Raise rates or unwind QE or both?


In last week’s report, we discussed the likelihood of the Bank of England raising interest rates in August and concluded that it is now a high probability event following the publication of a relatively hawkish set of minutes from the Bank of England’s MPC meeting on 21st June. The committee’s presumption is that GDP growth will rebound in the second quarter following a disappointing first quarter that was adversely impacted by one off disruptive factors. Additional credibility was added to the rationale last week when the ONS published its final reading for Q1 GDP which showed a small upward revision to initial estimates.

 

So the case for the Bank of England to tighten policy appears set. Historically, the primary weapon in the Bank of England’s armoury has been interest rates. If the MPC wanted to dampen inflation or stop the economy growing too quickly, it would raise interest rates. However, in the aftermath of the financial crisis, the Bank has another tool – it can withdraw stimulus provided via quantitative easing and theoretically have the same effect.

 

The Bank of England is set to publish its view on the ‘neutral rate’ in August. If the committee views this as being around 2% nominal over a three year time horizon, it would imply tightening of 50 basis points per annum over the next three years (which is broadly what the market is currently pricing in). This assumes that the MPC keeps its asset purchases steady at the current £435 billion which again seems reasonable after the MPC revised its forward guidance last month and stated that a portfolio unwind would not occur until rates reach closer to 1.5%.  

 

Given that QE is deemed by most as ‘extraordinary’ and was only implemented after rates had been cut to almost zero, some economists are of the opinion that it should be the first route when it comes to tightening policy. The problem with this is that its far more difficult to gauge what impact the latter will have – after all, most economists are still debating exactly what impact QE has had in providing stimulus.

 

 

 

 

CHART 1 – BoE (red) ECB (blue) and Fed (green) asset purchases

 

Source: Bloomberg

 

If we look across the Atlantic, the Fed are doing both in parallel without any disastrous consequences (so far) so maybe the MPC could follow the same path. However, while the Fed is gradually withdrawing monetary stimulus, Trump is providing plenty of fiscal stimulus. Clearly, Carney does not have that luxury and he also has the uncertainty surrounding Brexit to contend with. 

 

Based on Carney’s forward guidance, it looks likely that the BoE will first raise rates and then begin to reduce the size of its balance sheet thereafter. Overall, the expected path of rate increases / monetary tightening, is still relatively conservative and the market is only pricing in a solitary rate hike this year.

 

As previously highlighted, this is a key reason why we expect the pound to remain under pressure, particularly against the dollar in the short term. Looking at the chart above, we see the ECB (green line) is still expanding its balance sheet and hence we are less pessimistic on sterling’s prospects against the euro. Longer term, it is likely the dollar will start to under pressure when interest rate differentials start to narrow, but with little prospect of either the Bank of England or the European Central Bank dramatically shifting policy anytime soon, we expect the dollar to remain a dominant force in the months ahead.     

 

Author: Marc Cogliatti

 



 

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