BOE FOCUS-BoE could still go either way on QE next week

Published: 30 Jul 2009 04:03:03 PST

* QE decision next week finely balanced

* Governor King's casting vote could be pivotal

* BoE may want to avoid rise in yields

LONDON, July 30 - The Bank of England could go either way next week on whether to expand quantitative easing in what is shaping up to be one of the toughest decisions facing the Monetary Policy Committee since it was set up in 1997.

After pumping 125 billion pounds of newly-created money into the economy since March, policymakers now have to decide in their meeting on Aug 5-6 if they want to increase the asset-buying programme or call a halt for now.

Many analysts had expected the BoE to announce an expansion in the unprecedented programme last month but policymakers wanted to wait another month to see if more QE was needed given they would have new economic forecasts in August.

Things have not got much clearer and the MPC's unanimity since they started QE -- which seeks to foster freer lending and bolster demand -- may now break down as policymakers are genuinely vexed about what the next course of action should be.

Under serious consideration is likely to be adding another 25 billion pounds to the asset-buying to take the total to the full 150 billion pounds currently permitted by the government or stopping now and leaving open the option of doing more later.

A Reuters poll on Thursday showed economists split as to whether the bank would extend the programme in August, although the consensus was still that it would reach 150 billion. [ID:nLAG003615] Markets, on the other hand, last week warmed to the view that the QE programme would end in August after MPC member Andrew Sentance was quoted as saying the BoE could indeed pause.

But a closer read of the interview showed he was saying little the BoE had not said before -- they could stop or go on.

That was also before Friday's shockingly poor GDP number. The economy shrank by 0.8 percent in the three months to June -- much more than financial markets and BoE economists were predicting just days before the release.

People familiar with the BoE's thinking said that number will have been a wake-up call to the MPC, alerting them to the possibility they could be making a real mistake again by assuming the economy will soon get back on an even keel.

"The end-game for quantitative easing is a long way off," David Blanchflower, who left the council in May and was the only member to flag the extent of the global crisis last year, told Reuters.

"The BoE needs to expand QE a lot right now because otherwise any recovery will take an awfully long time."

HARD SLOG

The problem for the MPC is they are deep in uncharted waters. No one really knows what the effects of QE will be as it has never been tried in Britain before or for that matter anywhere but Japan.

So far, money supply figures are showing little sign of QE working its way into the wider economy. Financial institutions appear to be paying down debt rather than increasing lending.

Lack of credit remains a massive constraint on the economy as businesses up and down the land struggle to meet their cashflow needs.

So BoE policymakers have to decide on whether they can count on growth resuming next year as forecast or whether they should worry that the huge degree of slack in the economy means that inflation will be below target in 2 years time.

They will also be looking at what is happening in the global economy and the improvement in market conditions.

"What the Bank seems to be saying is don't assume we are finished," said RBS analyst Ross Walker. "There is every chance we may see a more prolonged pause before they decide whether to do any more."

Deputy Governor Charles Bean said this month he did not expect the BoE's outlook to have changed materially since May, when policymakers predicted a long, hard slog to recovery and inflation well below target even with all the easing in place.

Little change from that could imply further stimulus might be needed, especially given the rise in sterling, up about 6 percent since the May Inflation Report.

But MPC members are also likely to be worried about doing too much and stoking inflation. Oil prices have been rising as have other commodity prices and inflation could become a problem again once the global economy recovers, a senior UK Treasury source told Reuters this week.

Pausing, however, could push up yields and tighten financial conditions more than necessary. Gilt yields fell more than 50 basis points in March when the BoE announced the QE programme, which focuses mostly on buying gilts with newly-created money.

Yields have been creeping up since. An end to the programme would not only remove the biggest buyer of gilts but also lead to speculation about when the BoE would sell back the bonds it has bought, pushing yields significantly higher and raising the risk of snuffing out any recovery.

The BoE will therefore need to tread a fine line even if it chooses to pause, leaving open the option of further stimulus.

It could do this explicitly or by presenting another below-target forecast for inflation in its August report.

In the end, Governor Mervyn King's views are likely to be pivotal because if the MPC is divided, it may not be politic for him to be outvoted on such a crucial and possibly controversial decision.