The Bank of England’s Monetary Policy Committee duly provided the additional £50bn worth of conventional gilt purchases that the market had been expecting at its February meeting, although two external members, Adam Posen and David Miles had wanted a larger amount of £75bn and some others had agreed to the £50bn amount because they were concerned that a larger amount would lead to the conclusion that conditions were even worse than feared.
The improvement in sentiment and data since this meeting has increased the proportion of economists and market participants who believe that this will be the last in the current round of quantitative easing. We disagree and expect the MPC to execute additional conventional gilt purchases in May as the methadone rush of 3yr LTRO gives way to new concerns over the European Sovereign Debt Crisis in the second quarter. We also expect the seasonal improvement in global activity over the past four months to give way to slower global economic conditions. Moreover, while the UK economy is expected to avoid a double dip recession in the first quarter the pace of activity is likely to remain subdued through the first half of the year.
Moreover, it is important to determine the trigger sensitivities around additional quantitative easing. Is it the threat of a double dip that motivates the central bank or the likelihood that growth in real activity will be less than 1% versus estimates of long-term productive potential of 2.5%. We believe that it is the latter and more quantitative easing is required.
Indeed, while the Bank can bask in the success of quantitative easing in reducing banks’ wholesale funding costs from 362bps at the start of the year, the current level of 304bps has been sufficient to force banks into raising their variable rate mortgages, which is likely to cool the nascent improvement in the housing market over the next few months and produce another year of negative real returns for residential housing.
More importantly, the mechanics of this second tranche have been materially altered from previous rounds by the Bank’s decision to follow the advice of the Debt Management Office to mirror its bands for the purchase program. The effect of this change has been to crunch the purchase bands from the previous, 3y-10y, 10y-25yr and over 25yr to new compressed ranges of 3y-7y, 7yr-15y and over 15y. The most charitable explanation has been that it has evened out the free float in these bands enabling the central bank to pursue further rounds of quantitative easing in the months ahead.
However, the net effect of the Bank’s actions have been to produce a pronounced hump in the yield curve. This was not a deliberate aim of the policy. Indeed, the Governor was visibly embarrassed at the Inflation Report press conference when the subject was broached and immediately passed on the question to Paul Fisher, the MPC member in charge of the operational implementation of QE, who explained; “this was a purely operational decision, although made in consultation with the MPC, designed to make sure that we can deliver on the MPC’s objective, which was, as stated back in October, buying along the curve. We are still buying along the curve and in quite large size. We don’t target any particular maturity, but the average maturity we would expect over the next three months is broadly in line with the average maturity in gilts, if anything slightly higher”. As Shakespeare might have responded, “methinks he doth protest too much”.
There are those who will welcome the consequences of this policy as a means of forcing increased bank lending, partially shielding the pension funds from the consequences of QE and putting downward pressure on Sterling, but this represents a fallacy of composition since the sum of the parts is less than the overall result and as the famously monetary purist Sir Mervyn King would undoubtedly note, the function of quantitative easing in springing the liquidity trap is to lower the term structure of interest rates to encourage risk appetite. The rise in medium term forwards militates against this policy and ultimately increases the requirement for more QE.
It is highly unlikely that the Bank will now restore the previous purchase bands for the next round of QE and the most that can be expected is that the Bank alters the amounts that it is willing to purchase in each particular segment to smooth the yield curve and maximise the impact of policy. In the meantime, the curve is likely to become more pronounced until consensus expectations once again discount more quantitative easing in the second and third quarters.
Chief Economist, Co-Fund Manager
Mar 6, 2012 at 11:25am