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On Thursday 6th October at 1200 BST/ 0700 ET the Bank of England (BOE) will announce its interest rate decision and its asset purchase target. We expect the Bank to keep interest rates at 0.5 per cent for the 33rd consecutive month. However, whether the BOE decides to increase its asset purchases - also known as quantitative easing (QE) - is a much closer call.
The Bank has kept its asset purchase programme steady at GBP200bn since November 2009. However, over the last few months the BOE has shifted to a much more dovish stance, which has boosted the chance of an increase in asset purchases, possibly to the tune of GBP50bn. We think there is a 30 per cent chance of an increase in asset purchases at Thursday's meeting; however we anticipate the rate-setting Committee to wait until November before pulling the trigger on more QE.
Over the last three months a few things have happened that makes another round of QE likely. Firstly, the economic outlook has darkened, global consumer confidence has tumbled and the economic crisis in Europe has reached a critical phase. This latest flare-up in Europe's sovereign debt crisis is threatening the banking sector, which has led to fears of a 2008-style credit crunch. If banks can't access funding then they can't lend, which will hurt the economy. So the BOE may think it is necessary to step in with more liquidity to boost lending and safe-guard growth. Another reason is that although growth slowed to a mere 0.1 per cent in the third quarter the government is sticking to its fiscal consolidation plans. Thus it is left to the Bank of England to plug the growth gaps caused by a contracting public sector.
The dynamics at the BOE have also changed. Hawk Andrew Sentence left the committee in May and at the last meeting no member voted for any tightening of policy. Hence the bar has been significantly lowered for more QE. Indeed, the minutes of the September meeting suggested that the decision was finely balanced on whether to embark on more last month.
So why wait until November? The answer is inflation. Prices in the UK continue to rise sharply, and the Bank expects prices to peak at 5 per cent in the coming months. Thus expanding the money supply at the same time as prices are rising opens the BOE up to criticism that it is fuelling inflation. We think the MPC is more likely to wait until November when it presents its last Inflation Report of the year before it acts. The Inflation Report will contain the Bank's latest growth and inflation forecasts. We expect these to be significantly lower to reflect the hobbled global economic environment that will put downward pressure on prices going forward. Thus, the Bank can use the report as evidence to back up its decision, which could limit the amount of criticism it has to face.
But the BOE may be about to play a dangerous game. As households pay off debt and consumption remains weak it is hard to see how more QE is going to boost the economy, especially when negative real interest rates aren't currently helping growth. The BOE is playing with its own credibility in our view and further QE past November will depend on the outcome of events in Europe.
If the Bank announces QE tomorrow then expect a dip in the pound. We could even see below 1.5350 in the short-term, which would open the way to 1.5000 - lows last reached in mid-2010. QE is usually negative for currencies and with the Federal Reserve keeping the size of its balance sheet steady with Operation Twist and the ECB reluctant to embark on QE, the pound could soon be winning the battle of the ugliest currency in the G10. However, if they decide to hold then sterling is likely to move in line with risky assets like the euro and stocks and we will have to wait for the minutes of the meeting, released on 19 October, to determine whether QE remains on the cards for next month.
Chart: UK Sonia GBP 3-month swap rates (white line) and GBPUSD. Rate expectations have fallen sharply in the last 6 months, and in recent days we have seen the prospect of QE tomorrow starting to get priced out as investors expect the bank to wait until November. If the BOE pulls the trigger at tomorrow's meeting expect rate expectations to fall and this to drag sterling lower.
Kathleen Brooks| Research Director UK EMEA | FOREX.com
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