The minutes from the latest Bank of England meeting held earlier this month were broadly dovish. Although there was no change in the voting pattern - all nine members voted to keep rates on hold at 0.5% and Adam Posen was the only member to vote for more QE - the tone of the minutes has changed dramatically in line with a weakening economic backdrop and a deterioration in the sovereign debt crisis in Europe.

Global economic outlook:

  •  The minutes noted that UK interest rate expectations in the UK had fallen dramatically in the weeks leading up to the September meeting, and rates were expected to remain on hold for 2 years considerably longer than previously thought.
  •  The BOE was also concerned by the tightening in short-term dollar funding conditions and the virtual closure of corporate bond and bank term funding markets to new issuance which affected banks in the UK along with the Eurozone as fears over a Greek default mounted. This is a major problem for UK banks, especially those who haven't funded themselves to the year-end.
  •  The bank also noted the slowdown in global growth indicators and noted that the global slowdown could be more protracted than forecast in the August Inflation Report, highlighting the quick deterioration in the economic outlook in recent weeks.

UK economy:

  •  The deterioration in economic growth was mainly due to external factors such as a slowdown in global trade and financial market volatility affecting consumer confidence.
  •  Although inflation remains elevated the MPC still sees inflation falling back sharply in 2012, especially if the employment picture continues to deteriorate.
  •  The minutes noted there remains substantial risks to inflation in the medium-term in both directions.

The outlook for policy:

  •  Dovish: The MPC may have kept rates on hold, but it reviewed a range of policy actions to loosen monetary conditions further since the downside risks to inflation had increased with the weakening economic outlook.
  •  These policy actions included: more QE, changing the maturity of the assets it holds on its balance sheet (a bit like Operation Twist expected by the Fed later today), lowering interest rates below 0.5%, and providing explicit guidance about the likely future path of the Bank Rate beyond what is available in the Inflation Report (also very Fed-like).
  •  Most members thought it was increasingly probable that further asset purchases to loosen monetary conditions would become warranted at some point

Overall:

The Bank may not have done anything at its September meeting but the whole tone of the minutes has shifted compared with August. Now the fear is that inflation (which has been above target for years) will fall too sharply as the economic outlook deteriorates. This increased risk of deflation has worried policy makers to such a degree the majority of MPC members think there will be further policy loosening at some stage.

The fact the Committee discussed possible measures that could be used to loosen policy further is extremely dovish, and follows the Fed. In fact the BOE seems to be taking its cues from across the Atlantic. Not only is it looking at the possibility of more QE, and cutting interest rates below 0.5%, but it is also considering the possibility of explicitly committing to keeping rates on hold for a prolonged period and extending the maturity of the assets it holds on its balance sheet - thus keeping rates lower for longer.

But what will happen next? We have seen economic and financial market conditions deteriorate even more since the September meeting so we may get some more calls for QE in October. However, in terms of further policy action to loosen monetary conditions this may wait until November. This is a traditional month when the Bank announces policy changes since it coincides with the release of the last Inflation Report of the year. Thus, we could see a further loosening of policy get priced into the rate and FX markets in the coming days and weeks. The Short Sterling December contract along with the pound has had a big move today. GBPUSD has found support at 1.5620, however, depending on how dovish the Fed is later we may see a further decline in sterling in the coming days. Added to this, until the ECB adopts a more dovish stance EURGBP is likely to remain supported. So for now the pound is likely to be the laggard of the majors. And due to the tight relationship between rate expectations and the pound, as long as looser policy remains on the cards at the BOE this is pound negative.

3-month GBP swap rates (white line) and EURGBP. Swap rates are a good indicator of rate expectations and tend to move in-line with sterling, as swap rates have fallen EURFGBP has stayed elevated albeit in a range.

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UK-US 2-year government bond yields (white line) and GBPUSD (green line) - as the yield spread has fallen this has dragged GBPUSD lower, although we have to wait for the Fed this evening to determine the future direction of GBPUSD.

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Kathleen Brooks| Research Director UK EMEA | FOREX.com

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