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No more arrows left in the quiver?
With the UK Government constrained by fiscal austerity, it is left to The BoE to save the economy from slipping back into a recession. But can it, considering that the BoE’s previous attempts to boost the economy through quantitative easing have not been entirely successful?
Issue Date - 27/10/2011
As sovereign debt woes in the eurozone intensify, the Bank of England (BoE) has followed its US counterpart and boosted its asset purchase programme. BoE has just announced (on October 6, 2011, at its monetary policy meeting) that it will pump cash into the economy to ease credit and improve growth by expanding its asset purchase programme to £275 billion, up from the £200 billion purchased till December 2009. Interestingly, the key interest rate was held steady at 0.5% (the central bank has been holding its key policy rate at a record low of 0.5% – the lowest in the BoE’s 315-year history – for 30 months now).

The reason is simple. Policymakers want consumers to spend more. The theory is that if consumers are spending and money is going round the financial system, the country’s economic recovery will be quicker.

Yes, the idea seems very well – sadly, it may well be too simplistic. Fresh data suggests that UK is returning to recession, with financial markets experiencing stress levels not seen since the collapse of Lehman Brothers in 2008. What’s more threatening is that a new financial crisis would involve not just the private sector but also fiscally stressed government. In fact, official figures show that the UK economy grew by 0.1% between April and June 2011, less than the 0.2% estimated previously. Even on a year-over-year basis, growth decelerated to 0.7% in Q2 2011 from 1.6% in Q2 2010. Thanks to the UK manufacturing output which slipped back a bigger-than-expected 0.3% in August, denting hopes that the sector will lead the economic recovery. The Office for National Statistics reported that although industrial output rose 0.2% in August, it was still down 1% on the year.

These numbers suggest that the strategy of keeping the interest rate low is currently not working for BoE and also perhaps explain why it has chosen to increase its programme of quantitative easing (QE) by £75 billion. Significant reductions in the bank rate have provided a large stimulus to the economy but as the bank rate has approached zero, further reductions are likely to be less effective in terms of the impact on market interest rates and demand, both monetarily and behaviourally. Then how does BoE provide a further stimulus to support demand in the wider economy? That’s where QE seems to be leveraged – a tactic used by policymakers across the globe to boost the supply of money by purchasing assets like government and corporate bonds. Again, sounds like a fine plan in theory; yet, things may not run as seamlessly in reality. UK has already had one round of QE (BoE stopped buying government bonds in December 2009, after purchasing about £200 billion in public debt) and further cash injections may erode the real value of its currency (interestingly, the value of GBP has fallen sharply against US dollar since BoE announced the second round of QE, from $1.5308 on October 6, 2011 to $1.5643 on October 10, 2011), in turn increasing the prospects of higher inflation in an already inflated economy.

In fact, the rate of CPI inflation significantly exceeds the BoE’s mandated target of 2%, which argues against further QE at this point. Even allowing for the 1% tolerance band on either side on the 2% target, CPI inflation has been well above the 2% target since early 2010 (for newbies, inflation in UK has been constantly above 4% since January 2011 with the last reading at 4.5% in August 2011). Thus, in the current climate, if QE is overdone, it could cause consumer goods to become unaffordable leading to stagnation. Although BoE argues that CPI inflation will recede in the coming months as some temporary factors, such as the hike in the value-added tax (VAT was raised to 17.5% from 15% in January 2010 and then to 20% in January 2011) and higher energy & commodity prices, begin to dissipate, it may be problematic for it to engage in further QE until a downward trend in CPI inflation is actually in place. Not to forget, since the first VAT hike almost two years ago, the CPI inflation rate has risen by over 1.50%.

Furthermore, data also suggests that the composition of UK demand is continuing to rebalance away from public and private consumption and towards external demand (while private consumption saw a de-growth of 0.6% and 0.4% in Q2 & Q3 respectively, exports have risen 5.5% & 5.6% respectively during the same periods). This really raises concerns over BoE’s readings and hope for UK’s recovery. In fact, the possibility that the European debt crisis and global economic cooling will be more prolonged poses a downside risk to Europe’s third largest economy (UK stands behind Germany and Russia). Says Enam Ahmed, Senior Economist, Moody’s Analytics to B&E from London, “We believe UK will slip back into a mild recession, pulled down by fiscal austerity and weakening demand at home and abroad. Risks to our outlook are weighted to the downside, as concerns remain about the euro zone debt crisis.” And why not? After all, the single currency area is UK’s largest trading partner (more than 50% of UK’s trade is with the EU), and prospects for the region have weakened substantially over the last few months.

However, with the UK government constrained by fiscal austerity (the government plans to reduce the budget deficit to 7.9% of GDP this year and to no more than 3% of GDP by 2014, from 9.9% in 2010), BoE really seems to have no other means to save the UK economy. Interestingly, previous attempts to boost the economy through quantitative easing have not been entirely successful. The last time the BoE announced increased bond purchases, yields did come down but then rebounded quickly. If the same thing happens again, it will prove fatal as this time round, conditions are different – the recovery is faltering, with a high risk of a recession. The saving grace to all this is that if UK collapses, the world doesn’t necessarily need to follow...

Manish K. Pandey           

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