Of Monument Securities
LONDON (Dow Jones)--For the financial markets, the chief message from Mr King's presentation yesterday of the Bank of England's latest Inflation Report was that the MPC is keeping an open mind on whether there should be more asset purchases than the ?200bn agreed at its last meeting. Mr King's rebuttal of the suggestion that the Bank's 'quantitative easing' (QE) will soon end seemed to amount to more than the kind of ritual incantation favoured by ECB policymakers that 'we never pre-commit'. All the same, the markets are likely, on reflection, to conclude that Mr King would make remarks along yesterday's lines, even if he felt there was a strong presumption against pressing QE further. He is never going to pre-announce the end of QE because to do so would make the Bank's task harder. He cannot know for sure how the economy will evolve. To say there will be no more QE would, therefore, be offering a hostage to fortune. Furthermore, the gilt market's adverse reaction to the announced reduction in the rate of Bank asset purchases is a clear warning that the termination of the asset-buying programme will be fraught with risks. Mr King would probably not want to cross that bridge before he has to.
It is a measure of how far QE has come to dominate the sterling capital markets that Mr King's asset purchase comment eclipsed other elements in his presentation. Why, indeed, should investors worry as much about the economy's growth and inflation prospects as about how many hundreds of billions of pounds of securities the central bank is likely to purchase. One of the medium-term drawbacks of QE, which is only likely to come fully to light after QE ends, is that it reduces investors' sensitivity to fundamental market factors and thereby increases the likelihood of serous misallocation of capital. It is perhaps as well that the markets did not focus on the Bank's latest forecasts for the economy. They might have latched on to what appears a glaring inconsistency between the Bank's GDP forecast and the comment on that forecast in the accompanying text.
After highlighting the factors likely to affect the GDP outcome, the text states, 'on balance, the Committee [the MPC] continues to judge that the interaction of these factors points to a slow recovery in the level of economic activity.' Yet, the fan-chart representing MPC members' expectations for growth in GDP has a very clear V shape. At first glance, this seems to run counter to the Bank's stated caution with regard to the growth outlook. However, the Inflation Report helpfully includes a second fan-chart showing members' expectations for the level of GDP. On initial inspection, the shallow U shape of the mean path of the projected GDP level appears consistent with a cautious view on the economy. When we look closer, though, we find that the MPC's mean path has GDP returning by early 2011 to the peak level it reached in 2008Q1. Seeing that the fall in GDP from the peak to 2009Q3, a period of six quarters, was some 6.0%, the MPC's projection implies an impressive recovery. The UK economy would have to regain, in the six quarters to 2011Q1, all, or most, of what it had previously lost. In other words, the recovery would have to be as steep as the preceding slide. It is, in the end, a matter of semantics whether we should describe such a recovery as 'slow'. Possibly, the Bank's choice of words is influenced by its view on how much slack there is in the economy at present. MPC members may believe that an upswing that proceeded at a rate of roughly 1.0% per quarter would be too slow to take up this slack as expeditiously as they wish. If that is so, we must conclude the MPC will take some shifting from its ultra-accommodative stance. The implication of the report's text is that the committee would, ideally, like to see faster GDP growth than it is projecting in the fan-chart. Consequently, even if growth were to pick up to a rate of 1% per quarter from now on, which is a stronger rate than most other forecasters are projecting, the MPC would still not see the possible inflationary impact of bottlenecks in the supply chain, skill shortages and cost-plus pricing behaviour as a worry. Presumably, they would rely on the textbook equations that abstract from the messy realities of the workaday world. The upside risks to inflation cannot help but seem more concrete when policymakers are basing their actions on an analysis that relies on the twin propositions, both highly questionable, that there is a huge 'output gap' and that the 'output gap' is the only important determinant of inflation out to the forecast-horizon.
The MPC might see it as a policy success if inflation expectations were boosted as a result of the stance it has adopted. With regard to limiting downward pressure on prices, the report points out the pressure will be less 'if wage and price-setters expect monetary policy to be successful in reducing the degree of spare capacity over time, and so expect inflation to remain close to target.' The MPC's worry here is that economic agents, believing the committee will fail to keep prices moving up fast enough, will act on that expectation. From the outset of the financial crisis, MPC members harboured a morbid concern over deflation risks. At first, there might have been some grounds for such anxiety but, for months past, it has been clear that inflation is overshooting expectations and that deflation risks are negligible. The next few months should finally disabuse MPC members of the notion that inflation expectations might collapse. As the Bank's report acknowledges, inflation is likely to rise sharply in the near term. The Bank cites the reversal of the VAT cut and the effects of sterling's past depreciation as factors in this. But there are also significant base effects to unwind. In short, underlying inflation has never really been as low as the past months' headline data have suggested. The mean path of the Bank's CPI fan-chart has inflation on that measure approaching 3.0% early next year. That could be an under-estimate. Mr King could soon have another chance to exercise his writing skills.
May The Force Be With You.
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