GLOBAL CENTRAL BANK FOCUS August 2016 With Decisive Policy, Stacks Odds in Its Favour

AUTHOR At its 4 August meeting, the Monetary Policy Committee (MPC) of the Bank of England (BOE) sparked considerable excitement when it announced an ambitious programme of monetary easing via a wide variety of measures. The sharp market moves that followed indicate that the consensus did not expect the Mike Amey Managing Director MPC to deploy such a wide array of policy options. Portfolio Manager The BOE also forecast the UK economy slowing to marginally positive growth rates and inflation rising to (slightly) above the 2% target.

At the press conference following the announcements, BOE Governor was at pains to suggest there is plenty of scope to augment the existing policy easing, but he was also clear that this was intended to be a significant and decisive policy response.

Given the lags in monetary policy and the fact that the BOE’s own forecasts show growth returning to 2% (annualised) within two years’ time, why did the BOE embark on such an aggressive monetary easing programme? And, given how low rates are already, will it make any difference?

Before we try to answer these questions and assess the market implications, let us remind ourselves of the breadth of the MPC’s recently announced actions:

• Cut the Bank Rate (policy rate) by 25 basis points to 0.25%, and indicate that the MPC expects to ease further towards but remain above zero (at which point they will cease further interest rate reductions).

• Restart the quantitative easing (QE) programme by buying £60 billion of nominal gilts (UK sovereign bonds) over a six-month period, which according to PIMCO calculations equates to 120% of gross nominal issuance.

• Restart term financing for UK banks via a four-year Term Funding Scheme (TFS) with interest rates close to the Bank Rate. 2 August 2016 Global Central Bank Focus

• Initiate a corporate bond buying Figure 1: UK growth forecast indicates post-Brexit dip, then return to programme by purchasing £10 2% annualised billion in sterling-denominated

corporate bonds in the secondary R G market (out of an eligible universe of £150 billion, according to the Bank of England). • In conjunction with the BOE’s Financial Policy Committee, ease capital requirements on UK banks and building societies.

EXPLAINING POLICY DECISIONS

One way to delve beneath the UK G BOE announcement into the thinking that Source: Bank of England Quarterly Inflation Report, August 2016 culminated in these policy decisions is to look at the various strategies the BOE could have employed given Figure 2: Will UK headline CPI finally reach target? BOE is initial conditions, and what their optimistic for 2018–2019 potential payoffs could be, as well as the associated risks. After all, we C have very little hard data with which to gauge the scope of the post-Brexit growth slowdown, so I suspect that much of the MPC’s debate centred on how much they should do now versus waiting to see the hard data. And clearly there was debate:

Amongst the nine-person MPC, there were dissenters both on the UK C BOE corporate bond buying programme Source: Bank of England Quarterly Inflation Report, August 2016 (Kristin Forbes) and on the increase in QE (Kristin Forbes, Ian McCafferty and ).

Having access to the very same, very Broadly speaking, UK monetary to try and stem any fall in future limited set of data ahead of the MPC policy was on hold in the run up to activity. One argument for the decision, we at PIMCO believe the the EU referendum. An above-trend former is that the policy stance MPC was wise to go for an aggressive growth rate was expected to raise already appeared expansionary, as policy response. CPI to target in due course, although shown by the above-trend growth the MPC was happy to wait for clear rate ahead of the EU vote. One Let’s start with those initial evidence of an upward push on argument for the latter is that conditions, and the BOE’s central prices before raising official interest inflation is already below target, and forecasts for the UK economy. In the rates. Then, in the aftermath of the thus any material slowdown risks run up to the historic June vote on EU vote, confidence slipped sharply: pulling down inflation further and the UK’s membership in the The widely followed purchasing putting downward pressure on European Union, real GDP growth managers’ index (PMI) fell to levels medium-term inflation expectations, had been running at a modestly not seen since 2009. making the task of subsequently above-trend 2% level (see Figure 1), raising inflation (and inflation Policymakers faced a thorny whilst inflation remained stubbornly expectations) even harder than it decision: Wait and see whether the below the 2% target, both on the already is. We believe the MPC was fall in the PMI translates into a headline CPI measure (see Figure 2) right to opt for the latter after and on an underlying basis. genuine fall in activity, or act quickly August 2016 Global Central Bank Focus 3

