When the Bank of England decided to expand its quantitative easing policy by 25 billion pounds to 200 billion on Thursday, it was essentially hedging its bets.

After Britain’s economy shrank unexpectedly in the third quarter, and with two thirds of the City expecting an expansion to the QE programme, simply shutting off the tap of government bond purchases would risk being more of a shock than the economy could bear.

On the other hand, the Bank clearly believes that the worst is over for the economy and that recovery will come soon — even if it’s going to be weak.

Thursday’s decision means the central bank will keep buying government debt until February, but at only half the pace of before. This still amounts to around 2 billion pounds a week, not including the much smaller sums of corporate debt that the Bank is buying.

What the decision means for a typical household is harder to calculate. The Bank says that its quantitative easing programme has raised the price of government and corporate
bonds, making borrowing cheaper.

But for average firms and consumers looking for a loan, the benefit is harder to spot.

There is little clear evidence that banks are much more willing to lend than a few months ago — though the Bank would argue that quantitative easing has been instrumental in avoiding the recession turning into a depression.

In the longer term, the big unknown is the impact that quantitative easing will have on inflation. Sterling’s weakness against the dollar and the euro will push inflation up in the short term, and going forward the Bank of England said it faced a balancing act.

While rising unemployment and half-full shops and factories will keep a lid on prices, policymakers know that quantitative easing could exert upward pressure on demand and prices for months if not years after it has stopped.

That’s why they took the decision today which could mark the gradual phasing out of this unprecedented policy of asset purchases.

-Jane Foley is research director at Forex.com. The opinions expressed are her own.-

The discrediting of the efficient markets theory in the aftermath of the financial crisis appears to have been accompanied with growing support for the view that rather than efficient in nature, financial markets are predisposed towards the formation of bubbles.

A bubble can simply be defined as an occurrence that begins when the price of an asset has been driven significantly above it “fair” value. According to the efficient markets theory this would not happen.

If bubbles are a natural outcome of financial market activity it is relevant to ask whether the very loose fiscal and monetary policies of many central banks and governments are presently sowing the seeds of the next bubble.

Even though the real economies of the U.S., UK, Eurozone and Japan continue to be defined by expectations of rising unemployment and falling real wages, access to cheap money has already helped restore the profitability of many investment banks.

In turn, this has fed risk appetite which is evident in the rally in stocks since the spring, increased demand for “risky” currencies and a recovery in commodities prices. Brent oil has rallied by 128 percent from its 2009 low. The ability of oil to rally despite the existence of oil supplies well above the seasonal average suggests there is already speculative element in this market which could be in danger of driving prices above their fair value.

This week’s meetings of the Federal Reserve, the Bank of England and the European Central Bank have focussed attention not so much on rates, but on the extraordinary policy decisions taken by these central banks in the wake of the financial crisis and whether conditions are ripening in favour of a gradual withdrawal of some of these policies.

The Fed last week ended its $300 billion treasury bond purchasing plan, though it will carry on buying mortgage backed securities. The Bank of Japan last week announced that it will stop buying corporate bonds at year end. The Reserve Bank of India also removed emergency support measures last week.

This week there is speculation that the ECB could announce that it will hold no more 12-month cash tenders next year. By contrast the Bank of England is expected to increase quantitative easing at the November 5, Monetary Policy Committee meeting. Supporters of quantitative easing continue to stress that the lack of clear inflation pressures suggests there is room for these plans to be extended.

However, the lack of response in either money supply or inflation indices could equally be illustrating that these plans are not having a significant impact on the real economy and are therefore no longer appropriate. The paring back of these plans are likely to have an impact on the ability of some banks to turn an easy profit and thus should rein in risk appetite and limit speculative and “bubble” forming activity.

Unfortunately, a bubble can only be truly confirmed after it has burst; a characteristic with clear destabilising consequences. If bubbles are natural phenomena within financial markets, the need for tighter regulation and ongoing reviews of processes that oversee the financial system are absolutely necessary.

This conclusion, while in complete contrast to the implications of the efficient markets theory, ties in very well with the political desire to reform the banking regulatory framework in order to protect the tax payer from future hefty bank bail-out costs. The banking landscape, while already vastly different from just two years ago could continue its transformation for years.

researchEMEA@forrex.com

-David Kuo, Director at the financial website The Motley Fool. The opinions expressed are his own.-

Go on. Admit it. You didn’t see it coming, did you? You never thought a member of the G20 nations would dare to break ranks and raise interest rates this soon.

