There were no rate changes or surprises from European central banks on June 4. The Bank of England refrained from extending the funds for its asset purchase program, while the European Central Bank (ECB) only added details to its plan to buy £60 billion ($85 billion) of covered bonds. ECB President Jean-Claude Trichet was adamant that this was not "quantitative easing," but "enhanced credit support," and also repeated again that current rates are appropriate. This supports our view that rates have troughed.
The ECB confirmed that it will purchase £60 billion of covered bonds, and said purchases will take place between July of this year and the end of June 2010, in both the primary and secondary markets. Bonds will have to be euro-denominated and issued in the euro zone, and eligible as counterparts in the ECB's credit operations. Trichet said the purchases will be spread over the euro zone and suggested that the central bank is likely to concentrate on three-to-five-year bonds.
Trichet once again stressed that the program does not constitute quantitative easing but, rather, enhanced credit support, and said he expects automatic stabilization. The ECB continues to concentrate on the banking channel in its approach to the crisis. The focus on covered bonds also means that the ECB has minimized its risk exposure.
Trichet said in the introductory statement that "current rates are appropriate, taking into account" the ECB decisions of early May, "including the enhanced credit support measures, and all the information and analysis which have become available since then." The central bank said it confirmed its expectation that "price developments over the policy-relevant horizon will remain dampened by the marked weakening of economic activity in the euro area and globally." At the same time, after two quarters of very negative growth, "economic activity over the remainder of the year is expected to decline at much less negative rates" and positive growth rates are expected by the middle of next year.
This assessment already incorporates adverse lagged effects, such as the expected deterioration in labor markets. Also, inflation expectations remain "firmly anchored," and the ECB expects "price stability to be maintained over the medium term, thereby supporting the purchasing power of euro area households." This introductory statement is clearly more optimistic on the growth outlook than the previous one, and the fact that the central bank judges rates to be appropriate backs our view that the refi rate has troughed at 1.00%.
The latest ECB staff projections show GDP growth this year at -5.1% to -4.1%, which brackets a midpoint of -4.6%. Growth next year is seen between -1.0% and 0.4%. Both projections are lower than the previous staff forecasts, but the ECB already suggested at the last meeting that growth forecasts will be revised down, which indicates that the last cut already took account of the weakened outlook.
The ECB still judges risks to the outlook for economic activity to be balanced. On the one hand, there are concerns that the turmoil in financial markets could have a stronger impact on the real economy, as well as that protectionist pressures could intensify and that there could be adverse developments in the world economy stemming from a disorderly correction of global imbalances. The ECB now also sees risks from "more unfavorable developments in labor market."
Openings for Optimism
On the other hand, "there may be stronger than anticipated effects stemming from the extensive macroeconomic stimulus under way and from other policy measures." There may also be a quicker improvement in confidence than currently expected. This again sounds more optimistic than last month, which is no surprise after the wave of positive survey findings since the last meeting.
Turning to inflation, Trichet noted the decline in the headline rate to just 0.0% year-over-year in May, but repeated that "the further decline in inflation rates was fully anticipated and primarily reflects base effects resulting from the sharp swings in global commodities prices over the past 12 months."
Trichet said again that, due to base effects, annual inflation is likely to decline further, and remain negative over the coming months before rising again later in the year. Trichet repeated "such short-term dynamics are, however, not relevant from a monetary policy perspective." The new staff projections show inflation around 0.3% this year and 1.0% next, which is little changed from the March projections. Trichet stressed that medium term inflation expectations "remain firmly anchored in line with the Governing Council's aim of keeping inflation rates at levels below, but close to 2% over the medium term."
As last month, the ECB judges the risks to the inflation outlook to be broadly balanced, and Trichet repeated that they "relate in particular to the outlook for economic activity," while on the upside they relate to higher-than-expected commodity prices. The ECB now also warned that "increases in indirect taxation and administered prices may be stronger than currently expected owing to the need for fiscal consolidation in the coming years."
