Economics Weekly - Threat of deflation leading BOE to money creation; Weekly economic data preview - More bad economic news to come
Economics Weekly - 16
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
combatrecession 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: â€˜...channel 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 marketsâ€™ indicates the
growing official determination to tackle dislocation at source.
Quantitative easing or
directly boosting money supply is the next stepâ€¦
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 â€˜deep
recessionâ€™. He also noted that â€˜money in the economy was not growing quickly
enoughâ€™. 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 Bankâ€™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 Bankâ€™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.
â€¦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
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.
In the wake of the G7
finance ministersâ€™ and central bankersâ€™ 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 makersâ€™ updates,
including speeches by ECB President Trichet and by Fed Chairman Bernanke will
attract close attention. The minutes of the BoEâ€™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 â€˜deep recessionâ€™ 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 Fedâ€™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.
ô€‚„ The BoEâ€™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 â€˜not yet
judged to be significantâ€™. 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 Septemberâ€™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 Â£63bn. Retail sales, another key economic indicator, are expected to
have grown modestly, or not at all in January.
ô€‚„ US financial markets are closed for Presidentâ€™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.
ô€‚„ Concerns about German banksâ€™ 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.
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