Bank of England Set to Launch QE3

The odds strongly favor the Bank of England enacting a further GBP50 billion of quantitative easing (QE) at the conclusion of the Monetary Policy Committee (MPC)’s July meeting on Thursday. This would take the stock of QE up to GBP375 billion.

The MPC were on the brink of approving more QE at its June meeting, and with latest economic data and surveys largely grim, the outlook uncertain and troubling, the Eurozone crisis continuing, and latest inflation developments largely favorable, we believe that a majority of MPC members will decide that more QE is now warranted and justifiable.

Nevertheless, we expect the Bank of England to decide there is not a compelling case, for now at least, of taking interest rates below 0.50%.

It looks odds-on the Bank of England will announce more QE at the conclusion of its July meeting Thursday. The minutes of the June MPC pointed pretty strongly to more QE being enacted in July, and this view was broadly reinforced by the generally grim testimonies of MPC members to the Treasury’s select committee on 26 June.

This would effectively be the launch of QE3. QE was first launched in March 2009 and amounted to GBP200 billion through to February 2010. QE was then put on hold through to October 2011, when it was revived as UK economic prospects took a downward turn and another GBP125 billion was spent through to early May, taking the stock up to GBP325 billion. The Bank of England then held off from increasing QE further at the May and June MPC meetings.

Notably, the minutes of the June MPC meeting revealed there was a vote of just 5–4 against more QE in June, with Bank of England Governor Sir Mervyn King among those favoring immediate further action. Furthermore, the minutes reveal that some other MPC members acknowledged that “further stimulus was likely to become warranted at some point” but wanted to see how matters developed, including developments in the Eurozone. Some MPC members also remained concerned about persistent above-target rates.

We suspect that latest developments are likely to prod at least one more MPC member into favoring more QE in July, and expect a GBP50-billion extension to be announced, taking the stock up to GBP375 billion. Latest economic data and survey evidence have been weaker and disappointing overall, increasing the risk that the economy suffered further contraction in the second quarter.

In addition, although the Greek election result reduced the likelihood of an imminent Greek exit from the Eurozone, tensions and problems in the single currency area remain elevated with Spain a central focus.

Meanwhile, latest inflation developments have been largely reassuring for the Bank of England. Consumer price inflation has fallen more than the Bank of England expected recently (falling to a 30-month low of 2.8% in May and averaging 2.9% so far in the second quarter compared with the 3.2% forecast in the May Quarterly Inflation Report) while oil prices have hit an 18-month low and wage growth remains low.

Adding to recent better inflation news, the latest survey by Citi/YouGov showed that consumers’ expectations for inflation retreated to a 26-month low of 2.4% in June from 2.8% in May and 3.0% in April. In addition, expectations for inflation over the next 5–10 years moderated to 3.2% in June. This was the equal lowest level (with January) since May 2010 and down from 3.4% in May and 3.7% in April. This is welcome news for the MPC as there has been concern within the committee that extended above-target consumer price inflation could lead to lasting higher inflation expectations, which would encourage businesses to try to increase their margins and pass on their cost increases. There is also the danger that higher inflation expectations could lead to workers pushing for higher wage increases, although this is hard to see at the moment, given the amount of slack in the labor market and workers’ weakened bargaining position.

Even so, more QE in July is not a stone-dead certainty. It could be that the five MPC members currently against more QE would prefer to hold fire for at least a little longer given that the Bank of England and Treasury have just announced “Funding for Lending “ measures aimed at getting banks to lend more to businesses and for mortgages and at cheaper rates.

On the interest-rate front, it is notable that at their June meeting, the Bank of England discussed the case for lowering interest rates from the current level of 0.50% for the first time since last September.

Nevertheless, for the time being at least the MPC is sticking to the view that there is not a compelling case that lower interest rates would have an overall beneficial impact, and would not have any advantages over more QE. The MPC remains concerned that even lower interest rates would hit banks’ profit margins and constrain their ability to lend. There is also concern that the functioning of money markets would become impaired. In addition, the Bank of England doubts that taking interest rates below 0.50% would significantly help many borrowers, although it did acknowledge that the number of people with mortgages contractually linked to the bank rate has increased since early 2009.

While we would not rule out a future trimming of interest rates from 0.50% to 0.25%, we believe it is more likely that they will stay at 0.50% through to 2014.

