RBS European Economics | Insights

1 August 2011

QE2: What will it take?
QE2: What will it take?
Summary 1. Background 2. BoE GDP forecasts 3. Inflation barrier 4. MPC Minutes & policy 5. Conclusions p.1 p.2 p.3 p.4 p.5 p.6

As UK GDP forecasts are scaled back, speculation about QE2 mounts. The MPC’s current growth projections are at least as weak as when the Bank announced its asset purchases in August (£50bn) and November (£25bn) 2009. But weak growth is not enough. Elevated and sticky inflation presents a significant barrier: CPI inflation is currently almost twice the average rate when QE purchases were announced. The MPC’s latest CPI projections are much less benign than they were in 2009 – and the inflation forecasting ‘baggage’ of the past few years will impose some constraints on future policy discretion. The launch of QE2 requires some combination of: further downward revisions to GDP forecasts, meaningful undershoots of existing MPC inflation projections, and perhaps even some form of systemic shock (most obviously euro area or US sovereign debt crises triggering a second credit crunch). UK QE2 may well require a ‘Lehman’ type event as this would, implicitly, necessitate a cross-border policy response – the BoE’s scope to go it alone seems much more constrained in 2011-12 than in 2009. Ceteris paribus, neither the GDP data (cumulative growth of just 0.2% over the past three quarters) nor the MPC’s current growth expectations obviously present an insurmountable hurdle to QE2. The May 2011 Inflation Report forecasts show the MPC expect the level of GDP to be 5.2% higher in two years’ time vs 5.0% in the August 2009 and 7.3% in the November 2009 Reports when a cumulative £75bn of QE was announced. But other things are not equal. The persistent inflation overshoot/BoE forecast error makes restarting QE more difficult – at least unilaterally. CPI inflation at 4.2% in June, and averaging 4.3% this year, is almost twice as high as the average rate prevailing when the four QE policy announcements were made during 2009 (2.2%). Moreover, during 2009, the MPC’s central expectation was for inflation to remain comfortably below target for almost the entire forecast period, in contrast to current projections which show an overshoot into 2013. The outstanding stock of QE purchases is at least as important as any additional flow. The £200bn of gilt purchases will not begin to mature until 2013 and, even then, the initial natural run-off is low: £7.7bn in 2013 and £20.9bn in 2014. The Bank has indicated that any further QE would be substantial in scale – this is not a policy instrument which lends itself to fine-tuning – so small-scale purchases to replace maturing gilts seems unlikely. The most recent MPC Minutes dampened expectations that QE2 is imminent. After markets seized on the line in the June Minutes that ‘further asset purchases might become warranted’ the Bank back-peddled in July, making no explicit mention of QE and referring to possible policy responses in a symmetrical fashion. In conclusion, from a macroeconomic perspective, inflation falling back towards its target is a more important prerequisite than a further deterioration in the growth outlook per se. The near-term prospects for inflation are not obviously conducive towards immediate QE2. Hence, whilst QE2 in 2011 cannot be ruled out entirely, its launch would probably require a ‘Lehman moment’ – ie, a major event carrying systemic risks. Be careful what you wish for.

Ross Walker UK Economist +44 207 085 3670 ross.walker@rbs.com www.rbsm.com/strategy Bloomberg: RBSR<GO>

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1. Background
RBS European Economics | Insights 1 August 2011 2 The economy continued to expand in Q2 but underlying growth remains rather sluggish and forecasts are being scaled back – the level of GDP is not expected to reach its previous (Q1 2008) peak until 2013 (Charts 1 & 2). This backdrop has encouraged a debate about further policy easing. The clear preference among UK policymakers (the Bank and the Treasury) has been for a tighter fiscal-looser monetary combination. As such, we would not expect any deterioration in growth to result in a dilution of fiscal tightening; rather, monetary easing (further QE) would be the more likely response. Whilst there is a debate to be had about the precise form QE would/should take – gilt purchases as per the previous experience, private credit purchases or even more radical steps such as equity stakes or even a more direct injection of liquidity (the metaphorical ‘helicopter drop’) – our strong expectation is QE2 would be overwhelmingly gilt purchases.