Decline in Money Supply Growth
Turning to monetary developments, the ECB noted the marked decline in M3 growth and the pace of underlying monetary expansion, as well as private sector credit growth. However, the central bank continues to suggest that the deceleration in lending to non-financial corporations partly reflects "a lower need for working capital" and is demand-driven. The statement reads that "the past reductions in key ECB rates have continued to be passed on to lending rates to both non-financial corporations and households," adding that "the resulting improvement in financing conditions should provide ongoing support for economic activity in the period ahead."
The ECB summarized that "the current key ECB interest rates are appropriate taking into account our decisions of early May, including the enhanced credit support measures, and all the information and analysis which have become available since then." Growth is expected to stabilize and improve gradually. Inflation expectations remain firmly anchored in line with price stability, while the cross check with the monetary analysis supports the assessment of moderate inflationary pressure. Against this background the ECB expects "price stability to be maintained over the medium term."
Trichet stressed that monetary policy works with time lags and will therefore take time to feed through. Once the economic environment improves, "the Governing Council will ensure that the measures taken can be quickly unwound and the liquidity provided absorbed."
The ECB is clearly seeing light at the end of the tunnel, and there is no sign that further rate cuts are in the pipeline in this environment. The refi rate has very likely troughed at 1.00%, and a widening of the covered bond purchase program is only a possibility if markets take another turn for the worse. In the central scenario this is likely to have been "it" from the ECB.
Squeezing Out Liquidity
We expect the ECB to keep rates unchanged for the rest of the year, and the ECB will likely start to take some of the extra liquidity out as the economy stabilizes next year. Indeed, with the ECB starting to see past the current crisis and towards appropriate exit strategies, a rate hike could come quicker than many thought. It is no surprise that Bund futures nose-dived during the press conference.
Turning to the Bank of England (BoE), the British central bank held its asset purchase target steady at £125 billion ($201 billion), and kept the repo rate stable at 0.5%, as expected. The BoE expects it will take another two months to complete the purchases, which is in line with its May estimate. The bank also reiterated that the scale of the program will be kept under review.
There had been some hopes that the program would be extended by another £25 billion ($40 billion) this month as well, as it did in May, but the BoE statement included no details on its outlook or reasoning behind its decision.
The BoE Monetary Policy Committee (MPC) minutes from the May meeting, combined with its May inflation report, suggest that the central bank could hold the repo rate at a record low of 0.5% for longer than market players had previously anticipated, and that the Asset Purchase Facility could be extended further, despite some signs that economic contraction is now slowing.
In line with the IMF, the MPC appears weary of placing too much emphasis on these early encouraging signs. They prefer to continue to support markets by purchasing Gilts, but also corporate bonds and commercial paper, in an effort to underpin lending and thus money growth in the economy. We expect the BoE to hold the repo rate steady until the second quarter of 2010, with the possibility of increasing its asset purchase target by another £25 billion to £150 billion.
Meanwhile, the dynamics of the MPC are changing. Arch-dove David Blanchflower participated in his last meeting in May, and was replaced by David Miles at today's meeting. In April, in his position as Morgan Stanley's (MS) chief U.K. economist, Miles expected British gross domestic product to contract by just 1.3% this year, one of the most optimistic forecasts among City economists. However, we do not believe this change to the MPC will significantly speed up the timing of the first rate hike.
BoE MPC minutes from the Mar. 4-5 meeting showed that the committee thought the asset purchases would be the most effective if the purchases were from the domestic non-bank financial sector. However, so far banks have been more eager to sell their Gilts, though recently there has been a pickup in demand in the non-competitive auctions. Libor spreads over OIS have tightened since the scheme was announced, Libor has come down, and three-month Sterling Libor has narrowed the gap to Euribor, although the former is still higher despite a lower policy rate. Meanwhile, M4 money supply data have not shown any improvement from the BoE's unfunded asset purchase program.
The BoE suspended its monthly reserves target arrangements with commercial banks in March. The Bank is now targeting a net supply of reserves around the levels initially envisaged by banks for March, plus the amount of reserves injected via the BoE's asset purchase program. In order to achieve this, the central bank continues to hold weekly OMOs. At the same time, the rate paid on the operational deposit facility has been cut to zero, while the rate on the lending facility is at 0.75%.
