Lloyds TSB column: Will QE become QE2?

SIGNS of a weakening in the UK economy are becoming more widespread. Since GDP growth of 1.2% in Q2, UK purchasing managers’ indices have turned lower, volume retail sales has shown the first fall in four months and business and consumer confidence is turning down. With interest rates pretty much as low as they can go at 0.5%, the only real monetary option left is quantitative easing – directly injecting liquidity into the economy via the central bank buying securities from the financial markets.

Normally, a loosening of fiscal policy would also be an option for the authorities at a time of economic stress, but of course that is ruled out by the size of the UK’s budget deficit. Instead, fiscal policy is being tightened in order to ensure that the UK avoids being tainted with the funding concerns associated with the sovereign risk crisis facing a number of the smaller members of the eurozone, like Greece and Ireland.

With fiscal policy ruled out and interest rates already low, the only viable option for loosening policy falls to QE. Bearing in mind that the Bank’s forecast of growth for 2011 is at the high end of expectations, close to 3%, weaker growth would leave the economy with more spare capacity, and so lower inflation, than expected previously by the MPC. Some MPC members thought that this could mean a need for further stimulus to ensure that inflation hits the 2% target in the forecast period.

Admittedly, not all of the economic news on the UK has been negative in the last month. Manufacturing activity seems to be holding up well. Reports from the Bank of England’s own officials suggested that consumer demand was still rising and that services activity and company exports were up in September. In addition, surveys of sales activity by the CBI showed that retailers’ expectations were still fairly robust. Unfortunately, the overall bias of the data in the last month still points to a slowdown being underway.

To help assess the usefulness of further QE, the question that has to be asked is: what has it achieved in the time that it has been in operation? Chart a shows that QE has been followed by a sharp rise in money GDP – one of the originally stated aims of QE was to get nominal GDP growth into a 4- 6% range. This has been achieved. Of course, the fear about a renewed slowdown is that it will fall back. Chart b shows that equity prices are higher. However, annual money supply growth is still falling and the velocity of circulation, the number of times money changes hands in the economy is also declining, though more recently at a slower pace.

Our analysis of the effects of QE on bond yields shows that without it, yields would still have fallen but are around 100 basis points lower with QE – chart c. In other words, QE does make a difference. Interest rates not only seem likely to stay low well into 2011 but, as the fiscal squeeze in 2011 takes effect, some further offset on the monetary side seems to be becoming inevitable. We estimate that, given the amount that has been spent so far on QE (£200bn), a further £50bn or so will be required to have a significant impact. Nor would concerns about inflation seem to stand in the way of further QE: in the September meeting, the majority view on the MPC was quite explicitly that the upside risks to inflation had not materially changed in the last month. Since this was despite the fact that CPI inflation remained at 3.1% in August – well above the 2% target – there seems relatively little concern about its history but plenty about its future path. This further cements the likelihood of a second round of QE or QE2 – either later in 2010 or in early 2011.

If any part of your business is exposed to the inflation rate, then please contact Lloyds TSB Corporate Markets to discuss how we may be able to help you to mitigate this risk for your business.

For more information on how we can help your business, please contact:

James Thomas
Regional Director
Lloyds TSB Corporate Markets
Telephone: 0121 635 9153
james.thomas@lloydsbanking.com

Trevor Williams
Chief Economist
Lloyds TSB Corporate Markets
Telephone: 020 7158 1748
trevor.williams@lloydsbanking.com  

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