EEF blog

Tomorrow the Bank of England's Monetary Policy Committee will announce its first decision of 2012.

Although CPI inflation currently stands at 4.8% it is highly likely to fall below target in the latter half of 2012. A rate rise now seems firmly off the table.

In fact, in many ways, a boost to the asset purchase program (a.k.a. QE) now seems increasingly likely. The ongoing Eurozone crisis is affecting the real economy. Not only have export orders looked weaker in recent months, but the uncertainty generated by the crisis has led to some companies holding off on investments. More recently there are signs that the crisis is putting strains on the banking sector, both at home and in the Eurozone, which could cause further problems with access to finance.

That said, it is unlikely that the Bank will chose to increase asset purchases tomorrow, not least because the current round of purchases is not yet complete. If a decision is made to loosen policy further it is more likely to come in February, following the Bank’s Inflation Report which will contain its next round of forecasts. We’ll also have a bit more data around how the last few months of 2011 looked.

This is a summary of the MPC minutes - you can find the full version here. 

Financial markets

• Increased stress in financial markets associated with euro governments and banks is reflected in volatility in asset prices and a reduction in liquidity across a range of markets.

• Stresses on short-term funding markets are driving up costs for European banks, including UK banks. Domestic lending in the UK could be affected if higher costs persist.

International economy

• European activity indicators have weakened, particularly in the periphery, but indicators even for France and Germany suggest flat output.

• U.S. indicators mixed with encouraging signs of investment in quarter 3 like to be short-lived as business and consumer confidence are weak. The passage of Obama’s $450 billion stimulus bill through Congress looks uncertain.

• Some gradual slowing in activity in China. The rebound in activity in Japan following the earthquake and tsunami also looks to be short-lived with weak prospects beyond 2011q3.

Money, credit, demand, and output

• The latest revisions to national statistics have revised up the contribution of net trade to growth from the onset of the financial crisis through the recession and into the recovery. This is now more in line with what was expected given the depreciation in sterling.

• Business surveys suggest weak growth in 2011q3 in both services and manufacturing sectors.

• Mixed evidence on the weakening of external demand for UK exports with CIPS/Markit PMI suggesting falling demand but other surveys suggesting this is holding up, particularly to markets outside Europe.

• Credit conditions have remained tighter since the financial crisis but no sign yet that recent financial market turbulence has tightened conditions still further.

Supply, costs, and prices

• MPC expected inflation to rise above 5% in the short term [as it has, to 5.2%] before falling back sharply in 2012 as VAT and oil price rises fall out of the series.

• Inflation expectations as measured by surveys of households remain unchanged while implied expectations through financial markets have fallen somewhat – though such implied expectations are volatile in times of financial stress.

• Excluding the impact of bonuses in some sectors, recent data suggests wage growth remains modest.

• The degree of slack in the labour market is a key factor in determining how much additional downward pressure there will be on  inflation.

Immediate policy decision

• The main upside risks to inflation in the medium term are expectations of higher inflation becoming embedded in wage and price-setting behaviour, lower spare capacity in the economy than thought, and another rise in commodity prices.

• No recent data suggest any strengthening in the upside risks.

• The main downside risk to inflation in the medium term is weak demand being unable to absorb the spare capacity in the economy.

• Ongoing problems in the eurozone area and the strains these are putting on financial markets have increased recently and the outlook for the UK economy had weakened.

• The MPC voted unanimously for Bank Rate to be maintained at 0.5% and also unanimously to finance a further £75 billion of asset purchases (QE).

The Governor of the Bank of England believes inflation is heading down. And, as Chris Dillow’s article on Investors’ Chronicle today points out,

It’s highly likely that inflation will fall a lot next year. Basic maths tells us as much.

He’s referring to the statistical composition of the inflation data, which means that over the course of the next year the impact of VAT and energy price rises will fall out of the measure and bring inflation down.

There are other – non-mathematical – reasons to believe that inflation might fall in the coming months too. Global economic weaknesses are likely to hold down the demand pressures that would ordinarily push up prices.

But, as Dillow points out, there is an alternative view that inflation could still rise. As Jeremy Warner over at the Telegraph notes:

The problem with inflation, repeated historical experience has demonstrated, is that once out of the bag, it is extremely difficult to put back in. There is only so much wage erosion through inflation that people will take before they start to demand compensating pay rises.

Also – as both writers add – in the medium term inflation is likely to be pushed up by the recent extension of quantitative easing.

The question remains: which of these factors is likely to play a bigger part? We will know the Monetary Policy Committee’s view of this when they release their minutes tomorrow morning.

To be fair my earlier post didn't cover everything the Chancellor said.

He also mentioned the possibility of the government using its balance sheet (made credible by him) to act a guarantor behind SME lending, thereby encouraging banks to lend more. There are already schemes in place with a similar theme - the Enterprise Finance Guarantee and the Export Enterprise Finance Guarantee.

