lunedì 17 agosto 2009

A weak Pound is welcome, BoE’s Governor King indicated

In the article What future for UK economy we highlighted that most economists believed that the Bank of England will be the first to implement an exit strategy from its expansionary monetary policy, (i.e. by raising interest rates), as the economic outlook has been improving and markets have been discounting that inflation will be higher in the United Kingdom than in the others major developed economies. However, the meeting of the Central Bank’s Monetary Policy Committee on August 6 and the Governor Mervin King’s press conference on Wednesday 12 indicated that the BoE’s exit strategy is far from close.

Indeed, the Bank of England’s projections both on economic growth and inflation have shown that the medium term outlook for the UK economy remains very uncertain. As regards the economic outlook, there were two main items of interest. The first one is that the signs of economic recovery appeared in the last few weeks (i.e. the manufacturing PMI’s increase above 50 in July and the PMI service’s jump at 17 months high), have not changed the medium-term economic base scenario: the British economy is likely to suffer the consequences of the last two years crisis’ for a long time. The second one is that even if the BoE forecasts for a return to a GDP growth of 3% y/y starting from the second half of 2010, in line with the average growth rate pre-crisis, were right, this would not be enough to close the gap with the lower growth recorded in the last two years, leaving intact the deflationary pressures. The process of debt reduction for companies and households, whose debt reached in Q1 the threshold of 173% of disposable income, will require many years. Personal consumptions should also be penalized by the negative trend of the labour market, which is expected to worsen over the coming months. To date, jobs losses (the number of unemployed exceeded 2.4 million) were less than in the previous recessions and a worsening of the labour market is very likely in the coming months: the number of unemployed is expected to exceed 3 million in the coming months. Consumptions and investments are also likely to be restrained by the tightening of the credit market as the banking sector is still in a bad way and it will take several years for it to repair balance sheets.

The main item of interest was the outlook for inflation. The Governor King indicated that the risk of a fall in deflation is higher than the risk of an unwelcome increase of inflation. Mr King said that a drop of inflation below 1%, which would force him to write a letter to the Chancellor of the Exchequer to explain why it was not complied with the inflation target of 2% with a tolerance limit of + / - 1%, is very likely in the autumn. The thesis of the Bank of England is that the risks of deflationary pressures are greater than the risks of higher inflationary pressures as the nominal expenditure and the monetary aggregates’ growth are expected to remain weak and the impact of the assets purchase program (it was increased to 175 billion Pounds on August 6) is difficult to assess.

The Bank of England’s projections indicated that should interest rates remain unchanged at 0.5% and the asset purchasing program unchanged at 175bn Pound throughout the reporting period, inflation is expected to reach the 2% target in 2 years, while should interest rates follow the trend implicit in the market rates the 2% level would not be reached. Therefore, this projections indicated that the market expectations that rates could rise to 4% in the last quarter of 2011 may be too optimistic about economic growth and inflation. For these reasons the main indication from the King’s press conference on Wednesday 12, was that the rates should be lower and for longer than expected by the investors.

Expectations of lower rate increases over the next few quarters weakened the Pound, risen during the week above 0.86 against the euro, breaking the downward trend started in December 2008 with the Euro/Sterling close to 1 that brought the exchange ratio below 0,85.

However, the Bank of England showed that the Sterling decline in 2008 played a positive role for economic recovery, both increasing the profitability of exporting companies and containing the deflationary pressures. Considering the general rule that an increase of 6% (the last quarter’s rebound in the Pound versus the others major currencies) corresponds to an increase in rates of 1,5%, it seems difficult that the Central Bank may accept passively a further Pound increase should this happen without an upward revision in the outlook for inflation. For these reasons, in the case of a new Sterling appreciation the Bank Of England may increase its expansionary monetary policy, with an increase of the Asset purchase program as the main possibility.

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