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Monday February 16, 2009 - 12:16:21 GMT
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Economics Weekly - Threat of deflation leading BOE to money creation; Weekly economic data preview - More bad economic news to come

Economics Weekly - 16 February 2009


Threat of deflation leading BOE to money creation


The transition from using interest rates as the sole monetary policy tool by the Bank of England to combat recession and the continuing dislocation in credit markets and to using other less conventional measures is now firmly underway. The final step will be for the Bank to directly boost money supply and it now has permission from the government, via the Treasury, to embark on a course to do just that. There have been some very clear signposts in the last few weeks and months, not least the rapidly deteriorating global economic situation. This is leading to a significant weakening of global inflation pressure as commodity prices fall. In addition, despite a plethora of government initiatives and increased public spending around the world, stresses in credit markets remain intense.

The announcement of the details of how the Asset Purchase Facility (APF) will initially operate as it starts on 13 February in order to: ‘ funds directly to the parts of the corporate sector whilst also underpinning secondary market activity and helping to enlarge the private issuance market, and so removing obstacles to corporate access to capital markets’ indicates the growing official determination to tackle dislocation at source.


Quantitative easing or directly boosting money supply is the next step…

The only difference between credit easing (what has just been announced) and quantitative easing is the offsetting sales of Treasury bills to fund the buying of securities that takes place in the former, as in the APF. But before quantitative easing, and efforts to directly boost money supply occur, it is fairly clear from the latest Bank of England Quarterly Inflation Report (QIR) that interest rates will be cut further. The Governor described the UK as being in a ‘deep recession’. He also noted that ‘money in the economy was not growing quickly enough’. From the perspective of the inflation target itself, the support for his comments could be discerned from the forecasts of UK economic growth and CPI in the QIR.


Chart a shows that CPI will undershoot the inflation target of 2% at the end of the 2 year horizon, Q1 2011, based on interest rates remaining at 1%. To compound this picture, an extension of the forecast beyond this period shows that CPI continues to undershoot the target, see chart b. Further, this forecast is based on market implied interest rates, which are lower than 1% for the year ahead and so suggest that even with lower Bank rate, the inflation target will still not be met. Chart c highlights this clearly, with the Bank’s own assessment of future market interest rates made at the time the report was being put together showing Bank rate below 1% throughout this year and only rising to 2% by Q1 2011. And this was before the Bank’s gloomy assessment of the economy, since then market rates have dived even lower. Chart d shows that a range of market-driven interest rates have fallen sharply in the last few weeks and especially since the QIR on Wednesday. In other words, financial markets expect that Bank rate may be cut to the ultimate low, effectively zero.


…but first, base rate will be cut below 1% and perhaps kept in a range as in the US

The justification for the fall in market rates is fairly straightforward: assuming cutting interest rates works normally (it will not of course since when they get this low they increasingly lose their potency but setting that aside), a cut of 1% usually leads to 0.4 percentage point rise in inflation. However, with Bank rate at 1%, a cut to zero will be insufficient to raise inflation back to the target by 2011. A look at chart e shows that in the latest QIR, the forecast for CPI inflation has been cut to well below 1%, remaining below that level until almost at the end of the 2 year forecast period. This means that if the Bank of England is serious about hitting the inflation target and believes its forecasts for economic growth and inflation, then it will have to resort to boosting money supply via quantitative easing.


Weak global growth, falling commodity prices and credit market dislocation could combine to lead to an extended period of low price inflation in the UK

Why does price inflation remain so far below its target? The reason is depicted in chart f which shows that the forecast for economic growth has been scaled back dramatically since November 2008. With a drop in gdp of about 3-4% forecast for 2009, the UK economy opens up a very large and negative output gap (the difference between potential growth and actual growth). This spare capacity keeps inflation under downward pressure well beyond 2011, even though the economy starts to recover. But the key point is that despite the cuts in interest rates since November last year, the latest QIR shows a sharp downward revision to economic growth, see chart g. Recovery therefore may not happen in the way depicted in the latest QIR forecast. With an already very loose fiscal stance, there is little in the way of big tax cuts or public spending increases that can be announced without upsetting bond markets.


This means that efforts to unblock credit markets, via credit easing and quantitative measures to boost money supply may be the best way to try and help economic recovery along. It was noticeable that the MPC pointed out that the risks to its already gloomy gdp projections were to the downside, and so are the risks to inflation, even at the low levels that were projected in the latest forecast. The Bank of England is in new territory at a time when the outlook for the UK and world economy is one of the most uncertain in recent history.

