MPC willing to 'Sentance' UK to deflation to avoid temporary inflation
MPC appears set to halt QE – but it will be a mistake
This week’s data and January MPC minutes will play a crucial role in finalising market expectations for next month’s all important decision on whether to expand, halt or reverse quantitative easing. The minutes will attempt to be as neutral as possible, but its thunder has already been stolen by an interview that external MPC member Andrew Sentance gave to the Guardian newspaper last week.
Mr. Sentance noted that the Bank had done enough stimuli and should now adopt a wait and see approach, halting its QE program. Furthermore he warned that a lot can happen over the next twelve months and those investors should not assume that rates will be on hold during this period given the risks to inflation.
This message has been reinforced by consumer price data. Consumer prices rose by 0.6% during December, boosting the annual rate to 2.9% and it is virtually inevitable that the Governor will be forced to write a letter of explanation to the Chancellor when inflation rises above 3% next month. Further confirmation should come from retail sales data this week and while these statements represent the views of just one MPC member the optimistic growth outlook forecast by the MPC last November suggests that this view is shared by the majority of MPC members.
The Ignis Rates team is wary of the gap between description and prescription because we expect the MPC to halt quantitative easing, but believe that it will prove to be a mistake. Variable term risk premia across the curve provides another blow to the efficient market hypothesis. Our measure of term risk premia (the gap between 5yr spot gilt rates and the 5yr5yr forward gilt yield shows that risk remains elevated. Higher risk premia provides an incentive to defer consumption and increase savings. The Bank specifically mentioned this paradox of thrift when it initiated QE in February 2009. Term premia remains elevated and the consequence is likely to be further slowdown in average earnings growth over the next few months.
The term risk premia could rise further over the next few months, but risk reward suggests that 5yr5yr forward rates are already above the economy’s long-run nominal productive potential and hence neutral rate of interest, while the impact of halting Quantitative Easing is likely to be an effective tightening of short-term interest rate expectations.
The Minutes of the January MPC on Wednesday will attempt the impossible – to discuss the economy without hinting at the outcome of next month’s crucial quarterly decision on whether to maintain, expand or start reversing quantitative easing. We believe any potential Delphic comments have been undermined by the combination of external MPC member Andrew Sentance’s comments to the Guardian newspaper last week, prospective December consumer price data and preliminary fourth quarter GDP data. The traditionally accurate National Institute of Economic and Social Research’s estimate of fourth quarter growth was 0.3%, which is likely to provide the basis of the market consensus, although after recent misses, we believe that the ONS will err on the side of optimism with a provisional release of 0.4% due on January 26th. The previously close coincidence between the two output-based measures of economic activity have faded over the past year.”
For Stuart’s full commentary please see his blog at www.ratesviews.com.
These are the views of the author and do not necessarily reflect those of Ignis Asset Management.