates until mid-2013 at the earliest, one suspects that there is little potential further boost from this channel – Governor Mervyn King said as much in the Q&A after the August Inflation Report. In response to a question on whether the BoE could mimic the Fed in signaling that rates are likely to remain low over the next couple of years, he suggested that market interest rates in 2013 were almost unchanged from where they are now, despite the lack of a commitment.

Portfolio balance effects: Undoubtedly, there is some scope to still boost the economy, but much less than in 2009, in our opinion. Yields are significantly lower than in 2009, across all parts of the curve. Lately, some MPC members have made the case that longer-maturity yields are not at historical lows, but they are still at incredibly stimulative levels. Moreover, in addition to reducing yields on the assets it buys, the BoE hopes that the sellers (preferably non-bank financial institutions) will use the funds to invest in riskier assets like corporate bonds and equities, reducing their risk premia. Towards the longer end of the curve, pension funds and insurance companies are significant owners of gilts, given their desire to match their long-term liabilities. Given the increased uncertainty and weakening economic outlook and the failure of the last round of QE to promote a sustainable recovery, one could seriously question the current appetite among these institutions to move up the risk curve into equities and corporate bonds.

Confidence effects: The theory behind the life-cycle hypothesis of consumption suggests that if consumers believe they have a permanent increase in wealth, they will increase current consumption. The failure of QE to deliver last time further increases the risk that consumers view any increase in asset prices as fleeting, disappearing once policy-makers pull away the punchbowl. It would be extremely surprising if businesses weren’t equally sceptical.

Liquidity premia effects: When financial markets are dysfunctional, central bank asset purchases can improve market functioning by increasing liquidity through actively encouraging trading. Asset prices therefore increase through lower premia for liquidity. Evidence from Japan, the UK and US certainly supports the efficacy of this type of intervention. However, at the current juncture, the UK’s asset markets are not particularly dysfunctional, and where there are problems these are emanating from the eurozone.

Bank lending effects: By purchasing assets from non-banks, the BoE injects monetary base into the financial system, and these extra funds should end up in deposits at the commercial banks. Under normal circumstances, this would typically spur a surge in lending to households and corporates and subsequent gains in broader measures of money. However, the money multiplier (broad money/monetary base) is currently impaired, primarily due to an elevated desired reserve ratio among the banks (desired reserve ratio = [required reserves + excess reserves]/deposits). A number of well publicised factors are currently making banks refrain from lending (and accumulate excess reserves), and these factors are unlikely to abate in the foreseeable future. Admittedly, though, the BoE has never been particularly optimistic about the efficacy of this channel in recent years either.

Meanwhile, the factors likely to reduce the efficacy of the different mechanisms described above suggest that the benefits from a US-style Operation Twist would also be quite limited (at the September meeting, the BoE suggested that further asset purchases were preferred at the current juncture).

Another Round of QE Poses Significant Risks to BoE Credibility

There has been a drumbeat of support recently from government officials and some business leaders for the BoE to resume QE. Given the coalition government’s fiscal mandates, it may have very little wiggle room to ease discretionary fiscal policy to bolster growth. Indeed, the risk is that intentional fiscal slippage could undermine its fiscal credibility and fuel a sharp jump in borrowing costs. Hence, the onus falls on the monetary authorities to support the economy at the present time. However, we believe that one should not underestimate the risks posed to the BoE’s own credibility by embarking on another round of QE. In a recent speech, MPC member Ben Broadbent suggested that, while the UK inflation-targeting regime looked robust, “That’s clearly not something that can, or should, be taken for granted. Credibility is earned, over time, by keeping inflation close to its target”.

Strikingly, the BoE would be the first of the major developed central banks to start injecting money back into the economy (unsterilised), despite the UK having much higher inflation than its peers. When the MPC initiated QE in March 2009, inflation stood at 2.9%, and there had been a complete collapse in the outlook for growth and consumer prices. In contrast, inflation is likely to reach 5% in the coming months and the growth slowdown has not yet been dramatic. Any further policy-induced weakening in the currency would fuel further upward pressure on inflation.

In our opinion, much of the perceived ‘safe haven’ status of the UK during the recent financial crisis has been due to investor confidence in a combination of the country’s fiscal and monetary policies. The risk is that, thinking in terms of the simplistic Uncovered Interest Rate Parity model, foreign investors may begin to demand higher interest rates to compensate for fears of further sterling depreciation. We have already seen a sharp decline in net gilt purchases by foreigners in the last couple of months (they turned net sellers in August). These data can often be quite volatile, so one should not read too much into it just yet, but it certainly suggests to us that policy-makers should proceed with caution.

Policies to Reduce the Lending Spread Would Be Most Effective, but They Are Unlikely at the Current Juncture

The key problem for the economy is the large spread of effective lending rates to households and corporates over the Bank Rate and the lack of provision of credit to key areas of the economy, such as SMEs and first-time homebuyers. The lending spread has increased sharply since the onset of the financial crisis (and this understates the true spread as it excludes all those that have been refused loans).

In its August Inflation Report, the BoE highlighted the two key components of the lending spread, the rise in the cost of bank funding relative to the Bank Rate and the spread that banks add over their funding costs (reflecting a wide range of factors, such as credit risk charges to cover possible loan losses, lenders’ mark-up, etc.). A rise in the latter component (particularly for certain borrowers) was unsurprising, after the lax lending standards of the preceding years.

The main problem in terms of credit provision, however, is the former. Moreover, the ongoing crisis in the eurozone is exacerbating the banks’ funding problems. Since the beginning of August, credit default swap premia (the cost of insurance against default for bondholders) for the major UK lenders have absolutely soared, signaling a further rise in the banks’ cost of funds and the future rates at which they lend to the wider economy.

In our opinion, increased gilt purchases by the BoE will do little to ameliorate this (even if they were of considerable size). We think that, in order to reduce the spread or to provide more lending to SMEs, the monetary authorities may at some point have to consider more aggressive quasi-fiscal-type measures. Adam Posen, in particular, has suggested a number of different schemes. We certainly don’t think that the BoE is there yet. However, if there was a significant blow-up in the eurozone or the UK looked to be entering a more prolonged downturn, we believe that the BoE may consider them under instruction from the government. We will discuss some of the potential quasi-fiscal type measures the authorities may consider employing in a forthcoming publication.

Source: Jonathan Ashworth, Morgan Stanley, October 4, 2011.

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