When the fog clears more stimulus will be required - Capital Economics
UK Economics

When the fog clears more stimulus will be required

MPC Watch
Written by Andrew Wishart

The initial recovery has been encouraging, but the downside risks remain. We think much more support will eventually be needed in the form of a further £250bn of QE in total (the consensus is £100bn more). As the current QE programme will continue until the end of the year, the MPC does not need to act at its next meeting on 17th September. Instead, it will probably wait until November, when the damage to the labour market is clearer, to announce the next £100bn instalment of QE.

  • Downside risks to the Bank of England’s forecasts are crystallising
  • MPC will wait until the current QE program is ending before adding more stimulus
  • QE still the tool of choice, negative rates possible further ahead

The initial recovery has been encouraging, but the downside risks remain. We think much more support will eventually be needed in the form of a further £250bn of QE in total (the consensus is £100bn more). As the current QE programme will continue until the end of the year, the MPC does not need to act at its next meeting on 17th September. Instead, it will probably wait until November, when the damage to the labour market is clearer, to announce the next £100bn instalment of QE.

Bank wary of tightening prematurely

In August, the MPC added forward guidance to its existing stimulus package of interest rates of 0.10% and £300bn of QE, of which the latest tranche of £100bn is due to be completed around the turn of the year. The Committee stated that it “does not intend to tighten monetary policy until there is clear evidence that significant progress is being made in eliminating spare capacity and achieving the 2% inflation target sustainably”. In contrast to the Fed, which will allow inflation to overshoot with its new “average inflation target”, the Bank of England will not tolerate above-target inflation. Rather, the Committee is committing not to tighten policy until there is hard evidence in the data (rather than just its forecast) that inflation is close to and on course to hit the 2% target.

The case for optimism

The data released since the August meeting suggest that the initial leg of the recovery has continued apace. GDP rose by 8.7% m/m in June. And while that still left output 17.3% below its pre-virus level, timelier data suggest that significant further progress has been made. Retail sales rose above pre-virus levels in July, and data from Barclaycard show that credit and debit card spending was higher in August 2020 than a year earlier. Meanwhile, a mini boom is underway in the housing market, with transactions reaching pre-virus levels in July and survey data pointing to even higher activity in August.

What’s more, CPI inflation surprised to the upside in August, rising to 1.0% when the Bank of England expected it to be 0.7%. As a result, the Bank’s Chief Economist, Andy Haldane, thinks that the “recovery is not given enough credit and the popular narrative is on the gloomy side of neutral.”

An increasingly treacherous path ahead

However, Haldane appears to be in a minority of one. Other MPC members are wary of reading to much into the recovery. Gertjan Vlieghe has pointed out that “a few months of rapid growth in the period when lockdown measures were eased…tells us little about how the economy will evolve further out.” And government support is still being phased out. There were probably around 3m employees on the furlough scheme in August (down from a peak of 8.8m). Many have returned to work. But HMRC data suggest about 750,000 people had lost their jobs by July. External MPC member Michael Saunders has pointed out that the longer workers are left on the scheme, the less likely they are to return to work. So a significant proportion of the 3m still on furlough will also lose their jobs. A 1m rise in unemployment would push the unemployment rate up by 3ppts. The Bank’s forecast that the unemployment rate will rise from 3.9% to over 7.0% looks sensible to us.

Moreover, the MPC’s relatively optimistic assumptions on the virus and Brexit are being challenged. And the government is contemplating tightening fiscal policy. (See here.) The MPC assumes that social distancing restrictions are not re-imposed and consumer caution due to the virus gradually fades. But the number of virus cases is accelerating, and the government has already tightened restrictions in response.

The MPC’s forecasts also assume a smooth transition to a comprehensive trade deal at the end of the year. But it increasingly looks like any deal will be more limited, if there is one at all, raising the prospect of another (albeit smaller) shock to the economy. Either way, the uncertainty wrought by the virus and Brexit will mean investment is slow to recover.

Even though the initial recovery has been better than expected, the downside risks of a resurgence of the virus, a no deal Brexit and a tightening of fiscal policy are all starting to materialise. We think that the MPC will have to add more stimulus to take up the slack in the economy left over after the crisis. Indeed, Saunders already considers it “quite likely” that more stimulus will be needed. (See Table 2.)

The MPC can afford to wait

That said, the MPC doesn’t need to act yet as it has a QE programme in place that will last until the end of the year. Moreover, waiting for a clearer view of the labour market damage after the furlough scheme ends will provide a better guide to how much stimulus is needed. And by November the Bank may know with more certainty how Brexit will pan out.

Chart 1: Market Inflation Expectations

Source: Refinitiv

One thing that could have prompted the Committee to act earlier is a big change in inflation expectations, which would suggest that investors or households were losing faith in the MPC’s ability or commitment to meet the inflation target. But after falling initially, they have returned to pre-virus levels. (See Chart 1.)

What will it do?

The Bank has embarked on a research program to assess its policy tools, so things may change.

But we doubt that the MPC will use negative rates soon as it played down the chances of using them in August. Market expectations of a cut to -0.1% in 2021 are likely to be disappointed. The MPC’s concern is that at a time that banks are likely to be realising loan losses, the additional hit to their profits from negative rates could cause them to reduce lending. And we don’t think that the Bank will follow the Fed and change the inflation target. (See here.)

