Dovish Tones in Bank of England and Fed Reports

October 20, 2010

It has become gospel in central banking circles that important policy changes must be communicated clearly in advance in order to produce desired market reactions.  Minutes from the Bank of England’s October 6-7 meeting and the Fed’s report on regional economic conditions, known as the Beige Book, constitute an education of the public to anticipate new quantitative easing as soon as the first week of November.

Bank of England minutes confirmed a 3-way voting split, which most analysts suspected would happen.  Andrew Sentance voted for a 25-basis point rate increase as he did at the four previous monthly meetings but offered nothing new to strengthen his argument.  For Mister Sentance, the need to raise the 0.5% Bank Rate is a matter of Bank of England credibility.  The mandate is to achieve a 2.0% CPI inflation rate, recognizing that deviations up to a percentage point above or below can and will inevitably happen and be tolerated if deemed temporary.  U.K. inflation has been 3.0% or higher each month of 2010, however, and such an overshoot cannot be overlooked by policymakers in the view of Mister Sentance without evoking a risk that people will take the promise of price stability less seriously.  That’s all the more true, since a coming hike in the value added tax is likely to put further upward pressure on the CPI.  There has been no sign that Sentance has converted any of the other policymakers to considering his recommendation of a rate hike.

Fellow policymaker Adam Posen wanted to increase the asset purchase target by 25% to Gbp 250 billion from Gbp 200 billion, and the minutes indicate that some other Monetary Policy Committee members, who sided with the majority vote of no change in policy settings, agree that “the likelihood that further monetary policy stimulus would become necessary in order to meet the inflation target in the medium term” has indeed increased.  Posen argued that stable expected inflation and subdued wage growth depress the risk of excessive inflation even if monetary policy is eased and who predicted a medium-term undershoot of the inflation target if such action is not taken.   Other policymakers were sympathetic to the arguments for more stimulus but did not vote for such a move this month, preferring to wait and see more data and explicitly citing next month’s quarterly inflation review.  The number of Posen sympathizers is not indicated, but it seems to be a majority of the 7 other officials who voted for not doing anything in October.  The minutes explicitly indicate that most believe the economy contains a considerable margin of spare capacity and, therefore, that demand could expand considerably before widespread capacity constraints put upward pressure on inflation.  With that belief structure, Britain’s economy may need to improve, not just fail to deteriorate, to convince the fence-sitters to wait another three months until February before taking action.

Top Fed officials have meanwhile signaled that the U.S. recovery needs to show improvement to avert additional quantitative easing.  The previous Beige Book had spoken of a broad deceleration of the rate of economic growth.  Today’s Beige Book covering developments in September and the first week of October does not indicate an additional decline in the rate of positive growth but calls that pace mostly modest.  Only in the Boston, Chicago, and Minneapolis districts has growth picked up or improved.  This does not meet Bernanke’s litmus test, so failure to announce quantitative easing on November 3 might imply a serious and regrettable split among policymakers with a majority taking a more hawkish stand than their chairman.

In a world where some central banks are raising interest rates, new stimulus has negative implications for sterling and the dollar.  The Bank of England minutes even hint that a reason to supply more stimulus is the failure of sterling depreciation thus far to lift net U.K. exports as much as hoped.  Competitive depreciation by everybody is self-defeating, however, and efforts to avoid an escalating currency war could override the predispositions of Fed and Bank of England policymakers and produce a different result than today’s publications suggest.  The near juxtaposition of Treasury Secretary Geithner’s endorsement of a strong dollar and a rate increase in China has market players on alert for the possibility of a coordinated truce on currencies.  Is this the eve of a second Plaza Accord?  One huge difference already comes to mind.  The original agreement among G-5 finance ministers at the Plaza Hotel in New York in September 1985 was a total surprise.  The diplomacy needed to reach such a deal usually requires complete secrecy and is best done with few, not many, negotiators.  Stay tuned.

Copyright Larry Greenberg 2010.  All rights reserved.  No secondary distribution without express permission.

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