Chart 1: UK GDP: actual & RBS forecast
Level, Q1 2000 = 100
125 120 115 110 105 100 95 00 01 02 03 04 05 06 07 08 09 10 11 12

Chart 2: 2011 UK GDP forecasts
HM Treasury survey of independent forecasters, % y/y
2.8 2.6 2.4 2.2 2.0 1.8 1.6 1.4 1.2 1.0
Jan10 Apr10 Jul10 Oct10 Jan11 Apr11 Jul11

Consensus RBS

Source: ONS, RBS

Source: HM Treasury, RBS

A key issue now confronting sterling markets is: how bad will things need to get to prompt QE2? The experience of ‘QE1’ provides the most obvious benchmark. We consider both data trends and expectations for both GDP growth and inflation at the time of each QE policy announcement. Table 1 summarises the key variables. For GDP expectations, we produce the full calendar year growth estimates implied by the MPC’s published central projections for % y/y GDP. For inflation, we focus on the central projection in two years’ time – the MPC’s principal focus in terms of policy. The prevailing situation at the time of the 2009 QE policy announcements was typically one of recession with contraction/subtrend growth expected to persist over the first year of the Bank’s projection, before a recovery got underway in second year. Inflation data at the time varied, but CPI was generally expected to be some way below target. NB, QE policy announcements tended to coincide with Inflation Reports, so it is appropriate to treat these projections as the basis for the Bank’s policy response.

Table 1: Bank of England QE announcements
Timing & scale of QE purchases. Key GDP & CPI data & forecasts
QE announcement date QE addition, £bn QE total, £bn GDP, % y/y, latest data at time of QE -1.9 -4.1 - 5.6 -5.2 GDP, MPC forecast, % y/y (Yr 1 & Yr 2) -3.0, 2.3 -3.0, 1.8 -1.2, 2.8 0.5, 4.1 CPI inflation, latest data at time of QE, % 3.0 2.9 1.8 1.1 CPI inflation, MPC forecast at 2-yr horizon, % 0.5 1.2 1.4 1.7 Source: ONS, BoE, RBS

5 March 2009 7 May 2009 6 August 2009 5 November 2009

75 50 50 25

75 125 175 200

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2. BoE GDP forecasts: weak, but not weak enough
RBS European Economics | Insights 1 August 2011 3 The following charts (Charts 3-6) provide more detail on the MPC’s expectations for GDP at the time QE asset purchases were announced. The orange bars in the charts show the MPC’s central projection for the level of GDP when the QE purchase announcements were made; the grey bars show the latest forecasts for the level of GDP, contained in the May 2011 Inflation Report. Our approach is to chart the level of GDP, where the base of 100 is the latest available quarterly GDP level at the time each of the four QE purchase decisions were made. It is clear that the MPC’s growth expectations were significantly weaker in March 2009 (Chart 3) and May 2009 (Chart 4) than at present (ie, May 2011 Inflation Report).

Chart 3: BoE GDP forecasts
At time of March 2009 QE & latest projection, quarterly levels
110 108 106 104 102 100 98 Q Q+1 Q+2 Q+3 Q+4 Q+5 Q+6 Q+7 Q+8 Q+9 Q+10 Q+11 Q+12 MPC forecast at time of March 2009 QE Current MPC projection (May 2011)

Chart 4: BoE GDP forecasts
At time of May 2009 QE & latest projection, quarterly levels
110 108 106 104 102 100 98 Q Q+1 Q+2 Q+3 Q+4 Q+5 Q+6 Q+7 Q+8 Q+9 Q+10 Q+11 Q+12 Forecast at time of May 2009 QE Current MPC projection (May 2011)

Source: BoE, RBS

Source: BoE, RBS

The position in August (Chart 5) 2009 was almost identical to the current juncture. Most intriguingly, when the MPC announced its final £25bn tranche of asset purchases in November 2009 the GDP trajectory was significantly stronger than at present (Chart 6): whereas back in November 2009 the MPC expected the level of output to be 3.0% higher after the first year and 7.3% after two years, the comparable figures in the May 2011 Inflation Report are 2.5% and 5.2%.

