BoE Preview: Financial Conditions Deteriorate

In May,  a third of the Monetary Policy Committee  (MPC)  voted in favour of a 25 basis points rate hike. Inflation was more than twice the Bank of England’s target. Our base rate indicator suggested that monetary conditions should be eased, not tightened. Only Adam Posen, external member of the MPC, wanted to increase the asset purchase target. In October, the MPC decided to restart quantitative easing as “the deterioration in the outlook had made it more likely that inflation will undershoot the 2% target in the medium term” and  raised the target by GBP75bn. A typical central bank way of saying that the economy needs substantial stimulus and we better get started now!

Base rate indicator suggests more QE is coming – but perhaps not yet

Our base rate indicator, essentially an augmented Taylor rule for the UK economy, has fallen substantially over the past year, strongly hinting at more QE. The 10 input factors are equally weighted and except for the current level of consumer price inflation, they all suggest monetary policy should be eased. Particularly the low levels of consumer confidence, the negative broad money growth and slide in private disposable income must be surely worrying for policymakers.

The base rate indicator started to fall rapidly in mid-2008 and bottomed out in early-2009. It is important to emphasise that the indicator fell almost half a  year before the BoE responded and reduced rates to crisis levels. Economic and financial conditions recovered somewhat but the indicator never suggested it was time to tighten monetary policy – not even when inflation soared. Since mid-2010, the indicator has  been  falling and  now points toward substantial monetary stimulus – i.e. more QE.



When more stimulus is required why not accelerate the asset purchase programme?
Well, the Bank of England would probably like to increase the “run rate” of purchases due to the depressing economic outlook and inflation projection, but it might be afraid the market cannot absorb accelerated Gilt buying: “Market capacity made it difficult to increase the monthly rate of purchases substantially above what was already under way”,the latest Minutes said. We interpret that as more QE surely will come but not at a faster pace – i.e. the current pace, of about GBP5bn a week will be maintained going forward.

We believe the Bank of England will continue to buy Gilts in most of 2012. The first increase is due to be announced in January and can be either GBP50bn or GBP75bn. The former would signal  that  the Bank is levelling off  while the latter would indicate that stimulus continues unabated and more might be coming.

We believe the total asset purchases will amount to £400bn by end-2012. It is difficult to estimate the total programme but we expect the economy to expand in H2 12, after having backpedalled for some time. Our base rate indicator will be an important tool.

SLS might be extended – new repo facility launched today
The Bank of England’s Special Liquidity Scheme (SLS), introduced in 2008 to
improve the liquidity position of the banking system, expires in January 2012. The SLS has allowed banks and building societies to swap their high quality mortgage-backed and other securities for UK Treasury Bills for up to three years. It successfully helped especially smaller banks  and building societies through the liquidity crisis in 2008 and 2009. If the liquidity situation does not improve naturally, we believe the SLS will either be extended or replaced,  see  UK Research: SLS expiring soon  – extension might be needed.

Today, the Bank of England introduced a new facility to provide market liquidity to address potential strains in financial markets. The Extended Collateral Term Repo can be seen as an “SLS light”, but as it is substantially smaller, it is a poor replacement. The statement said:  “There is currently no shortage of short-term sterling liquidity in the market. But should that position change, the new facility gives the bank additional flexibility to offer sterling liquidity in an auction format against the widest range of collateral,” The operations will offer sterling for 30 days against collateral currently allowed for use in the bank’s Discount Window Facility. We see the new facility as an official confession that liquidity is too tight in the banking system and the Bank of England is afraid it could tighten further.

...let’s not forget: Coordinated central bank action could come
The Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, the Federal Reserve and the Swiss National Bank last week announced coordinated actions to enhance their capacity to provide liquidity support to the global financial system. The purpose of these actions was to ease strains in financial markets and thereby mitigate the effects of such strains on the supply of credit to households and businesses and so help foster economic activity. These central banks agreed to lower the pricing on the existing temporary US dollar liquidity swap arrangements by 50bp so that the new rate will be the US dollar overnight index swap (OIS) rate plus 50bp. After such a move, markets  always  hope for more: Unilateral central bank action  has a poor track record while coordinated central bank action often works and delivers long-lasting results. Central banks can still move closer together, which most likely will be well received in markets.