weighing the potential risks and As I wrote in last month’s blog, the new source of demand coming benefits. With interest rates already “Brexit Aftermath: Outlook for the from the QE programme. The BOE’s close to zero and inflation below UK”, our expectation is for growth to highly accommodative stance should target, the costs of subsequently fall to just above zero over the next 12 also enable the British pound to dealing with any potential inflation months before recovering back remain weak. overshoot seem very manageable towards the 1.5% to 2% levels we had It’s also important to ask what when measured against the challenge ahead of the Brexit vote. This outlook impact, if any, these measures will of pulling up inflation if downward was predicated on a protracted set of likely have on the banking industry. price pressures turn out to be negotiations over the UK exit from Lower rates and a flatter yield curve stronger than expected. the EU, a modest slowdown in certainly put pressure on banks’ consumer spending and a more There is also this added bonus: If the profitability; however, the other significant slowdown in business UK economy performs better than policy measures – term financing investment. We expected a monetary expected, the MPC can now claim operations (TFS) and easing of response and got one, and we expect some of the credit, and if the capital requirements – were designed a fiscal response as well. We see little economy deteriorates, then the MPC to cushion the potential reduction in reason to change those assumptions can at least gain some solace from profitability. PIMCO’s financials or expectations. the fact that it wasn’t as if they didn’t credit analysts also note that the try. In effect, we could say the MPC POLICY: NEXT STEPS AND underlying commercial banking has stacked the odds in its favour! INVESTMENT IMPLICATIONS businesses of the UK banks are still highly profitable, and as such the That does not mean that the MPC will POTENTIAL OUTCOMES: new monetary policy measures MONETARY AND FISCAL sit on their hands in the months and should not seriously hamper the quarters ahead. Certainly there What is the likelihood the policy functioning of the banking system. remains a high degree of uncertainty arsenal works as intended? For a over the path of real activity, and the In summary, I applaud the MPC for start, we believe this monetary MPC has already indicated that if the their policy response at the August response will be supported by a fiscal economy follows the forecast, the meeting. Given the range of risks to response later in the year as the UK’s Bank Rate will likely be reduced again the UK economy, a strong policy new Chancellor, Philip Hammond, to close to but above zero. To my response trying to limit the slowdown looks to reset fiscal policy. With the mind this suggests the Bank Rate will in growth appears to be the right fiscal deficit currently at around 4% reach a terminal level of 0.1%, where it policy response, despite the lack of of GDP, there is not much scope to will likely stay for at least our cyclical hard data at this juncture. To repeat raise the deficit (unless growth (six- to 12-month) horizon. The BOE’s the words of BOE Chief Economist deteriorates further), but there is still current QE programme will be in a 30 June 2016 the ability to scrap the proposed enacted over the next six months, and speech, “I would rather run the risk of tightening of up to 1% of GDP per the fact that the BOE will be buying taking a sledgehammer to crack a nut year for the next four years (source: corporate bonds for the next 18 than taking a miniature rock hammer UK Office for Budget Responsibility). months suggests that if needed, the to tunnel my way out of prison”. There is also the scope to initiate QE programme can be extended Whether it turns out that the policy some form of infrastructure further. At this stage it is hard to sledgehammer does indeed crack the programme, which may not provide estimate whether there will be further nut remains to be seen, but at least we much of a short-term boost, but it rounds of QE, but from an investment know it won’t be for want of trying. could generate much-needed standpoint, what we can say is that medium-term productivity very easy UK monetary policy will be improvement and may support with us for the cyclical horizon. That business confidence in both the short in turn suggests that despite their and the medium term. current low levels, UK gilt yields will remain at these very suppressed levels and indeed it is possible that long bond yields could fall further given This material contains the opinions of the manager and such opinions are subject to change without notice. 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