Preview - Bank of England to take the plunge

October 6th 2011: Preview - Bank of England to take the plunge

If the Bank of England and ECB are as worried as they appear to be about deteriorating economic conditions and the threat of renewed recession, then there really is little point in waiting another month before taking action. There is certainly a strong case to be made against quantitative easing, but If the policy of bond buying is correct, then it must also make sense to make the move now. Given that there is at least a 50% chance of a Bank of England move, Sterling is liable to drift weaker in the run-up to Thursday’s decision. A vote to revive bond buying would also trigger initial Sterling losses, although there would be scope for a quick recovery given the international back-drop.

At the September MPC meeting, Posen again voted for an expansion of quantitative easing while several other members indicated that they were close to voting for additional action give the deterioration in international conditions. The global outlook has certainly become more hostile since then as the Euro-zone descends further into the debt crisis and the UK outlook remains generally grim.

The economy did receive one piece of more favourable news on Wednesday as the PMI services index advanced to 52.9 from 51.1 previously. The data certainly did not indicate a healthy economy, especially as business confidence weakened to a 30-month low, but there was some hope that the economy was not heading for a severe downturn. The second-quarter GDP figure was revised down to 0.1%, although it is forward-looking indicators which need to be looked at closely.

The most likely outcome is that the Bank of England will take additional action either in October or November, although there will be a split vote and the outcome will be close. In September, the MPC did debate whether a cut in interest rates or a US Fed style ‘operation twist’ would be more effective, but they concluded that bond purchases would be the most effective option.

The more difficult question that needs answering is how effective any further increase in quantitative easing will be and whether it’s the correct policy response. There has already been a sharp downturn in UK bond yields with benchmark 10-year gilts are below 2.25% while yields across the curve are at record lows. In this environment, further bond buying may have some effect in pushing yields lower, but the economic impact is likely to be very limited.

With inflation at 4.5% and the Bank of England expecting the rate to move to above the 5.0% level, medium-term confidence in inflation control will continue to deteriorate. The Bank of England will, therefore, need to tread a very fine path. If markets and consumers believe that the central bank has given up on inflation control, then there will be an underlying increase in bond yields as investors will want to be compensated for the expected capital loss. In this context, further bond buying could prove to be counter-productive as underlying yields would be liable to increase.

There is certainly a strong case to be made that the policy of further bond buying is inappropriate and could even make conditions worse, but the Bank of England appears to see no other viable option at this stage.

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