Main Economic Releases

Manufacturing Purchasing Managers’ Survey for June

The manufacturing purchasing managers' index (PMI; out Monday) is expected to show that overall activity in the sector contracted at a reduced rate in June after suffering a substantial fall in May. Specifically, we forecast the PMI to have improved to 48.0 in June after slumping to a three-year low of 45.9 in May from 50.2 in April and 51.8 in March. Nevertheless, this would still be below the critical 50.0 level that indicates flat activity.

It is difficult to gauge just how much manufacturing activity was held back in June by the extra day’s public holiday resulting from the Queen’s Diamond Jubilee celebrations. It does seem likely though that the PMI may have improved to a limited extent after suffering such a substantial drop in May. Furthermore, the Confederation of British Industry (CBI) has already released its industrial trends survey for June which showed a pickup in activity after a sharp dip in May. Specifically, the CBI’s orders balance improved to -11% in June after dipping to a five-month low of -17% in May from -8% in April. In addition, a balance of +7% of companies expected to raise output over the next three months, which was up from -3% in May (which was the first negative balance in 2012).

UK manufacturers clearly face a very challenging domestic and international environment. Domestic demand for manufactured goods is handicapped by still-squeezed consumers’ purchasing power as well as by tighter public spending. In addition, the current, highly uncertain economic environment is leading to some orders being delayed or cancelled.

Meanwhile, Eurozone economic weakness, in particular, is limiting overall foreign demand for UK manufactured goods. In addition, exporters have had to cope with the pressure on their competitiveness coming from sterling hitting a 33-month on a trade-weighted basis in May.

Manufacturers are helped by the sharp drop in oil prices reducing the squeeze on their margins and giving them more scope to price competitively. In addition, sterling has fallen from its May peak levels.

Mortgage Approvals in May and House Prices in June

The Bank of England is expected to report on Tuesday that mortgage approvals for house purchases fell modestly to 51,000 in May after edging up to 51,823 in April from 51,067 in March. This would be well down on the 25-month high of 58,610 in January. Mortgage approvals have broadly stabilized at a lower level after being lifted towards the end of 2011 and early on in 2012 by first-time buyers looking to complete purchases before a stamp-duty concession ended 24 March.

Significantly, mortgage approvals are very low compared with long-term norms. Mortgage approvals have averaged 86,888 a month since 1993, while a level of 70,000–80,000 has in the past been considered consistent with stable house prices.

The Bank of England is also forecast to report that net mortgage lending amounted to just GBP0.8 billion in May. This would be down from GBP1.1 billion in April and would again be very low compared with long-term norms.

Meanwhile, house prices on the Halifax lender’s measure (out during the week) are expected to have fallen 0.2% month-on-month (m/m) in June. This would leave house prices down by 0.8% year-on-year (y/y) in the three months to June. House prices on the Halifax measure have recently been erratic, rising 0.5% m/m in May, falling 2.3% in April, rising 2.2% in March, and falling 0.4% in February.

The Nationwide lender has already reported that house prices fell 0.6% m/m in June on their measure, and were down 1.5% y/y. This was the third drop in four months as prices had previously risen by 0.2% m/m in May after falls of 0.3% in April and 1.0% m/m in March.

We suspect house prices will drift lower over the second half of 2012 in the face of limited activity, low and fragile consumer confidence, muted earnings growth, and high unemployment. We expect house prices to end up losing around 3% from current levels.

Housing market activity is persistently low compared with long-term norms and while it may eventually be lifted by more mortgages being granted at decent interest rates under the “funding for lending” scheme recently announced by the Bank of England and the Treasury, this is unlikely to be a major factor in the near term at least.

Furthermore, there remains a significant danger that house prices could fall even more than this due to the serious downside risks to the UK economic outlook, particularly stemming from the problems in the Eurozone centered on Greece and Spain.

It is possible that house prices will gain some support from a shortage of properties on the market, but this tends to vary markedly between regions as a factor. Meanwhile, although mortgage interest payments as a percentage of disposable income are currently very low, other affordability measures are not so favorable with the house price/earnings ratio above its long-term average.