For now, then, the preferred tool is still QE which could be strengthened with more forward guidance. Overall, we expect asset purchases to rise by £250bn to £995bn in a number of steps starting with another instalment of £100bn in November. (See Table 1.)

Finally, since some QE this year was done for financial stability rather than monetary policy reasons, the Governor mooted reversing it at some point to maintain policy space for future crises. But this is a long way off yet. We expect interest rates to stay at 0.10% or below for the next five years and doubt that QE will be unwound within ten years. (See here.)

Table 1: MPC Meeting Outcomes & Forecast

Date

Rates

QE

Date

Rates

QE

30th Jan. 2020*

0.75%

4th Feb. 2021*

0.10%

11th Mar. 2020 (Emergency meeting)

0.25%

18th Mar. 2021

0.10%

19th Mar. 2020 (Emergency meeting)

0.10%

+£200bn

6th May 2021*

0.10%

+£100bn

26th Mar. 2020

0.10%

24th Jun. 2021

0.10%

7th May 2020*

0.10%

5th Aug. 2021*

0.10%

18th Jun. 2020

0.10%

+£100bn

23rd Sep. 2021

0.10%

6th Aug. 2020*

0.10%

4th Nov. 2021*

0.10%

+£50bn

17th Sep. 2020

0.10%

16th Dec. 2021

0.10%

5th Nov. 2020*

0.10%

+£100bn

17th Dec. 2020

0.10%

Sources: Bank of England, Capital Economics. *Denotes publication of Monetary Policy Report.

Table 2: Summary of MPC Members’ Views (Members ordered from most dovish to most hawkish)

Member

Term End

Previous Vote

Past Non-Consensus Votes

Recent Key Comments

Michael Saunders
(External Member)

Aug. 2022

Rates: 0.10%

QE: £745bn

Voted to increase QE by £100bn in May.

Voted to cut rates in Nov. & Dec. 2019 and Jan. 2020.

“Risk management considerations imply we should lean strongly against downside risks at present…I consider it quite likely that additional monetary easing will be appropriate in order to achieve a sustained return of inflation to the 2% target.”(Speech, 4th Sep.)

Jonathan Haskel
(External member)

Sep. 2021

Rates: 0.10%

QE: £745bn

Voted to increase QE by £100bn in May.

Voted to cut rates in Nov. & Dec. 2019 and Jan. 2020

“I am concerned about the economy getting stuck and recovering only slowly and undershooting the inflation target.” (Speech, 23rd Jul.)

Gertjan Vlieghe
(External member)

Sep. 2021

Rates: 0.10%

QE: £745bn

Voted to cut rates in Jul. 2016, while the other 8 members voted to keep rates on hold.

“There is a material risk in my view that it could take several years for the economy to return to full capacity and inflation to return sustainably to target, even with monetary policy at its current settings.” (Report to the Treasury Committee, 19rth Aug.)

Silvana Tenreyro
(External member)

Jul. 2023

Rates: 0.10%

QE: £745bn

None.

“My central case forecast is for GDP to follow an interrupted or incomplete ‘V-shaped’ trajectory, with the first quarterly step-up in Q3… But I think that this will be interrupted by continued risk aversion and voluntary social
distancing in some sectors, remaining restrictions on activities in others, and in general, by higher unemployment.” (Speech, 15th Jul.)

Sir Jon Cunliffe
(Deputy Governor – Financial Stability)

Oct. 2023

Rates: 0.10%

QE: £745bn

Voted against raising rates in Nov. 2017.

“Given the economic hit – a very deep synchronised hit to the global economy – we can expect very significant losses on credit to firms and households.” (Webinar, 9th Jun.)

Andrew Bailey
(Governor)

Mar. 2028

Rates: 0.10%

QE: £745bn

None.

“Because of the uncertainty and the risks, we are going to need more than normal evidence and assurance that the economy is on track and therefore inflation is on track to return to target before we act.” (Treasury Comm., 2nd Sep.)

Ben Broadbent
(Deputy Governor – Monetary Policy)

Jun. 2024

Rates: 0.10%

QE: £745bn

Voted against QE extension in Jul. 2012.

“Were there a serious concern that inflation would drift away from target, whether because of higher levels of debt or for any other reason, you’d expect to see it reflected in higher “breakeven rates” in gilts markets. Thus far that has not happened.” (Speech, 2nd Sep.)

Sir Dave Ramsden
(Deputy Governor – Markets & Banking)

Sep. 2022

Rates: 0.10%

QE: £745bn

Voted against raising rates in Nov. 2017.

“Because there is the interaction between supply and demand effects…I think the inflation fan and the downward skew is probably not as great as it is for GDP.” (Treasury Committee, 2nd Sep.)

Andy Haldane
(Chief Economist)

Jun. 2023

Rates: 0.10%

QE: £745bn

Voted against QE extension in Jun. 2020.

Voted to raise rates in Jun. 2018.

“The turnaround in the fortunes of the global and UK economies in the past few months has been quite remarkable. And even now that recovery is not given enough credit and the popular narrative is on the gloomy side of neutral.” (City AM Podcast, 7th Sep.)

Sources: Bank of England, Bloomberg, City AM, HoC Treasury Committee


Andrew Wishart, UK Economist, +44(0)7427 682 411, andrew.wishart@capitaleconomics.com