These schemes are being used but demand for them is hardly overwhelming.When the scheme was first introduced it was to support facilities of up to £1.3 billion from Jan 2009 to March 2010. BIS figures show in the end the scheme was used to support loan offers of less than £950 million of which around £780 million was actually drawn. Over the next year to March 2011, with facilities of up to £700 million able to be supported, loans of £490 were offered with £460 million actually drawn.It's a little unclear what more the government may do further here.

Will they extend the scope of the EFG to cover larger businesses or larger loans? Will they increase the guarantee from 75%? Will they lower the fee charged for using it? If they did any or all of these things there would be a cost. And if the Chancellor considers this a macroeconomically meaningful intervention it would have to be done on a very large scale - so it might be a considerable cost. And being on the hook for what could be a very large potential liability would presumably be something that people who judge the credit-worthiness of the UK might look at quite closely.

The government could buy packages of SME loans - securities that offered a stream of payments based on a portfolio of individual loans made by banks. Banks would then have cash that they might be inclined to lend out to SMEs who are currently struggling to get a loan. There is some element of uncertainty about that though - because the banks may have reasons - such as shoring up their own capital - for not doing this.

For this to happen there would have to be a suitably qualified securitising agent - perhaps a market participant but in the current conditions maybe a government entity would be required to perform this role. It will be important that the securitising is done robustly and that credit worthiness of the package of loans is accurately assessed.

But assuming the government can rapidly assemble the entity and it can do a quick and thorough job - someone still has to buy these assets.

If that someone is NOT going to be the Bank of England, then does that mean it's up to the government? If the government's buying a whole lot of assets, will it have to borrow a whole lot more ££ to do so? What does that mean for its fiscal plans?

So a lot more questions than answers still on credit easing.

On Monday, Chancellor George Osborne announced at the Conservative Party Conference that his officials were working on options for credit easing. Since then there has been intense speculation about precisely what he means by this.

Yesterday the Governor of the Bank of England, Sir Mervyn King, did a round of interviews explaining the MPC's decision to start QE again by voting to extend its asset purchases facility by £75 billion. The focus for the purchases will very much be gilts (rather than a riskier range of private sector assets).

This morning, the Chancellor was again speaking, this time on The Today Show to discuss QE and his own announcement. Some interesting thoughts came out of this.

The Chancellor repeatedly stressed that both he and the Prime Minister have been consistent since they were in opposition in saying that the current situation called for fiscal prudence but monetary radicalism. Like Monday he again seemed to be pushing the idea that his credit easing policy was in the monetary sphere of macroeconomic policy.

But he also noted that it was the bank's domain to expand the volume of credit (via QE) but the government's to steer it to where it needed to go in the economy, including to SMEs (via CE).

Asked further what credit easing meant, the Chancellor said there were several options being explored. He mentioned the relative size of the UK's corporate bond markets compared with those in the U.S. In the UK minimum corporate bond issuance seems to be £100-200 million. In the U.S. as little as $25 million can be raised in these markets.

This has been an issue floating around 1 Horse Guards Road (HM Treasury) since at least July 2010 as it was included in the government's access to finance green paper as a weakness in the UK funding environment that may need strengthening.

No doubt this is a weakness worth looking to strengthen. But I wonder if it is the priority. SMEs (say firms with turnover of up to £25 million) are consistently reporting the worst access to finance. Even if corporate bond markets could be made as accessible tomorrow as in the U.S., this isn't going to help SMEs.

So this suggestion seems to me more about having a meaningful outcome from the government's current Mid Caps Growth Review than targetting the most important problems afflicting the flow of credit to SMEs.

The government action is a little unclear too. Are they going to create demand by buying these bonds - with fiscal implications? Are they going to try to bring down some of the hurdles companies face to issuing bonds - such as fees from ratings agencies? And how quickly will this influence change, even were the government sitting ready to buy billions of corporate bonds tomorrow, will companies be in a position to issue them?

On Monday, Chancellor George Osborne announced at the Conservative Party Conference that his officials were working on options for credit easing. Since then there has been intense speculation about precisely what he means by this.

Yesterday the Governor of the Bank of England, Sir Mervyn King, did a round of interviews explaining the MPC's decision to start QE again by voting to extend its asset purchases facility by £75 billion. The focus for the purchases will very much be gilts (rather than a riskier range of private sector assets).

This morning, the Chancellor was again speaking, this time on The Today Show to discuss QE and his own announcement. Some interesting thoughts came out of this.

The Chancellor repeatedly stressed that both he and the Prime Minister have been consistent since they were in opposition in saying that the current situation called for fiscal prudence but monetary radicalism. Like Monday he again seemed to be pushing the idea that his credit easing policy was in the monetary sphere of macroeconomic policy.

But he also noted that it was the bank's domain to expand the volume of credit (via QE) but the government's to steer it to where it needed to go in the economy, including to SMEs (via CE).

Asked further what credit easing meant, the Chancellor said there were several options being explored. He mentioned the relative size of the UK's corporate bond markets compared with those in the U.S. In the UK minimum corporate bond issuance seems to be £100-200 million. In the U.S. as little as $25 million can be raised in these markets.

This has been an issue floating around 1 Horse Guards Road (HM Treasury) since at least July 2010 as it was included in the government's access to finance green paper as a weakness in the UK funding environment that may need strengthening.

