Bank of England chooses to wait in face of uncertainty

David Page, Head of Macro Research at AXA Investment Managers, comments on the recent developments at the Bank of England:

• The BoE left Bank Rate at 0.1%, in line with expectations and by unanimous votes.
• The MPC left the QE total unchanged, with the APF at £645bn. This was also in line with median forecast, but we had expected a £100bn extension. The Committee voted 7-2 in favour of this.
• The Monetary Policy Report contained a “plausible illustrative scenario”, which suggested a 25% contraction in activity in Q2 and a 14% drop for the year as whole, but pointed to elevated uncertainty.
• The Report suggested even less conviction around the inflation outlook. It sees inflation easing towards 0% around end-2020, before returning to 2% by 2022.
• The BoE also published the Financial Stability Report, which concluded that banks had more than adequate capital buffers in the plausible scenario.
• We are more concerned about the disinflationary effects over the medium term, but do not expect much more concrete evidence to emerge on this over the coming months.
• In the shorter term, we believe that a decision not to extend QE beyond its currently planned expiry in July would result in an undesirable tightening in financial conditions.
• We now forecast a £100bn extension to QE at the 18 June meeting.

The Bank of England (BoE) today announced its monetary policy decision for May. It left the Bank Rate unchanged at 0.10% as widely expected, by unanimous vote. It also left QE unchanged, leaving the Asset Purchase Facility target unchanged at £645bn. This was in line with the median consensus forecast, but we had expected a £100bn increase in QE today as the current programme is set to expire in early July. This was by split decision, with two members voting for an immediate £100bn increase. The majority of the Committee decided to wait for “more information... that was likely to become available over the coming weeks”, but these members “all” acknowledged prospective weakness in the economy and downside risks to the medium term outlook “might necessitate further monetary policy action to support the economy in the future”. We fully expect the MPC to increase QE, probably by £100bn at its next meeting on 18 June.

The minutes and Monetary Policy Report (MPR) that accompanied today’s decision gave much colour to the Bank’s decision. The BoE makes clear that forecasting in such circumstances is highly conditional. In its MPR it presents a “plausible illustrative scenario”. This scenario assumes the UK in lockdown until early June, with an easing in restrictions that is enacted across Q3. On this basis the MPC estimates a 25% contraction in GDP in Q2 2020, and an overall drop of 14% for 2020 as a whole. This differs from our own assumptions that sees an easing in restrictions in May and a “new normal established” earlier in Q3. It is a mark of the sensitivity of forecasts to these underlying assumptions that out own UK forecasts are for a 21% drop in Q2 activity and an overall drop in GDP of 8.5%. However, the Bank then assumes a recovery of pre-Covid levels of activity by H2 2021 and pencils in 3% growth in 2022. The BoE also highlights large confidence intervals around such forecasts and on balance sees “downside risks” to the medium term outlook, based on the persistence of social-distancing, job uncertainty and corporate risk aversion.

The broader question for the MPC was around inflation. The minutes were light on detail about the outlook for CPI inflation. They suggested that inflation would likely fall below 1% in H2 2020 (the plausible scenario sees headline inflation falling towards 0% by end-year), but the Committee forecasts CPI inflation to return to 2% by 2022. The MPC continues to be concerned by the potential longer-term supply effects of the pandemic, associated at least in part with reduced R&D spend and permanent capacity adjustment impacting longer-term productivity trends. This appears backed by research into pandemic effects suggesting that supply effects tend to dominate pandemics. However, the MPR also makes note of more recent research suggesting that supply effects merely result in larger demand shocks down the line. It concludes that research in this area is ambiguous. The MPC is also concerned that different economic sectors will see very different price responses, with some sectors seeing price increases. Moreover, it warns that aggregate prices may not be as dampened by increased economic slack, as firms costs may prove sticky and firms are unwilling to lower prices even if costs do fall as this may not be expected to lift sales volumes and firms may value short-term liquidity, rather than medium term market share. The overall impression is that if the outlook for growth is uncertain, the price outlook is even more so.

The BoE also published its Financial Stability Report (FSR) today. The FPC concluded here that banks were likely to have more than adequate capital buffers against the projected “plausible” scenario. MPC members stated that the financial system was in a position to support the economy, compared to during the financial crisis. MPC members were encouraged by the significant lending that had taken place already to the real economy and stated in the minutes that use of its CPFF scheme, which currently stood at £17bn, but had a capacity of around £50bn, would be taken into consideration. That the financial system has the capacity to support the economy is unequivocally beneficial, however, it remains to be seen how stimulative such lending proves.  

Today’s decision to leave policy – and particularly the QE total - on hold, we think, reflects a number of factors. First, monetary accommodation has been large and remains in place for now. Second, the MPC has little concrete evidence for the scale of the drop in activity this information will incur over the coming weeks, grounding the plausible scenario further in reality. Third, while the BoE appears to have little conviction over its inflation outlook, it does forecast this target in two years’ time. Fourth, the MPC has proven extremely sensitive to accusations on monetary financing, which it has strongly refuted, but today’s decision may reflect a desire to dampen such further speculation. These latter two arguments will persist for some time to come, however, the first two will expire over the coming month. A decision to extend QE or not in June will now be critical.

It is immensely difficult to try and forecast the future outlook against such a vast range of uncertainties and this creates important difficulties for an inflation targeting central bank, whose prime motivation is based on where it expects inflation to be in two years’ time. We fully recognise the uncertainties regarding supply impacts and different price movements in different sectors. However, we place more weight on the expected sharp demand shock associated with this pandemic. And our guess is that behavioural changes will create more persistent headwinds to demand growth. Moreover, in the context of a past decade that has seen a gradual lowering of inflation expectations on a global basis and technology add to structural capacity in the global economy, we suggest that the pandemic could exacerbate some of these disinflationary trends. With monetary policy already towards the limits of its support in many international economies and fiscal policy also stretched, we are more concerned about the risks of a longer-term undershoot of the inflation target. Many of these uncertainties will persist beyond the next few monetary policy meetings.

More concretely in the short-term, we fully expect continued elevated gilt supply beyond July, which would likely lead to an increase in gilt yields and a tightening in financial conditions if the BoE’s QE programme were to expire as currently scheduled in early July. As such, we fully expect an extension of QE at the next meeting on 18 June, we pencil in an additional £100bn, but do not expect this to be the last increase and so see risks that this could be larger in June. We acknowledge that the MPC has been proactive, in line with most international central banks. However, the support provided to the economy in the form of conventional policy – 65bps is small relative to previous downturns. Unconventional policy, QE has attempted to make up for it with a fast provision of £200bn of QE. However, long-term gilt yields have fallen by only around 50bps from Oct 19 – Jan 20 levels. This is around half the impact on longer-term yields assessed in the wake of the initial stages of stimulus in 20008-09. Finally, although the BoE has undertaken other measures in the form of the Term Funding Scheme with additional incentives for SMEs (TFSME), it is unclear as yet how much any additional borrowing will result in corporate spending, and hence how stimulative this will ultimately prove.

Financial market reaction was relatively muted. 2-year and 10-year gilts rose by 2bps to 0.02% and 0.25% respectively. Sterling posted a more substantial rise of 0.5% to the US dollar (<$1.24) and 0.4% to the euro (to £0.876). Market reaction was likely muted with policy changes in line with most market expectations and not significantly challenging broader views that QE would extend beyond July.