The Bank of England’s QE Decision Is on a Knife Edge

Summary

To QE or not to QE? That is the question facing the Bank of England’s Monetary Policy Committee (MPC) at its May meeting.

It is an extremely tight call as to whether or not the MPC will go for more Quantitative Easing (QE) at the conclusion of its May policy meeting on Thursday. The decision could well go down to the wire, with the decision influenced by data and survey evidence coming out over the next few days. The MPC’s dilemma stems from the most recent data and survey evidence indicating an unpalatable mix of sticky elevated inflation and weakened economic activity—the exact opposite of what the Bank of England (BoE) is hoping will occur.

We lean towards the view that the BoE will refrain from announcing more QE on Thursday, which will bring the programme to at least a temporary halt given that February’s GBP50 billion extension (taking the stock up to GBP325 billion) was due to be completed by early May. We expect the MPC to hold off from more QE in light of its current heightened inflation concerns and a belief that the economy is seeing underlying modest growth despite the reported first-quarter GDP contraction that put the economy officially back into recession.

However, we expect the MPC to keep the door very much open to more QE should the economy fail to show underlying improvement over the coming months. BoE Governor Sir Mervyn King has repeatedly indicated that the MPC will make its decision each month based on the inflation and growth evidence before it.

Meanwhile, we maintain the view that interest rates will not rise until at least late 2013 and could very well stay put at 0.50% until 2014.

Analysis

At face value, the 0.2% quarter-on-quarter (q/q) contraction in GDP in the first quarter of 2012 that officially put the UK back in recession would seem to call for more QE by the BoE’s Monetary Policy Committee at the conclusion of its 10 May meeting. However, the minutes of the April MPC meeting were markedly more hawkish and suggested that the committee members were less inclined to approve additional QE. It was particularly notable that arch dove Adam Posen dropped his call for an additional GBP25 billion of QE in April, leaving only David Miles of the nine MPC members in favour of such a move—and even for Miles, the call for more QE in April was “finely balanced.”

It was very clear in the minutes of the April MPC meeting that committee members had serious reservations about the likelihood of first-quarter GDP data showing contraction (which it duly did) and believed that the economy was seeing underlying moderate growth.

Furthermore, it was evident from the minutes of April’s MPC meeting that the committee is significantly more worried about the near-term inflation outlook and the risk that it may not fall back as far or as quickly as had been expected in the February Quarterly Inflation Report. Specifically, the minutes noted that while consumer price inflation had fallen back to 3.4% in February from a peak of 5.2% in September 2011, the decline had been “slightly less than the Committee had expected.” Furthermore, the MPC suspected that recent increases in oil and gas prices, as well as indirect tax changes announced in March’s budget, would keep inflation higher than previously anticipated in the short run.

Indeed, subsequently released data show that consumer price inflation rose back up to 3.5% in March. There is significant concern within the MPC that “above-target inflation would persist into the medium term, whether because of elevated external pressures, a rebuilding of margins, or a rise in costs.” Even so, the MPC still believes that medium-term inflation should be limited by the large degree of slack in the labour market.

However, it is premature to write off further QE either on 10 May or at a later stage, given that economic activity will likely remain muted overall, and prone to relapses through the next few months at least, in the face of still serious domestic and international headwinds.

Significantly, Martin Weale, who has been one of the more hawkish MPC members, has indicated that the first-quarter GDP data were weaker than he expected and boosted the case for more QE.

In addition, the purchasing managers’ surveys—on which the MPC had been attaching significant importance—were weaker overall for April than they had been in March, although they did still point to modest growth. Specifically, our weighted composite index for the purchasing managers' services, manufacturing, and construction surveys retreated to a five-month low of 53.2 in April from 55.0 in March and an average of 54.6 in the first quarter. Even so, it is still clearly above the 50.0 level that is supposed to indicate flat activity.

It is a very close call as to what the MPC will decide on Thursday, but we believe it will refrain from more QE for now while it monitors how economic activity and inflation develop.