Chart 5: BoE GDP forecasts
At time of August 2009 QE & latest projection, quarterly levels
112 110 108 106 104 102 100 Q Q+1 Q+2 Q+3 Q+4 Q+5 Q+6 Q+7 Q+8 Q+9 Q+10 Q+11 Q+12 Forecast at time of August 2009 QE Current MPC projection (May 2011)

Chart 6: BoE GDP forecasts
At time of November 2009 QE & latest projection, quarterly levels
112 110 108 106 104 102 100 Q Q+1 Q+2 Q+3 Q+4 Q+5 Q+6 Q+7 Q+8 Q+9 Q+10 Q+11 Q+12 Forecast at time of November 2009 QE Current MPC projection (May 2011)

Source: BoE, RBS

Source: BoE, RBS

In isolation, the MPC’s current (May 2011 Inflation Report) growth expectations appear to be sufficiently weak to allow them to deliver QE2. Yet, not only has the Bank not embarked on QE2, there has been only one of the nine members voting for it. Something else is presenting a more formidable barrier to QE: inflation.

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3. Inflation barrier
RBS European Economics | Insights 1 August 2011 4 We do not share the (seemingly ever more prevalent) view that the BoE has completely abandoned its inflation target – and, therefore, by extension that QE can be readily resumed. However, it is clear that the Bank is pushing its mandate flexibility – ie, the discretion it has to bring inflation back to target over a longer period of time – to the point where it appears to be a de facto nominal demand targeter. Implicitly, this approach gives more equal weight to real output and inflation. The key point is that with only one MPC member voting for QE (Adam Posen), against the backdrop of weak real GDP trends, this indicates that the inflation data do pose a significant hurdle to further monetary easing. Current inflation rates (4.2% in June 2011, and averaging 4.3% this year) are some way above where CPI was – and was expected to be – in 2009 when the MPC was implementing its QE asset purchases. The average CPI inflation rate when the (four) QE purchases were announced in 2009 was 2.2% (Chart 7) – substantially below current levels – and the MPC’s central projections were generally for CPI to be below target throughout the entire forecast period (Chart 8). The MPC’s 2009 forecast combination of weak GDP growth and below-target inflation provided the launch-pad for QE.

Chart 7: CPI inflation
CPI inflation & QE announcements (£bn)

Chart 8: CPI inflation & MPC forecasts
2009 Inflation Report central projections, %
6 Nov-09 Aug-09 May-09 Feb-09 Actual

50 75 50 25

4 3 2

5 4 3 2

1 0 Jan09 Jul09 Jan10 Jul10 Jan11

1 0 06 07 08 09 10 11 12

Source: ONS, BoE, RBS

Source: ONS, BoE, RBS

The Bank’s inflation forecasting ‘baggage’ is a barrier to QE2: over-optimism persisted throughout 2010 – though the February & May 2011 projections have, so far, proved more accurate (Chart 9). The MPC’s current expectations are for CPI to return to target in early 2013, hovering just below thereafter (Chart 10).

Chart 9: CPI inflation & MPC forecasts
2010 & 2011 Inflation Report central projections, %
6 5 4 3 2 1 0 06 07 08 09 10 11 12 13 14 Actual Aug-10 Nov-10 Feb-11 May-11

Chart 10: BoE CPI inflation fan chart
CPI projections based on market rate expectations, May 2011