Mortgage Lending Stabilization
Cutting the deposit rate to zero should minimize the risk that additional liquidity will remain within the banking system and, as the BoE eased refinancing conditions for banks, Prime Minister Brown and Chancellor Darling urged banks to pass on the recent BoE rate cuts to their customers. Nationalized Northern Rock set an example and started to expand its mortgage loan book, rather than to actively shrink it. Meanwhile, banks participating in the government's Asset Protection Scheme are required to increase lending to British businesses and home buyers. So far, only RBS (RBS.L) and Lloyds Bank Group (LLOY.L) have signed up to the program.
There is some encouraging evidence of mortgage lending stabilization. April mortgage lending data revealed 43,000 new mortgage approvals (median 41,000) vs. 40,000 in March. This is up from a low of 27,000 in November of last year, but still well below last April's new mortgage approvals reading of 54,000. Meanwhile, the BoE's Q1 Credit Conditions Survey reported some mild improvement to credit availability, and lenders expected increased availability in the second quarter for both households and corporations. Demand is expected to deteriorate further and funding costs are rising. The survey nevertheless suggests that efforts made by the BoE and the government are starting to have an impact.
The economy contracted by a sharper-than-expected 1.9% quarter-over-quarter in Q1 (median -1.6%). This decline left a 4.4% drop on the year, and the drop followed a 1.6% quarter-over-quarter drop in the final quarter of 2008. Consumer spending fell 1.2% quarter-over-quarter to leave the sharpest decline in almost 30 years. Yet, the first quarter is expected to have been the worst, and growth should contract by a slower pace in the second quarter.
Indeed, recent PMI figures suggest that confidence has bottomed. The services PMI broke through the 50-mark in May, indicating that the sector is now expanding, and manufacturing PMI has risen sharply since February. Similarly, retail sales continue to surprise on the upside, even though tight credit conditions, falling house prices, and the rapidly deteriorating labor market should all keep a lid on retail spending ahead.
In an environment of weak demand, CPI is likely to fall sharply this year, and we expect the measure to turn negative in the second half of 2009 before picking up again in 2010. April CPI stood at 2.3% year-over-year, which is still above the 2% inflation target, but we expect the measure to turn negative in the second half of 2009. Meanwhile RPI has already turned negative in March—for the first time since 1960—and stood at -1.2% year-over-year in April. Housing costs have come down sharply on the back of aggressive BoE rate cuts since Q4 of 2008.
As elsewhere, however, base effects from energy prices play a major role, and should lift inflation again in 2010, together with the planned increase to the VAT rate next year.
The risk of widespread deflation still appears small. For once, the weaker pound will lead to increased import price pressure, and inflation expectations remain anchored. The February BoE Inflation Attitudes Survey showed a further decline in median inflation expectation 12 months ahead to 2.1% year-over-year, which left the lowest reading since May 2005. However, this is still above the BoE's 2% inflation target. The Citigroup/YouGov's inflation expectations survey showed expectations 12 months ahead at just 1.6% year-over-year, but public inflation expectations for 5 to 10 years ahead still stand at 3.0%—which is clearly above the 2% target. This not only confirms that deflation risks are limited, but also stresses the need for credible exit strategies from current crisis programs for both the BoE and the government.
Like the ECB, the BoE will need to tighten policy again when growth starts to stabilize in order to prevent an overshooting of inflation expectations, while the government will be faced with the difficult task of reigning in a budget deficit that threatens to run out of control. It may be tempting to use reinflation and a falling currency as a way to deal with mounting debt levels, but these are short term solutions that leave later generations to pay the bill.
BoE Deputy Governor Bean provided some insight to possible exit strategies from its quantitative easing and tighter monetary policy in a recent speech. Bean noted that the repo rate might well be pushed higher before the central bank will start unwinding its asset purchases. The comments could have been aimed at calming market fears that the MPC might start unwinding its gilt holdings while at the same time the government is issuing record amount of public debt.