Last Thursday, the Bank of England announced its intention to launch a second round of a highly anticipated project known as quantitative easing (coined QE2 for short). The market reacted positively to the headline statement; an additional £75bn will be printed, marking a 50% increase on the £50bn consensus. Before exploring the implications of this news, let us first examine what QE is and why the BoE deem it necessary at this point in time.
Put simply, QE is an unconventional form of monetary policy, where a central bank prints its own currency and buys assets. In this case, the capital will be used to purchase UK Government Gilts (evenly weighted across all maturities). The policy has two core objectives:
- Lower the yield on UK Government debt (making borrowing on the money market more affordable.)
- Creating a trickle down effect starting with banks and other financial institutions who vend the assets providing them with more liquidity (and therefore credit) to offer to businesses looking to borrow.
Essentially, the plan is designed to 'loosen' the pockets of UK businesses, encouraging them to spend their way back to growth.
The extent to which printing will occur is certainly an issue to be scrupulous of. In my view, the additional £25bn on market consensus is an elusive reflection of the systemic threat to our economy from Europe (and indeed the rest of the globe). As discussed in a previous article, Greece has already put tremendous pressure on credit lines and this reaction confirms liquidity in the future could be a serious issue. Others have also questioned the extent to which inflation (CPI currently at 4.5%) could be a direct outcome of this policy. Simple supply/demand economics state that if supply increases (in this case, supply of currency), demand will fall (the value of the pound.) While BoE policy maker Martin Weale insists "evidence shows that QE does support the economy and there is no reason to believe that it feeds directly into inflation without supporting growth," I remain sceptical of his latter point. The BoE currently anticipate inflation rising above 5% in the short term but dropping heavily below the 2% target in the medium term (primarily next year.)
So what will be the benefits of this announcement? First, lets take a glance at the immediate impact. Directly comparing the FTSE against the Dow Jones (the latter re-based on the morning additional QE was announced) we witness the FTSE making progress:
Although progress on this relatively simplistic chart could be attributable to any factor within the UK, it is fair to say the majority may be attributed to the QE programme. Looking out to the medium term, not surprisingly, the lasting impact is much harder to predict. QE1 supported the domestic economy through one of the most potent rises in recent history, the benefits ultimately lasting a year and a half. The subject of diminishing returns comes into play however and I believe this wave of QE will only be enough for the next 6 months, after which the effect will ease off and essentially we'll be back to reality.
Except many believe we won't. Michael Saunders of Citi shares a view fairly indicative of the general consensus on this matter:
"I think it's the right thing to do, I think they will do lots more QE. What is important is they are moving ahead of consensus and that is likely to have a fairly powerful downward effect on yields, which is what they want to achieve. And they will go on doing QE until prospects for the economy improve significantly, or until they own the whole gilt market."
"He said his 'best guess' was the Bank of England would do 300 billion pounds of QE on top of the 200 billion done so far, bringing the cumulative amount to 500 billion. "Today's 75 is part of that 300. But that's only a rough guess and the key point is it is going to come in large scale."
"It's both that the economy is weak but also that the MPC's view is that QE is not a very powerful tool, or rather it takes a large amount of QE to have much effect on the economy. I think that in the markets people don't appreciate that what comes from that is that the MPC will use QE in a very large scale because it is only in very large scale that QE has a notable effect." (uk.reuters.com)
While I agree this is certainly the right action to be taking at this point in time, my view remains bearish on short term market support at this level. I believe it is only a matter of time before the systemic threat of Europe starts to dominate market sentiment once again and the market needs more than just a 'promise of a promise' from MerKozy before the FTSE solidifies itself above the 5,400 level.
"He said his 'best guess' was the Bank of England would do 300 billion pounds of QE on top of the 200 billion done so far, bringing the cumulative amount to 500 billion. "Today's 75 is part of that 300. But that's only a rough guess and the key point is it is going to come in large scale."
"It's both that the economy is weak but also that the MPC's view is that QE is not a very powerful tool, or rather it takes a large amount of QE to have much effect on the economy. I think that in the markets people don't appreciate that what comes from that is that the MPC will use QE in a very large scale because it is only in very large scale that QE has a notable effect." (uk.reuters.com)
While I agree this is certainly the right action to be taking at this point in time, my view remains bearish on short term market support at this level. I believe it is only a matter of time before the systemic threat of Europe starts to dominate market sentiment once again and the market needs more than just a 'promise of a promise' from MerKozy before the FTSE solidifies itself above the 5,400 level.
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