No doubt this is a weakness worth looking to strengthen. But I wonder if it is the priority. SMEs (say firms with turnover of up to £25 million) are consistently reporting the worst access to finance. Even if corporate bond markets could be made as accessible tomorrow as in the U.S., this isn't going to help SMEs.

So this suggestion seems to me more about having a meaningful outcome from the government's current Mid Caps Growth Review than targetting the most important problems afflicting the flow of credit to SMEs.

The government action is a little unclear too. Are they going to create demand by buying these bonds - with fiscal implications? Are they going to try to bring down some of the hurdles companies face to issuing bonds - such as fees from ratings agencies? And how quickly will this influence change, even were the government sitting ready to buy billions of corporate bonds tomorrow, will companies be in a position to issue them?

On the one hand:

QE could support growth (the Bank of England's Quarterly Report suggests that it does)

But on the other:

QE could cause the “wrong kind of inflation” as it pushes up CPI and RPI (through exchange rate effects) without necessarily increasing domestic prices charged and wages paid.

This means government expenditure has to go up (as benefits and other payouts are uprated with CPI/RPI inflation) but tax receipts linked to profit and income might not rise to compensate for this.

I wouldn’t be surprised if the Chancellor starts looking for a one-handed economist…

The Bank of England today published a paper looking at the impact of QE. The paper finds that QE had an economically significant effect, and

“may have raised the level of real GDP by 1½ to 2% and increased inflation by ¾ to 1½ percentage points … equivalent to a 150 to 300 basis point cut in the Bank Rate”

There has already been some debate about these figures, and the authors point out that there are large uncertainties even with the range quoted, but nonetheless they provide a fair amount of ammunition for those who are arguing for more QE.

One of these people is Vince Cable. As he said in his conference speech today:

“A lot of responsibility rests on the Bank of England to relax monetary policy further linked to small business lending”

While there are certainly ways that loose monetary policy does help businesses, it is not entirely clear that policy needs to be any looser than it already is. As far as improving lending to business there are two key reasons why additionally QE may not help:

Firstly, the Bank’s report makes clear that, even with the first round of QE, “the MPC expected little [economic] impact” through the channel of increased bank lending, due to other strains in the financial system. The continued tighter conditions in the financial system are indicated by many factors outside headline rates on lending. Tighter terms and conditions such as stricter covenants in lending agreements and attempts to move companies to more security-heavy forms of lending are discouraging some companies from even approaching their bank to ask for loans.

Secondly, although QE – through reducing the interest rate on gilts – can increase the attractiveness of capital markets to investors, it is not altogether clear that this benefits smaller firms, many of whose owners will be reluctant to use capital market funding which requires them to give up equity.

It will therefore take more than QE to improve the flow of lending to small businesses (discounting, perhaps, some of Adam Posen’s more creative suggestions made last week).

Cable rightly said in today’s speech he wants to see an end to ‘feast and famine’ in bank lending to SMEs. A key step towards this would be an indication of how the government will act in response to the ICB’s recommendations on enhancing competition in the banking sector.

More competition in our banking sector would put downwards pressure on the costs of finance faced by SMEs – critical when we consider other forces simultaneously providing upward pressure.

This is just one example of the more vigorous reform agenda we would like to see the government pursue, as a necessary corollary to a credible fiscal consolidation plan. The government must show it is committed to a relentless programme of dismantling the most important barriers to growth.

This coming Thursday the MPC will make its monetary policy announcement. Global economic indicators continue to suggest a weakening recovery, and following last month’s unanimous decision to keep rates on hold, no-one is expecting the committee to raise rates this month.

But there is some talk about increasing quantitative easing as a way to stimulate the recovery. Adam Posen has long been the lone voice on the MPC calling for increased QE, as he did once again in an article for Reuters on Wednesday.

His argument in favour of QE is as follows:

The evidence is clear that the Bank of England’s and the Federal Reserve’s asset purchases had a positive significant effect on consumption, on the relative prices of riskier assets, on credit availability, and on liquidity in the financial system. If the improvement was insufficient, because the response to a given injection was less than some hoped, increase the dose.

In other words, Posen believes QE works, and if it doesn’t work as well as it should, do more.

But is QE the right policy tool now? Today Allister Heath from CityAM argued that more QE would be wrong for the UK Economy saying that while there had been a slowdown recently “the British economy doesn’t need another boost to the money supply”. He has two key reasons for making this argument:

1. There is potentially too much liquidity in the economy and more QE could exacerbate this, and may also lead to asset price bubbles
2. What the UK really needs is lower inflation and greater certainty

While I agree that low inflation and certainty are very important for companies, Adam Posen’s article offers enough reasons to think that inflation could go down as well as up in the next year or so.

The first point is therefore more pertinent. There may indeed be too much liquidity in parts of the economy, in which case more QE could lead to the asset price bubbles and other problems that Heath’s article raises. But there are still areas of the economy where there is not enough liquidity and this is choking off growth – just ask companies who are unable to get loans at the moment.

And that raises the real question – does QE create liquidity for the people and business who need it? And if it doesn’t, then what will?