BANK OF ENGLAND
There is absolutely no doubt that the Bank of England is poised to take further action to try and boost the economy as it faces ongoing very sharp contraction, persistent very tight credit conditions, and the likelihood that consumer price inflation will substantially undershoot its 2.0% target level over a two-year horizon. It is also very evident that quantitative easing is now going to take the leading role in the Bank of England's further efforts to stimulate economic activity. What is not so clear is whether the Bank of England will cut interest rates further after bringing them down from 5.00% to the current record low level of 1.00% since last October. We suspect that the answer is yes, but it is by no means a gimme!
Both the Bank of England's February Quarterly Inflation Report and the minutes of the February meeting of the Bank of England's Monetary Policy Committee (when interest rates were cut from 1.50% to 1.00%) make it clear that the central bank realises that more action is needed to try and stimulate the economy. Furthermore, MPC members have been out in force over the last few days making speeches or giving press interviews, and they are clearly paving the way for quantitative easing to start.
The Bank of England acknowledges that the first half of 2009 is going to be particularly dismal for the U.K. economy. While the central bank expresses hope that - and forecasts - GDP will start to recover thereafter in reaction to all the fiscal and monetary stimulus that is being enacted both domestically and globally, as well as the weaker pound, it considers that there are substantial downside risks to this forecast. Indeed, in a recent speech, Bank of England Deputy Governor Charles Bean concluded that there is "roughly a three-in-four chance of growth turning out weaker than in the central case."
Furthermore, latest data and survey evidence remain extremely weak overall, indicating that the economy is continuing to contract substantially so far in 2009. Meanwhile, investment and employment intentions continue to be pared,
Critically, both the February minutes and Quarterly Inflation Report indicated that further monetary easing will be needed in order to ensure that the 2.0% target for consumer price inflation is not undershot by a significant margin over the medium term. Furthermore, the minutes concluded that "it is unlikely that the inflation target could be met solely by cutting Bank Rate." This was particularly true due to the fact that credit markets are not functioning normally. Therefore, the MPC voted unanimously at its February meeting in favour of Bank of England Governor Mervyn King writing to the Chancellor to seek authority to conduct purchases of government and other securities, financed by the creation of central bank money using the Asset Purchase Facility. This indicates strongly that quantitative easing is imminent, and the Bank of England could well announce that it is starting this as soon as Thursday.
Meanwhile, it is far from certain whether the Bank of England will cut interest rates further on Thursday. Yes, the case for cutting interest rates by 100 basis points from 1.50% to 0.50% in February rather than the 50-basis-point reduction to 1.00% actually enacted was discussed, and David Blanchflower unsurprisingly voted for this. There was a view that with interest rates already so low, the stimulus from bringing them down by more than 50 basis points was likely to be much reduced. It was also considered that there could be a point where very low interest rates could have an adverse impact on the economy through squeezing banks' spreads between their deposit and lending rates, thereby damaging their profitability. This could adversely affect banks' willingness and ability to lend.
With the economy clearly continuing to contract substantially in the first quarter of 2009, following the very sharp deterioration in the second half of 2008, and credit conditions remaining very tight, the Bank of England is certain to take further measures to support the economy. We still lean towards the view that the MPC will cut interest rates by a further 50 basis points from 1.00% to a new record low of just 0.50% next Thursday, although it is not a cast iron certainty given the MPC's concerns about the negative repercussions that very low interest rates might have on the banking sector and some doubts about how much benefit another reduction will have. Furthermore, we now believe that 0.50% is likely to prove the floor for interest rates, rather than 0.25% or even zero, as we had previously thought. Quantitative easing is poised to come to the forefront in the Bank of England's ongoing efforts to stimulate the economy and this could very well start in March.
EUROPEAN CENTRAL BANK
When leaving interest rates unchanged at 2.00% at its February policy meeting, the European Central Bank (ECB) hinted that it was likely to cut rates again at its March 5 meeting. Economic developments since the ECB's February meeting have substantially boosted the case for lower Eurozone interest rates.
It has been confirmed that the Eurozone economy fell off a cliff in the fourth quarter of 2008, while latest data and survey evidence point to further sharp GDP contraction in the first quarter of 2009 with few signs of any significant easing in the Eurozone's economic pain anytime. In addition, credit conditions remain extremely tight in the Eurozone, and this is increasingly impacting on economic activity. Meanwhile, Eurozone consumer price inflation has fallen appreciably below the ECB's target of "close to, but just below 2.0%" and a brief period of deflation cannot be ruled out across the region.
Consequently, it is odds-on that the ECB will deliver its hinted interest rate cut on Thursday. Indeed, ECB policymakers have consistently indicated in their recent public utterances that the bank currently has scope to cut interest rates further.
Since the ECB's February policy meeting, it has been revealed that Eurozone GDP contracted by a massive 1.5% quarter-on-quarter in the fourth quarter of 2008. This marked a substantial deepening of the Eurozone's recession following GDP contraction of 0.2% quarter-on-quarter in both the third and second quarters. Furthermore, the very latest data and survey evidence offer little, if any, relief.
Indeed, overall Eurozone business and consumer confidence sank to a new record low in February, according to the European Commission's survey, while the purchasing managers' composite index for the Eurozone services and manufacturing sectors showed activity contracting at the fastest rate in February since the series started in 1998. In addition, latest hard manufacturing data are dire, while Eurozone unemployment is now rising substantially. On top of this, Eurozone exports are being hit ever harder by sharply weakened global economic activity. Consumer spending is showing some resilience across the Eurozone helped by the boost to purchasing power coming from lower inflation, but it is still pretty muted and coming under increasing pressure from rising unemployment.
Meanwhile, Eurozone consumer price inflation plunged to 1.1% in January. This was the lowest level since mid-1999 and down sharply from 1.6% in December and a peak of 4.0% in July/June 2008. It was also well below the ECB's target of "close to but just below 2.0%". While this sharp retreat in consumer price inflation has been largely the result of the very sharp retreat in oil and commodity prices from their mid-2008 peak levels, it is clear that underlying inflationary pressures are now diminishing appreciably.
Significantly, core Eurozone consumer price inflation fell at an increased rate in January, dropping to 1.8% from 2.1% in December and a peak of 2.6% last August, while recent survey evidence consistently points to extremely weak economic activity across the region hitting companies' pricing power ever harder. On top of this, consumers' inflation expectations have fallen back very sharply in recent months, while markedly rising Eurozone unemployment is diluting workers' ability to push for higher wages. In addition, annual Eurozone M3 money supply growth slowed to 5.9% in January from 7.5% in December and a record high of 12.3% in November 2007. Thus, there is a very real possibility that Eurozone consumer price inflation will substantially undershoot the ECB's target level of close to 2.00% for an extended period.
There is therefore a compelling case for lower Eurozone interest rates, which the ECB seems to accept. However, any hopes that the ECB could deliver a very large rate cut on Thursday are very likely to be dashed. Latest comments by ECB policy makers - most blatantly Provopoulos - suggest that they are still reluctant to cut interest rates by more than 50 basis points from 2.00% to 1.50%, and we suspect that this is what they will deliver. Further out, we expect Eurozone interest rates to come down to 1.00% in the second quarter and then stay there for the rest of this year. Significantly, senior ECB policymaker Axel Weber has stated that he believes 1.00% should be the floor for the ECB's key interest rate. Meanwhile, the ECB is under increasing pressure to come up with additional measures to try and boost economic activity.
By Howard Archer