Threat of deflation leading BOE to money creation
Tue, Feb 17 2009, 06:05 GMT
by Trevor Williams
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: ‘...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 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.
