Thursday’s FT has an interview with the Bank of England’s executive director for markets, Paul Fisher, on the subjects of quantitative easing, inflation, deflation, the output gap, money supply, and the UK economy in general.
The whole thing makes for worthwhile reading for QE-watchers, but we’ve provided some excerpts of the most salient points below.
To start with, here’s a rather amusing Q&A on the UK output gap — the theory beloved of central bankers in the US and UK. Put simply, when the output gap is a negative number, there’s said to be `slack’ in the economy — it’s operating below its full capacity. This, in traditional economic theory, suggests deflationary pressures as companies cut prices and jobs to deal with the spare capacity.
Here’s the Q&A:
FT: As you say, relative to the forecast of August 2007, the central forecast of 2009 was output 8% lower than that; so that is the amount of the economy has lost, at least in the short term. What is your sense of how much of that is permanent?
PF: This is extremely difficult to calibrate; I wouldn’t want to get hung up on a number. The most difficult thing for us to judge, going forward, is what happening to the supply side of the economy. It will be natural in the current circumstances for there to have been some damage done to the supply side, certainly in terms of the level of output that we expect to get back to; hopefully not the growth rate, although that can’t be ruled out. And in particular within that context it is the degree of difficulty caused by the impairment of the banking system and the restrictions on banks being able to lend; we don’t know precisely what sort of drag on potential growth and on actual growth that will have. So, that will again be a big focus of the discussions as we go through the inflation report round, trying to sort out exactly where the supply side of the economy is, because that is what we need to do to judge the outcome of inflation given the demand forecast.
FT: You must have some sort of sense though. You could have a range between zero and eight.
PF: A large chunk; a pretty large chunk.
FT: A pretty large chunk of the eight is spare capacity?
PF: No. It would be a reduction in supply, and still leaving a very significant output gap.
FT: So, pretty large chunk is a permanent reduction in supply?
PF: This is never completely permanent, but for the period of the forecast horizon there would be a reduction in supply.
FT: But still quite a large output gap?
PF: Still quite a significant output gap, which would last over the forecast horizon. The first thing to do is to get growth back to and above trend rates so you start closing the gap, and that is still some way off.
The output gap Q&A — and indeed the whole exchange — culminates in the below:
FT: And so the element of the output gap you were talking about earlier, which you think if largely over the supply. Does that mean that on longer-term inflation pressures you still think they’re very muted?
PF: Obviously the main way we look at this is through inflationary forecast which takes everything into account, which you want it to pick out some indicators, you look at the degree of spare capacity, what’s happening to money growth, which in absolute terms is still quite muted, and what’s happened to earnings growth, which is very muted. So there’s no medium term inflationary signals coming through from any of those sort of indicators. And inflation expectations remain fairly well behaved under the circumstances. So, there’s no medium term pressures coming through those indicators. Nor have we had in our medium term inflation forecasts ourselves.
Others will be more interested as to whether Fisher gave any hints about the direction of the bank’s QE programme.
The Bank of England is nearing the £175bn limit of its gilt-buying scheme and there is speculation as to whether it will decide to allot more money to the programme at its next meeting in November. Here’s the Q&A:
FT: Now we’re sort of coming close to the 175 limit which was decided in the August meeting. Using the knowledge you now have about how you think QE is working, both on asset prices and in confidence, if you stick at 175, what would you predict to be the effect on government bond yields and confidence?
PF: Well, first of all, let me say I think it’s unlikely we would ever say we had stopped, and that we were going to stick at a particular number. It’s much more likely, say, that we would pause. I think that’s important that we want to keep open the option of doing more later, even if we had formally stopped. And that may give people some pause for thought in terms of the market reaction. I think some of the expectations out there are a bit too black and white about the exact date on which we stop, and then after that, the next thing we’ll be selling. So I think we want to keep open our options at that stage.
And we don’t know. Everybody is telling us and expecting that there will be a reaction in gilt prices at that point, but we’ll have to wait and see. Certainly, the market remains with elevated volatility relative to normal.
But actually, I think the remarkable thing is how well the gilt market has functioned given that we now hold 165 billion of a market which in total is only 700 billion, including index linked and everything.
FT: So you must have some… before you can take a decision to pause, you must have a sense of how you think the market is going to react.
PF: I think what we have to decide always is what’s the important policy decision in terms of the medium run in the UK economy. That’s got to be our focus. Then you might want to try and mitigate any extreme market reactions to that. But you can’t let the short run market reaction dictate and stop you from pursuing the best monetary policy that’s in the best interests of the economy.
FT: You must have a sense of whether, if you paused, whether that would send gilt yields higher, because that’s one of the operations… the way that you have the effect on the economy as a whole. So you must have a sense of whether a pause would… you say people in the market tell you the gilt would rise, and that’s certainly what they tell us. Do you think that’s right or wrong? Because you’re going to have to have that sense before you take a decision.
PF: Well, no. If we think we’ve done… what we’ll be looking at is the medium run inflation outlook, and the short run fluctuations in gilt yields won’t necessarily impact too much on that. But yeah, you wouldn’t expect gilt yields to go down on the board’s announcement, so it’s a sort of one-sided bet in that sense.
But you don’t know. People obviously are expecting us to stop at some stage, and so to a degree it will be priced into the market. Whether we’ll do it in November or at some later date may be uncertain. But the fact of us reaching a stopping point shouldn’t be a surprise to anybody, and we’ll probably learn something when we get to that stage, and we’ll learn something which will help us then to set policy when it comes to selling in the future, or recommencing purchases.
Interpret that as you like.
But to get you started, here are the preliminary thoughts of Monument Securities’ Marc Ostwald:
Markets will also need to digest the implications of BoE’s Fisher suggesting that QE will be paused in November, and decide whether this is as much an exercise in damage limitation for Gilts, as well as a sensible approach, in so far as they should not be closing down their options to do more QE if needed. Nevertheless it does mean that the Gilt market will have to absorb an average £4.2 Bln of supply each week without the help of ‘a buyer of last resort’!
Related links:
Moving targets, QE edition – FT Alphaville
A gap in the output gap – FT Alphaville
Sticky inflation, redux – FT Alphaville