Meanwhile, we maintain the view that interest rates will not rise until at least late 2013 and could very well stay put at 0.50% until 2014. Interest rates are clearly not going to be raised for quite some time, given the fragility of the economy and the need to counter extended tight fiscal policy. At the same time, there is clearly little interest within the BoE for taking interest rates lower than 0.50%. Indeed, it is significant that even at the height of the 2008/09 recession, the Bank of England did not take interest rates below 0.50%, which reflected doubts within the MPC that even lower interest rates would have a net beneficial impact.

Main Economic Releases

RICS Housing Market Survey for April

The April housing market survey from the Royal Institution of Chartered Surveyors (out overnight Monday/Tuesday) will provide important insights as to how housing market activity is developing following the ending of the stamp duty concession for first-time buyers on 24 March. There were indications from Hometrack’s April survey that already low growth in new-buyer registrations had slowed in April. Also of interest will be developments in the number of properties coming on to the market given the possibility that a shortage of available properties could provide support to house prices. Again though, Hometrack’s April survey indicated that more properties are coming to the market.

Meanwhile, we expect the RICS survey to reveal that the balance of surveyors reporting that house prices rose over the previous three months was stable at -10% in April after improving to this level in March from -13% in February.

We maintain the view that house prices are likely to drift lower over the coming months in the face of soft economic fundamentals and low consumer confidence. Specifically, we expect house prices to fall by around 3% by the end of 2012. Housing market activity is very low compared with long-term norms. The economic fundamentals still look troubling for the housing market, with unemployment high and likely to rise further, earnings growth muted, and the outlook uncertain. Indeed, the housing market may well be hit by heightened consumer concern over the economic outlook following the news that the UK is officially back in recession as GDP contracted 0.2% q/q in the first quarter.

It is also possible that housing market activity and prices will be softer in the near term as a result of the stamp duty concession having brought forward a significant amount of first-time buyer activity. In addition, relatively tight credit conditions may well make it hard for many people to get a mortgage. In fact, some mortgage rates have risen recently because of lenders’ higher borrowing costs in wholesale markets, and this could well weigh down on housing market activity

The squeeze on consumers’ purchasing power should eventually ease much further as inflation retreats (inflation is likely to be sticky in the near term because of high oil prices), which may help house prices to stabilize later in 2012 along with ongoing very low interest rates and hopefully a sustainable acceleration in economic activity. However, wage growth looks set to remain muted and unemployment could well rise further, so the overall environment will still be very tough for house buyers.

British Retail Consortium Retail Sales Monitor for April

The British Retail Consortium (BRC) retail sales monitor for April (overnight Tuesday/Wednesday) will be of major interest, indicating how well consumer spending held up in April after the Office for National Statistics reported a 1.8% month-on-month (m/m) spike in retail sales volumes in March. A resilient BRC survey would support the belief that the economy is seeing underlying moderate growth, whereas a poor figure would fuel concerns that the economy could contract again in the second quarter, especially as GDP will be hit by the extra day’s public holiday resulting from the Queen’s Diamond Jubilee. Stripping out the boost coming from a panic buying of fuel, retail sales volumes still rose 1.5% m/m in March. Retail sales can be volatile from month to month, and it is likely that sales were lifted in March by warm weather bringing forward purchases of summer of clothing and footwear, and outdoor products such as gardening items. It is also notable that March’s jump in sales volumes followed a 0.8% drop in February.

The general expectation is that the BRC monitor will show an increase around 0.5% y/y in April on a like-for-like basis (which strips out the effect of additional floor space) compared with a rise of 1.3% in March and a fall of 0.3% in February.

If the April BRC survey is relatively decent, it will boost hopes that consumers are gradually preparing to spend, and this will help the economy return to growth. Alternatively, a very weak BRC survey would fuel fears that the UK economy is headed for further GDP contraction in the second quarter.

