With the two leading central banks in Europe scheduled to make monetary policy announcements on Thursday, we are looking forward to an active and busy trading session. Throughout the past year, the Bank of England’s monetary policy meetings had very little impact on the British pound because outside of an increase in Quantitative Easing in October 2011, the central bank remained on hold for most of the year. Unlike the European Central Bank who holds a press conference after every meeting regardless of whether monetary policy is changed, giving investors the opportunity to dissect where the central bank stands, the BoE does not release a statement unless changes are made. This month however, the focus will be on the GBP versus the EUR. While the ECB is expected to leave their main refinancing rate at 1.00 percent, the BoE is expected to raise asset purchases by GBP 50 billion to GBP 325 billion. Considering that the Eurozone is the source of global uncertainty, many investors may be wondering why U.K. policymakers feel that it is necessary to increase monetary stimulus and Eurozone officials do not. The answer lies in the performance of both economies since the last monetary policy meeting, the scale of the drop off in inflation and the amount of support that has already been provided.
UK vs. EZ - Tale of Two Economies
Since the January monetary policy meeting, there was more deterioration than improvement in the U.K. economy. Retail sales rebounded in the month of December, but early signs of consumer spending in January showed a pullback in demand. Consumer confidence indicators have been mixed with little improvement in the labor market. Prior to the last monetary policy meeting, the U.K. ILO unemployment rate rose to its highest level in 16 years and in December it stayed at that level. Manufacturing and service sector activity accelerated in January but these improvements were undermined by the contraction in GDP in the fourth quarter which raised concerns about the U.K. economy falling back into recession. Before the PMI numbers were released, investors had been looking for asset purchases to increase by GBP75 billion but the acceleration in economic activity coupled with the rise in equities and stabilization in the financial markets led to the tempering of expectations. Yet the main reason why the BoE is expected to ease at all is because the central bank made their intentions to expand asset purchases very clear in their November Inflation Report and at every opportunity since then. How changes in inflationary pressures are impacting U.K. and EZ monetary policy decisions are so important that we have dedicated a section discussing this below.
UK vs. EZ – Urgency of Inflation
The latest inflation reports show price pressures declining in both the U.K. and Eurozone. The most recent figures that we have from the U.K. dates back to December when the annualized pace of CPI growth fell from 4.8 to 4.2 percent. Since then, there have been early hints that prices have fallen further according to the British Retail Consortium’s Shop Price Index. Although annualized CPI growth is well above the central bank’s 2 percent target and 3 percent pain threshold, the BoE is very concerned about the possibility of inflation undershooting their 2 percent target in the medium term. Throughout the past year, they have stubbornly predicted a sharp decline in price pressures even as CPI reached a high of 5.2 percent. In the past year, inflation has indeed fallen sharply as the effects of last year’s VAT tax increase and higher energy prices drop out of the annual calculation. According to their November inflation projections, without a further expansion in asset purchases, CPI could undershoot their 2 percent target by as much as 75bp in the medium term. The BoE currently expects CPI to fall to 2.2 percent by the end of the year, which would represent a sharp decline over a very short period of time. Considering how close this projection is to their 2 percent target, there is an underlying urgency within the central bank to avoid the need to loosen monetary policy aggressively and risk stoking sharp inflationary pressures later on if inflation undershoots.
Inflation has also declined in the Eurozone but not by nearly as much. In January for example, the annualized pace of CPI growth in Germany slowed slightly from 2.1 to 2.0 percent. In the Eurozone, we only have data going back to December and even then inflation slowed to only 2.7 from 3 percent. Having cut interest rates by 25bp in both November and December, the ECB has taken steps to keep inflation from falling sharply. According to the last monetary policy announcement, the central bank expects inflation to stay above 2 percent for several months to come, before declining below that level. This indicates that there is a very different level of urgency on inflation in the ECB compared to the BoE this month which explains why UK policymakers are expected to ease and EZ is not.
Unlike the Bank of England, the European Central Bank provided a great deal of stimulus to the region’s economy towards the end of the year. Aside from cutting interest rates by a total of 50bp, they also provided a tremendous amount of liquidity. Last year, the central bank started a Long Term Repo Operation where it offered unlimited amounts of 3 year liquidity to banks in return for collateral with credit ratings as low as Single A – demand was extremely strong with the ECB lending EUR489 billion, the highest ever for a 3 year operation. Flushed with liquidity, banks have become more willing to buy sovereign debt and lend in general, helping to ease credit conditions around the world. At the end of February, they will be conducting another massive LTRO program and the ECB does not plan to ease monetary policy further ahead of the liquidity injection. The central bank will want to wait and see how the second 3 year refinancing operation impacts the market before cutting interest rates again. Although we expect ECB President Draghi to sound slightly more upbeat, he will still leave the door open for additional rate cuts this year.
The last time the Bank of England provided any additional support to the U.K. economy was back in October. For the past few months, they have been riding on the coattails of the ECB’s operations but with inflation falling sharply and growth contracting in the fourth quarter it is their turn to step up support for their own economy.
Impact on GBP and EUR
Both the British Pound and euro have weakened against the U.S. dollar ahead of Thursday’s monetary policy announcements. Since the middle of January, the GBP/USD has appreciated more than 4 percent and the sustainability of these gains will hinge upon the central bank’s monetary policy decision. The 3 most likely scenarios for the GBP tomorrow are the following – the BoE could keep their QE program unchanged, which would drive the GBP/USD towards 1.60. They could opt to raise it by GBP50 billion and say something bullish about the economy which would minimize the downside impact of more QE on the GBP or they can raise asset purchases and warn of more to come, which would probably send the GBP/USD to 1.57.
The EUR on the other hand will probably have very little reaction to the ECB monetary policy announcement. ECB President Draghi’s post monetary policy meeting press conference will be main driver of volatility in the euro. If Draghi emphasizes the improvements in the region’s economy over the downside risks, the EUR/USD could break above 1.33. If he downplays the improvements and overemphasizes the possibility of more stimulus, the EUR/USD could slide back towards 1.31.
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