Money Moves Markets

Today’s Inflation Report signals that the MPC sees little mileage in further cuts in Bank rate and will soon start buying gilts as well as corporate securities with the explicit aim of boosting the supply of broad money. This shift is significant and welcome but the new policy needs to be implemented swiftly to affect macroeconomic outcomes this year.

The central growth and inflation projections in the Report stretch plausibility, with GDP forecast to recover rapidly from the third quarter and annual CPI inflation below target as far as the eye can see, despite sterling’s plunge and next year’s VAT hike. There is a suspicion that the MPC is downplaying inflation risks to justify its new policy of printing money.

Further points:

The Report argues that additional cuts in Bank rate might provide little stimulus, either because banks fail to pass them on to borrowers or their own interest margins are squeezed, damaging earnings and lending capacity. The MPC is therefore close to embarking on quantitative action beyond the current Asset Purchase Facility (APF) remit. Specifically, the APF will be expanded in scope and scale and financed by creating bank reserves.

The Bank of England’s adjusted M4 measure – excluding financial intermediaries – rose by just 3.8% in the year to December. To bring the annual growth rate up to, say, 8%, adjusted M4 would need to expand by about £70 billion. The Bank’s asset purchases are unlikely to have a one-for-one impact on M4 so the buying programme may need to exceed £100 billion to have the required impact on monetary trends.

While it is difficult to infer precise figures from the chart, the central growth projection based on unchanged interest rates is consistent with GDP declining by about 1.25% and 0.5% respectively in the first and second quarters before stabilising in the third. It then embarks on a strong recovery, rising by more than 0.75% per quarter over the following year. This is not impossible but looks unlikely barring an early substantial pick-up in money growth.

The central inflation forecast shows the annual CPI increase falling to a trough of about 0.75% in the fourth quarter, recovering to 1.25% in the first quarter of 2010 as the recent VAT cut is reversed but slumping back below 1% later in 2010 and in 2011. The 2010 numbers look suspiciously low given the VAT change and likely lagged effects of the large fall in the exchange rate (manufactured import prices rose 14% in the year to December).

The Report assumes the December VAT cut lowered the CPI by about 0.75 percentage points. This implies that annual inflation will rise by 0.75 percentage points when the reduction drops out of the annual comparison in December 2009 and by a further 0.75 points when the 17.5% rate is restored in January 2010. Yet the Report forecasts an increase of just half a point between the fourth quarter of 2009 and the first quarter of 2010. Put differently, tax-adjusted inflation would have to fall to 0-0.5% for the 2010 projections to be met.