But Australia has done just that. The Central Bank of Australia has increased the cost of borrowing by 0.25 percent to 3.25 percent. It is doing what it thinks is right for the country regardless of what the rest may think. Now, Asian countries, keen to avert another bubble, may follow Australia’s lead and ratchet up interest rates before long.

Of course, Australia’s economy is vastly different to the UK’s. It has huge deposits of iron, aluminium and nickel that are in demand by mineral-hungry China. That said, Australia did briefly flirt with a downturn, which it successfully corrected with 21 billion pounds of fiscal stimulus.

But the UK is not Australia. We do not have huge deposits of mineral, and we are not near fasting-growing Asian countries either. What we do have are consumers saddled with over a trillion pounds of debt following a decade of binge borrowing, and a national debt burden of similar magnitude.
Therefore, it is unlikely that we will experience demand-led inflation. In fact, consumers are saving more of their household income than they have done for eight years.

The most recent Office for National Statistics report shows that between March and June British households saved 5.60 pounds out of every 100 pounds of household income. That is very different from the first three months of 2008 when we not only failed to save any money, but we even borrowed 50 pence for every 100 pounds of household income.

That said, we are still some way off getting our overstretched household finances back on an even keel. So, the savings ratio could go higher. In fact, it is still some way short of the long-run savings-ratio average of 8 percent of household income.

And herein lies the problem for the Bank of England.

According to the paradox of thrift, high levels of savings in a recession can prolong the economic downturn. That is because two-thirds of economic growth comes from consumer spending. So the less we spend, the longer it will take the UK economy to recover from the slump.
So what is the Monetary Policy Committee to do?

It has already slashed interest rates to historic lows. But that has failed to stimulate consumer spending. It has pumped 158 billion pounds of fresh money into the coffers of lenders through quantitative easing. But the money has, as yet, failed to invigorate the ailing economy.

However, both those measures will, in time, achieve their goals. The risk is not whether they will work, but instead, whether they will work too well and stoke inflation. Just as no one expected Australia to hike rates this soon, our days of enjoying low interest rates may end just as abruptly, and without warning. So save and invest what you can now.

- David Kuo is director at The Motley Fool. The opinions expressed are his own.-

What is the collective name for a crossing of fingers?

Because that seems to be what the Bank of England’s Monetary Policy Committee members are doing. They are collectively crossing their digits in the hope that they have done enough to steer the UK economy out of recession.

They have pumped billions into the UK economy and it doesn’t seem to be having much effect – yet. That is unless you are a banker looking to bolster your balance sheet with freshly minted notes. Banks are happy to swap their assets for the Bank of England’s cash but remain unwilling to lend. Additionally, there is still uncertaintyabout the ability of the economy to grow unaided if the central bank should stop printing money.

And just when you think that things could not get any worse, it just did. It seems another problem has crawled out of the woodwork is inflation. The Bank believes inflation will be extremely volatile. It may fall in September but near-term inflation may exceed initial forecasts. But because it believes the rise in inflation will be temporary, the suggestion is that interest rates can be maintained at around current record low levels for some time.

However, low interest rates, low growth and low prospects of an economic recovery are spooking foreign investors. Sterling recently sunk to levels not seen for five months against the euro. It has dropped from 1.30 euro a year ago to 1.07 euro, though it has since recovered to 1.11 euro.
UK exporters will undoubtedly welcome the favourable exchange rate against our European trading partners. But the fly in the ointment will be more expensive imports from European.

German cars, French wines, Italian luxury goods, Spanish holidays, Irish butter and Dutch Edam cheese will all cost more.

Inflation is the unspoken effect of Quantitative Easing. It is something we need to guard against if we are to ensure that our nest eggs and investments are not eroded over time. Leaving any money you have in savings accounts may seem like a sensible and safe thing to do now. But over the long term, cash has a terrible record at beating inflation. Consequently, it is better to invest in assets that have a proven track record against rising prices.

If you have a mortgage on a property, now is a good time to pay down as much of the loan you can afford while interest rates are low. If you have money that you can afford to put away for five years or more then it should be invested in shares rather than allowed to idle in a savings account.