Source: ONS, BoE, RBS

Source: BoE

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The most significant policy error – and where criticism is justified – centres on the Bank’s approach to the output gap. The conventional approach to estimating the output gap – in essence, comparing actual and forecast GDP outturns against an assumed underlying trend – may have functioned well enough during more benign phases of the economic cycle. It is less clear that this approach is adequate against the backdrop of an egregious credit boom, the most serious financial crisis in modern history and a crippling balance sheet recession. In short, the MPC appears to have under-estimated the size of the positive output gap in 2006-07 (ie, it under-estimated the macroeconomic overheating) and over-estimated the amount of spare capacity in the aftermath of the recession. Much of this comes back to the inadequacy of CPI inflation as a policy target – but that is another story. The pertinent issue here is that ‘permanent destruction’ of supply has almost certainly been greater than indicated by conventional output gap estimates or insolvency statistics. As such, we would expect the MPC to proceed more cautiously vis-à-vis any further significant monetary loosening.

4. MPC Minutes & policy: back-peddling in July
The June MPC Minutes fuelled speculation about QE2 with an explicit reference to more than one member mulling over asset purchases: ‘For some of these members, it was possible that further asset purchases might become warranted if the downside risks to mediumterm inflation materialised’ (Para. 25). This was a firmer and more specific statement than in the May Minutes which simply noted that: ‘were the downside risk to household spending to materialise, a path for policy weaker than that implied by market prices might become appropriate’. (Para. 36). At the time of the May Inflation Report markets were pricing-in 20bp of rate rises in 2011 and 70bp in 2012 – ie, the policy loosening option in May was for no (or smaller) rises in Bank Rate, rather than more asset purchases. Markets and City economists seized on the reference in the June Minutes to ‘further asset purchases’. Most significant is the apparent back-peddling by the Bank in July via a dilution of the wording in the Minutes (and this against the backdrop of a deterioration in the real economy and escalating financial market tensions). The July Minutes made no specific mention of further QE purchases and the reference to policy change was explicitly symmetrical: ‘If it were to become clear that one of those risks [upside or downside] had crystallised – and the medium-term outlook for inflation had deviated materially from the target in either one direction or the other – 5

RBS European Economics | Insights 1 August 2011

The Bank deserves some sympathy. VAT and other indirect tax hikes have been a significant upside influence on inflation (boosting CPI inflation on average by 1.6pp since January 2010 and currently accounting for 1.5pp – on the ONS’s assumption of a full pass-through). The MPC could not incorporate assumptions of indirect tax rises in its forecasts ahead of policy announcements by the Treasury (at least not explicitly in the central projections). Similarly, the MPC can be forgiven for under-estimating the scale of the external energy price shock – the Bank’s (eminently reasonable) forecasting convention is to assume that energy prices ‘evolve broadly in line with the paths implied by futures markets.’

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the Committee would respond by changing the stance of monetary policy.’ (Para 25). In short, the MPC appeared to make a clear effort in July to dampen market speculation that QE2 is imminent. RBS European Economics | Insights 1 August 2011 6

5. Conclusion
The Bank continues to interpret its inflation targeting mandate flexibly. The formal target enshrined in the Bank of England Act is ‘2 per cent at all times’. The MPC has always exercised discretion in terms of how quickly it has sought to bring periods of overshooting (or undershooting) inflation back to target – but never more so than now. To a large extent, given the scale and persistence of the inflation overshoot, nominal demand indicators have become the key lodestar for UK monetary policy. This approach means QE2 remains a live possibility. But it is an exaggeration to claim that the 2% inflation target has been completely abandoned – the scale of the current CPI overshoot does appear to be acting as a constraint on looser monetary policy. In terms of timing: inflation will either have to decline significantly – or the economy sustain a shock to demand of such severity that a sharp fall in future inflation becomes inevitable – before further quantitative easing can be pursued. In practical terms, with a meaningful downtrend in CPI unlikely before the turn of the year, February 2012 (an Inflation Report month) seems the earliest conceivable point at which QE could be restarted (barring a ‘Lehman’ type event in financial markets). For the record, our central view remains that there will not be a second wave of UK asset purchases and that the next move in policy will be a rise in Bank Rate (25bp in February 2012, with the risks skewed towards a later move).

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