Consumer Credit in May

The Bank of England is also expected to report on Wednesday that net unsecured consumer credit edged up just GBP200 million in May. This would be down from an increase of GBP268 million in April. It would also be substantially below the average monthly level of GBP1.1 billion in unsecured consumer credit seen since 1993. In April, there was a net repayment of GBP118 million on credit cards while there was a net increase of GBP386 million in other loans and advances.

Consumer appetite for taking on new borrowing remains limited while there is also an ongoing strong desire of many consumers to reduce their debt. Consumer desire to keep a tight grip on their finances is clearly the consequence of serious concerns over the outlook for the economy. It is very possible that increased worries over the outlook resulting from news that the economy is back in recession and from the situation in the Eurozone may well intensify the desire to improve personal finances.

Construction Purchasing Managers’ Survey for June

Major uncertainties persist over the true state of the construction sector, but it does appear to be finding life difficult even if it is not in as bad shape as was implied by the 4.9% quarter-on-quarter (q/q) drop in output reported in the first-quarter national accounts.

Survey evidence for the construction sector has tended to be appreciably better than the hard data, but worryingly the latest purchasing managers’ surveys have been softer. We expect the construction PMI (Wednesday) to have eased to a five-month low of 53.2 in June from 54.4 in May, 55.8 in April, and a 21-month high of 56.7 in March. Again though, it is difficult to gauge just how much services activity was held back in June by the extra day’s public holiday resulting from the Jubilee celebrations.

It is clear that the construction sector currently faces significant headwinds that are constraining activity. In particular, the government’s planned spending cuts are limiting overall expenditure on public buildings, schools, and hospitals. For example, the Bank of England’s regional agents revealed in their June business conditions survey that “construction output was reported to have continued to decline compared with a year earlier, as public sector contracts gradually came to an end. Where there was new work for the public sector, the jobs tended to be smaller than those they replaced.” On top of this, house building activity is likely to be constrained by persistently weak housing market activity, soft prices, and a still uncertain outlook.

If the economy continues to struggle to develop sustainable growth over the coming months, there is the danger that construction activity will be hit by some projects being put on hold or cancelled altogether—particularly large ones.

On a positive note, the construction sector could eventually benefit appreciably from various government measures aimed at boosting infrastructure and house-building. It remains to be seen just how much of a boost these measures provide and how soon they really kick in.

Service Sector Purchasing Managers’ Survey for June

We forecast the business activity index of the service sector PMI (Wednesday) to have eased to a seven-month low of 52.8 in June from 53.3 in both May and April and 55.3 in March. At least this would still indicate clear, albeit modest expansion, given that a level of 50.0 is meant to indicate flat activity. Once again, it is difficult to gauge just how much services activity was held back in June by the extra day’s public holiday.

While the service sector does appear to be growing modestly, its upside is currently being limited by difficult conditions in the private sector as well as by tighter government spending. For example, the Bank of England’s regional agents reported in their June survey of business conditions that some outsourcing companies “had been squeezed as public sector bodies brought work in-house”.

Meanwhile, many consumer-facing services companies are handicapped by the still generally difficult conditions facing consumers and the related inclination/need of many people to limit their discretionary spending.

Producer Prices in June

Producer price data (Friday) are forecast to show that output prices edged down a further 0.1% m/m in June after falling 0.2% in May. This would see the y/y increase retreat to a 32-month low of 2.5% in June from 2.8% in May, 3.2% in April, and a near-three-year high of 6.3% in September 2011. Core output prices are forecast to have edged up just 0.1% m/m in June after being flat in May. This would cause the y/y increase to fall to a 29-month low of 2.0% in June from 2.1% in May, 2.3% in April, and a peak of 3.7% in September 2011.

Meanwhile, the consensus forecast is for producer input prices to have fallen by a further 2.1% m/m in June after drops of 2.5% in May and 1.4% in April. This is primarily the consequence of sharply reduced oil prices and would cause producer input prices to be down 2.1% y/y in June. This contrasts with a peak increase in producer input prices of 18.5% y/y in July 2011.

The recent marked retreat in oil prices is easing the pressure on manufacturers’ margins and reducing pressure on them to raise their prices. In fact, the fall in input prices gives manufacturers’ increased scope to trim prices to win business. Meanwhile, the current weakness of the economy and muted manufacturing activity means that more companies feel the need to price competitively to try to gain, or even retain, business.