The Fed will be forced to pursue QE3 in 2012, but the UK should act before – Comment by Stuart Thomson, chief economist at Ignis Asset Management

• QE3 is not likely in the near-term
• The UK needs to act before the Federal Reserve
• UK growth will slow to 1.1% – central bank is too optimistic

“Picture the scene, the world’s best central banker calls the meeting to order, his acolytes crowd round, anxiously asking about additional quantitative easing, “are we there yet?”, “no” he replies, “ there is a small inflation hill to negotiate, but rest assured, we are getting closer”. The majority are reassured and vote for the current status quo, but the American continues his courageous demand for immediate asset purchases of £50bn.  We expect the Bank to resume unconventional monetary policy at its November or February meetings. In economic terms the choice, three months apart, is less important than the signalling message that the Bank wishes to convey. In other words, is it willing to cancel Christmas in order to regain anti-inflation credibility and review the impact of rapidly slowing inflationary pressures on consumers’ real personal disposable income, confidence and expenditure, or is it more concerned about the growth and the dangers of a double dip recession for over-leverage consumers, banks and government?  This is a political rather than economic decision, which would clearly be made easier if the Fed agrees to early QE3. QE3 is not likely in the near-term, but we believe that the Fed will be forced to pursue additional quantitative easing during 2012. The key question is whether the UK will lead or follow the US. We believe that the UK should pursue QE before the Fed, because fiscal austerity is more acute in the UK and the requirement for loose monetary policy to offset this economic squeeze is consequently more pressing. But we are acutely aware of the difference between prescription and description.

“As the August Inflation Report makes clear, headline inflation will peak within the next few months as the lagged impact of the higher energy prices over the past year feed through into utility prices between August and November. The Bank expects inflation to peak at 5% and then slow rapidly over the next 12 months. Once again the Governor provided a robust defence of policy, arguing that following the hawks’ demands for tighter policy would have boosted sterling and helped mitigate the import of higher imported commodity prices. However, this would have been at the expense of driving the economy back into a double dip recession, which would have been incompatible with its mandate. The outlook for inflation beyond the immediate hump is a clear vindication of the Governor’s forecast. Inflation is expected to slow rapidly from November onwards, breaking back below the official 2% target by next April.  The two hawks, Spencer Dale and Martin Weale have reversed their misguided calls for hikes, but this is a far cry from moving to additional easing. The hawks would prefer to wait until inflation reaches this “promised land”, regaining the anti-inflation credibility, and gauging the impact of lower inflation on confidence. The compression of real personal disposable income has been evident in the ASDA income tracker and the retail sales data. Retail sales, excluding auto fuels, rose by just 0.2% and were 0.2% lower than the previous year. The retail sales deflator accelerated from 2.3% to 3.1%, while retail sales volume grew by 2.8% from the previous year and by 4.8%, including fuel volumes. This correlation between nominal income growth and nominal expenditure growth appears to provide strong support for the resilience of consumer demand and hopes of a recovery in real terms as inflation slows rapidly next year and contrasts sharply with German consumer behaviour in the wake of their 2007 VAT hike. However, retail sales represent only 40% of overall consumer demand and we expect the forthcoming revisions to quarter two GDP to show a second consecutive quarterly contraction in consumer spending. Moreover, we expect the savings rate to have fallen further during the period as stressed consumer balance sheets forced them to dip into savings. This is unsustainable and we believe that rather than maintain their Alice in Wonderland spending habits, consumers will respond to real disposable income relief by raising their savings rates and accelerating the deleveraging of their balance sheets. This trend will be encouraged by the intensification of the public expenditure contraction next year and the weakness of employment. After two years of remarkable resilience the IL0-based unemployment measure rose from 7.7% to 7.9% in June and is likely to rise further over the next two years.

“The MPC lowered its outlook for growth over the near-term but maintained its Goldilocks scenario that the private sector will overcome the substantial fiscal drag and return growth to trend within the next couple of years. We believe that this false optimism is more damaging to the central bank’s credibility than its inflation errors. The central bank has repeatedly lowered its estimate of growth over the past year as activity has disappointed forecasts. This forecast has been lowered once again from 1.8% to 1.4%. We are more pessimistic expecting growth to slow to just 1.1% on the basis that economic data and sentiment is much more subdued. This is doomed to disappointment given the negative trend in domestic and global indicators. The Bank also repeated its mantra that there is likely to be substantial upward revisions to past data. This reflects a natural suspicion with the quality of ONS data and past experience in which the depths of previous recessions have been revised. However, statistical models are adaptive and after each recession these models have been adjusted. Models are highly sensitive to recent economic experience and correlations and we see no reason why the UK should be any different to the US or Germany, which have seen substantial downward revisions to growth in 2008/09 as the complacent assumption of the Great Moderation proved to be false.  The Bank’s growth forecasts suggest that it is expecting activity to rebound by 1.0% during the third quarter. After the inevitable disappointment, preliminary details of Q3 activity will be published on October 25^th, we believe that there is an opportunity to lower interest rates.

“The Inflation Report noted that there were downside risks to its growth forecast from the weakness in business and consumer sentiment indicators as well as the consequences of further intensification of the European Sovereign Debt Crisis. These are to some extent captured in the Bank’s measure of asset prices, bank funding costs and confidence, but it is impossible to quantify the tail risks of this event in the Bank’s fan chart. These unquantifiable tail risks clearly leave the policy biased towards easing. However, leaving aside European politicians inexhaustible capacity for chaos, it is clear that global leading indicators are slowing rapidly. The intensification of the fiscal austerity imposed by Europe’s creditor nations on the deficit periphery suggests that significant proportion of key export markets will be in recession during 2012. The lagged impact of monetary policy changes on the economy suggests that the early stimulus in November would be more effective than February. Nevertheless, QE is coming and the still steep gilt curve needs to flatten more.”

 Stuart Thomson

Chief Market Economist

Ignis Asset Management

Issued by Ignis Investment Services Ltd. Authorised and regulated by the Financial Services Authority.

This article contains the personal views of the author and do not necessarily reflect those of Ignis Asset Management – Chart source Ignis Rates ClearCurve, Bloomberg