The Confederation of British Industry (CBI) has already released its distributive trades survey for April, which was softer, but far from disastrous. Specifically the CBI survey showed that the balance of retailers reporting that sales were up y/y fell back to -6% in April after rising to 0% in March from a 34-month low of -22% in January. This figure compared with an overall average of +3% for 2011 and +42% for the second half of 2010.

There is currently still a lot of pressure on consumers, so they are likely to be cautious overall in their spending over the next few months at least. With consumer price inflation proving sticky at 3.5% in March, annual earnings growth limited to 1.2% in February, and fiscal policy still tight, the squeeze on purchasing power remains appreciable. Meanwhile, unemployment is still high and full-time employment is falling modestly, despite some recent signs of labour market stabilization. There is also the very real worry that already low and brittle consumer confidence will take a significant hit from the news that the UK is apparently back in recession, and this will lead to increased caution in spending.

Hopefully, inflation will eventually fall back appreciably further and support consumer spending, but this may well be delayed until the second half of this year. Even if consumer price inflation does eventually fall back much further, unemployment is likely to remain high and wage growth muted, so the overall environment will likely remain tough for consumers.

Industrial Production in March

We expect manufacturing output (Thursday) to have risen 0.4% m/m in March after a disappointing 1.0% plunge in February. This would still leave manufacturing output down 1.3% y/y in March. It is possible that manufacturing output was hit to a limited extent by the snow early in February; survey evidence from the CBI and the purchasing managers was reasonably decent for March, which suggests that there should have been some rebound in output. Meanwhile, overall industrial production is seen edging up 0.1% m/m in March after rising 0.4% in February, when it was lifted by a sharp rise in utilities output (because of the cold weather) and a pickup in oil and gas extraction. Despite the expected rebound in manufacturing output in March, overall industrial production is seen being held back by markedly reduced utilities’ output due to the milder weather. Consequently, industrial production is forecast to be down 2.2% y/y in March.

April survey evidence on the manufacturing sector was softer from the purchasing managers but reasonably decent from the CBI. Taken together, they pointed to a sector seeing moderate expansion.

While we believe the manufacturing sector is currently growing modestly, it faces serious challenges that are limiting its performance and at least its near-term prospects. Not only is Eurozone contraction and soft activity elsewhere hurting exports, but domestic demand for manufactured goods is handicapped by a still appreciable squeeze on consumers’ purchasing power as well as by tighter public spending. In addition, recent higher input costs centred on higher oil prices is bad news for manufacturers because it squeezes their margins and exerts pressure on them to raise prices at a time when demand remains fragile.

Producer Prices in April

Producer price data (Friday) are forecast to show a continued moderation in the y/y inflation rate while also indicating that recent elevated oil prices are impeding the retreat in inflation. Output prices are forecast to have risen 0.6% m/m in April, as they did in both March and February. Nevertheless, this would see the y/y increase retreat to a 29-month low of 3.1% in April from 3.6% in March and a near-three-year high of 6.3% in September 2011. Core output prices are forecast to have increased 0.3% m/m in April, after rising 0.1% in March, and 0.5% in February. This would cause the y/y increase to retreat to a 27-month low of 2.1% in April from 2.5% in March, 3.0% in February, and a 13-month high of 3.7 % in September.

Meanwhile, the consensus forecast is for producer input prices to have fallen back by 1.0% m/m in April after spiking up 1.9% in March and 2.5% in February. This is expected to be due to an easing in oil prices from their March peak levels. As a result, the year-on-year increase in input prices would fall back to 1.9% in April (the lowest since October 2009) from 5.8% in March, 7.8% in February, and a peak of 18.5% in July 2011.

The recent renewed sharp monthly rise in input costs primarily resulting from higher crude oil prices has exerted pressure on manufacturers to raise their prices in order to protect their margins. At the same time, though, manufacturers have faced an ongoing need to price competitively to gain, or even retain, business in a still challenging environment. A drop in input prices in April would therefore be of major relief to manufacturers.