Trevor Williams, Chief Economist, Corporate Markets



Weekly economic data preview - 16 February 2009


More bad economic news to come


In the wake of the G7 finance ministers’ and central bankers’ meeting in Rome at the weekend, market participants will continue to absorb the implications of discussions for economies and financial markets, while focusing on a wide range of new policy & data releases. With events running so fast, policy makers’ updates, including speeches by ECB President Trichet and by Fed Chairman Bernanke will attract close attention. The minutes of the BoE’s 4/5 February meeting will explain the rationale for the decision to cut Bank rate by 0.5% to 1%, although the very bleak February Quarterly Inflation Report has already given ample justification. A unanimous MPC vote to cut rates is widely expected - although it may be instructive to see if there was any support for a larger cut. Mervyn King indicated last week that the UK economy was in ‘deep recession’ and Bank rate may need to fall below the current 1% level, while quantitative easing measures, such as unsterilised purchases of gilts and corporate paper, may be required. In addition, the US Fed’s minutes from its 27/28 January meeting will inform on the extent to which members perceived the US economy to have deteriorated, leading to an acceleration in the implementation of wider asset purchase schemes. Economic data releases include UK and US CPI inflation - the US and the UK may have entered deflationary territory in January - and the German ZEW economic sentiment survey & EU-16 manufacturing & services PMIs for February.


􀂄 The BoE’s CPI inflation forecast (based on market interest rate expectations) published in the QIR shows inflation staying below the 2% target until the end of 2010. Mervyn King viewed the risk of deflation as ‘not yet judged to be significant’. However, CPI inflation data for January may show a sharp 1.1% contraction on the month, steeper than the 0.4% fall in December. This translates into 2.7% annual growth, below the figure of 3.1% a month earlier and well down from last September’s high of 5.2%. The RPI inflation measure, more commonly used in wage negotiations, could contract by as much as 1.6% on the month, translating into growth of just 0.1% on an annual basis (+0.9% in December). This suggests that wage agreements will settle well below current 3-month average wage growth of 3.2%, which together with accelerated job cuts in response to the slump in orders, will further weigh on the economy. Public finance data are also due - we expect the PSNBR to amount to a cumulative £63bn. Retail sales, another key economic indicator, are expected to have grown modestly, or not at all in January.


􀂄 US financial markets are closed for President’s Day on Monday, but are open to a wide range of almost uniformly negative economic growth-related data during the remainder of the week. Housing construction figures - housing starts and building permits - may contract, industrial production will continue falling at an annual rate close to 10%, capacity utilisation could break another low at 72.5%, while initial jobless claims may, for a third consecutive week, rise by over 600,000. In addition, two key surveys for February, the Empire Manufacturing and the Philadelphia Fed are likely to remain at very low levels. CPI, producer and import price inflation are all expected to be weak, pointing to the risk of deflation becoming a growing problem in the US. CPI inflation in January is expected to have contracted by 0.2%, the first annual contraction since 1955. In terms of external accounts, US TICS net international capital inflow data for December may rebound $20bn, but this is only half the level of funding required to cover the $40bn trade deficit in the same month.


􀂄 Concerns about German banks’ exposure to Russia, the news that German Q4 GDP contracted by a greater than expected 2.1% and plunging manufacturing orders, may contribute to a deterioration in the German ZEW economic sentiment survey to -33 in February compared with -31 in January. In addition, the flash EU-16 PMI manufacturing & services surveys for February will contract. Since the 1.5% fall in Q4 2008 GDP, economic data throughout the EU-16 has continued to be weak, indicative of an increased chance of a fourth consecutive quarter of GDP contraction in Q1 2009. A more comprehensive breakdown of the Q4 GDP data will be published at a later date, but indications are that a collapse in business investment and exports are driving the downturn. Weakness is widespread across the eurozone, although Austria has only had one quarter of contraction. Weak confidence suggests that the ECB may step up its policy response to the crisis by cutting official interest rates more sharply and by introducing other measures to improve credit market functioning.

Nichola James, Senior Economist


Economic Research,
Lloyds TSB Corporate
10 Gresham Street,
London EC2V 7AE
0207 626 - 1500


Any documentation, reports, correspondence or other material or information in whatever form be it electronic, textual or otherwise is based on sources believed to be reliable, however neither the Bank nor its directors, officers or employees warrant accuracy, completeness or otherwise, or accept responsibility for any error, omission or other inaccuracy, or for any consequences arising from any reliance upon such information. The facts and data contained are not, and should under no circumstances be treated as an offer or solicitation to offer, to buy or sell any product, nor are they intended to be a substitute for commercial judgement or professional or legal advice, and you should not act in reliance upon any of the facts and data contained, without first obtaining professional advice relevant to your circumstances. Expressions of opinion may be subject to change without notice. Although warrants and/or derivative instruments can be utilised for the management of investment risk, some of these products are unsuitable for many investors. The facts and data contained are therefore not intended for the use of private customers (as defined by the FSA Handbook) of Lloyds TSB Bank plc. Lloyds TSB Bank plc is authorised and regulated by the Financial Services Authority and is a signatory to the Banking Codes, and represents only the Scottish Widows and Lloyds TSB Marketing Group for life assurance, pension and investment business.



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