If the markets had any doubts, easy UK monetary policy looks set to stay for a very long while. Japan is already over a decade in to quantitative easing and UK policy dynamics seem to be shifting that way fast. The latest missives from the Bank of England underline that the monetary policy regime will remain easy for a long time to come. Low rates, expansive money supply, and a weak UK pound should remain the cornerstones of excessive lean-to easy policy, especially while the UK government continues to batten down the fiscal hatches, taking money out of the system in the process. It will be up to new BOE governor-elect Carney what new box of monetary tricks will be applied to kick start the UK economy later this year.
The key is the economy and how soon it can reach escape velocity to break free from the gravitational pull of recession. Judging by recent trends, it could take years before the economy begins its escape into stronger growth velocity. Over recent years, the forces of UK de-industrialisation and the spectacular fall from grace by the UK banking sector have ripped a great hole into recovery prospects ahead. The problem with the BOE’s massive monetary mobilisation is critical lack of traction. The UK remains in a classic liquidity trap. Not enough stimulus money is getting through to the real economy as new credit. Meanwhile, those that are in a position to invest and spend are simply holding back in the face of dire economic prospects. Businesses are reluctant to invest in new capital while recession forces grumble around them. UK consumers are up against it too.
The odds are that UK interest rates could flat-line close to zero for the next five years. Apart from energy and government induced supply-side price rises, core UK inflation is dead in the water. Demand pull inflation risks are virtually non-existent too, especially while UK consumers remain under duress. The Bank is well aware of this. The hints from the BOE are that QE will continue to pump-prime more liquidity into the economy. Neither are they averse to more a weaker pound to fast-fuel UK export sector recovery.
The policy of low rates and keeping the economy awash with cheap cash takes a leaf from the US Federal Reserve’s book during the 1980s savings and loans crisis. Back then, aggressive Fed rate cuts steepened the US yield curve, boosting the banking sector’s natural franchise – borrowing short and lending long – and restoring better balance sheet profitability in the process. The BOE should succeed with lower rates and a steeper UK yield curve in exactly the same way. If UK banks are encouraged to lend more money, the economy should get stronger and bank profitability should recover in tandem.
The implications for UK markets are quite clear. Sterling will be going lower, tacitly-endorsed by the BOE. A test of USD1.40 should not be ruled out in the weeks ahead. The forex markets can take a clear hint. UK rates will be nailed to the floor close to zero for many years, while rising inflation expectations will continue to steepen the UK gilt yield curve. The UK’s recent credit downgrade will also play a part there as long term risk premiums lever up in the UK bond yield curve. While King’s ‘put’ continues to fast feed the free lunch on asset buying, how far investors travel along the Capital Market Line will depend on prevailing risk perceptions. If Italian politics manage to settle, irrational exuberance should let rip again. The 2013 equity rally is not over yet, just sidelined while Eurozone event risk sorts itself out.
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