SH – 07 October 2011: BofE and ECB unveil new stimulus

– In his final meeting as President of the ECB, Jean-Claude Trichet announced Europe’s key interest rate is to
remain at 1.5%

– What we were surprised with was the additional €40 billion of covered bonds purchases, which are also positive for the banking system.

The Monetary Policy Committee concluded their meeting this month by voting to expand the Asset Purchase Scheme from £200bn to £275bn, with purchases to complete over the next four months. The committee also voted to keep interest rates on hold at record low levels of 0.5%.

The Bank of England has moved quickly to restart quantitative easing (QE) as fears mount of a double-dip recession. ONS figures released earlier this week showed that the recession had been deeper than previously estimated, while growth in recent quarters had also been revised down. In addition, the Bank of England is clearly concerned by the crisis engulfing the eurozone – the UK’s largest export region.

In our view, the restarting of quantitative easing will boost confidence and asset prices in financial markets, but we remain sceptical over its power to restart lending, and therefore have a meaningful impact on the real economy. Where QE might have an impact is on sterling. If the purchases of assets lead to a depreciation in sterling, then this could boost demand for UK exports. However, the depreciation would also raise inflation for households, who are already struggling to make ends meet.

Given our scepticism on the impact of QE, we expect the Bank of England to announce even more QE in February 2012, as the latest programme comes to an end.

European Central Bank

In his final meeting as President of the European Central Bank (ECB), Jean-Claude Trichet announced that the ECB’s governing council decided to keep Europe’s key interest rate at 1.50% despite most tremendous pressure from financial markets and international agents calling for a cut in interest rates.

The keeping of rates on hold was in line with our forecast, and so was the announcement that the ECB will be conducting new one-year unlimited liquidity auctions designed to provide longer-term funding for the ailing European banking system. What we were surprised with was the additional €40 billion of covered bonds purchases, which are also positive for the banking system.

Trichet and the ECB have been consistent in their use of policy tools and their separation principle: interest rates used to manage price stability, while non-standard measures such as the liquidity auctions used for credit and banking problems. Given that much of the concern over the last month has been over the health of the banking system, today’s policy action is appropriate.

However, some leading economic indicators have been signalling a slowdown in growth across Europe, while the ECB also admits that risks to their growth outlook appear on the downside. Many economists have been downgrading their forecasts aggressively, with a number now forecasting recessions in core Europe as well as the periphery. We expect growth to slow which is consistent with some of these indicators, though we are not forecasting a recession in countries such as Germany and France. Weak confidence will dent growth, but with interest rates very low, and the euro falling against most major currencies, the export-orientated economies should manage to keep growth going.

Meanwhile, inflation across the eurozone remains a problem for the ECB. While the Bank of England is comfortable restarting QE with inflation approaching 5%, the ECB is certainly not. The rise in eurozone inflation to 3% (flash estimate for September) may have been key to keeping ECB rates on hold this month.

Finally, it’s worth remembering that money market rates are already trading well below the base rate given the huge amount of liquidity the ECB is providing. It is arguable that a rate cut today would have made much of a difference to the real economy.