Crossing your fingers is not an option. Putting your money to work is because things just got a lot worse.

- Sumeet Desai, Reuters senior UK economics correspondent. -

Inflation unexpectedly held steady in July, official data showed Tuesday, but economists still expect big falls in the annual rate this year and monetary policy to stay loose for some time to come.

Is a 1.8 percent inflation rate good or bad news?

-- John Kemp is a Reuters columnist. The views expressed are his own --

The Bank of England's decision to continue with its asset purchase programme, or quantitative easing (QE), at the rate of 50 billion pounds per quarter in Oct-Dec, unchanged from Jul-Sep, shows bank officials are more worried about ending support for the recovery too soon than about risking inflation by leaving it too late.

The problem with QE is that you have to keep buying the same amount of assets each month to maintain the same monetary stance. With interest rates, the Bank can cut them and they stay cut. If asset prices drop with QE, it represents a tightening of monetary policy.

The Bank initially bought 75 billion pounds in the first 3 months (Apr-Jun) and then tapered this to 50 billion in the second three months (Jul-Sep) as the crisis engulfing the banking system and the rest of the economy eased. A cautious approach might have tapered the QE programme again to 25 billion in the final three months of the year before ending it entirely at the start of 2010. But the Bank opted to stick at 50 billion.

Critics point out that the programme has not achieved its announced objective of increasing bank credit and the amount of money in circulation. The rate of growth in M4, the broadest money supply measure, has risen only marginally. But that ignores the counterfactual of what would have happened to M4 in the absence of the programme -- it might have fallen sharply.

Growth in the monetary aggregates is, in any event, mostly endogenous. It depends on demand for credit. In the current environment, where many households and businesses have little or no collateral, credit is impaired, and most are focused on paying down debt rather than adding to it, limited growth in M4 is not surprising. Trying to make it grow faster is like force feeding a duck to make foie gras -- possible but unnatural.

QE has always been as much about restoring confidence, dispelling fears about deflation and ensuring a ready market for the safer securities banks hold as much as growing the money supply. On most of these measures it must be considered a qualified, if expensive, success. A full judgement will only be possible when the Bank has proved it can withdraw the excess liquidity in a timely manner to prevent an upsurge in inflation.

In the end, the decision to press on is driven by fears about the fragility of the current recovery, and the risk that if QE ends too soon, effectively tightening policy, whatever green shoots have emerged over the summer will be killed off by an autumn frost.

All recoveries are fragile and weak early on. While the rebuilding of inventories along the supply chain, often provides the initial boost, this must eventually be replaced by a more sustained increase in household and business expenditure.

But with their new focus on the experience of the 1930s, central bank officials worldwide are more worried than normal about doing anything to stall the recovery.

Looming over the debate is the experience of 1937, when the Federal Reserve responded to concerns about the amount of "excess liquidity" in the banking system and sharp rises in the price of some commodities, especially steel, by doubling reserve requirements on banks in the space of nine months. It effectively converted previously "excess" reserves against which the banks could lend into "required" reserves against which they could not.

The four-year old recovery (1933-1937) promptly collapsed amid tightening bank credit, and the United States suffered the second deep recession in a decade, with output not fully recovering until the onset of war in 1940-41 (https://customers.reuters.com/d/graphics/DSTMIRROR.pdf).

Anxious to avoid a repeat, it is no wonder that the Bank of England is in no hurry to tighten policy. While this level of QE must eventually generate inflationary pressures, the Bank judges, probably correctly, that it still has some time before policy needs to move to a more restrictive setting.

- Edward Menashy is chief economist at Charles Stanley. The opinions expressed are his own. -

The Monetary Policy Committee of the Bank of England has kept its key lending rate at a record low of 0.5 percent, last reduced in March 2009 when it indicated that conventional policy had reached its limit and unorthodox measures such as quantitative easing were to be used.

Recent economic statistics however have been strong with the UK service sector staging a surprise return to growth in May 2009 thus raising the prospect that the country’s recession may be about to end. Also the Nationwide survey of consumer confidence hit a six month high in May 2009.

Recently the CBI indicated that the banks would tighten credit less aggressively in the next three months.  The survey indicated that only 7 percent of firms expected to be offered tougher conditions for new lending, down from 36 percent from the March 2009 survey.

So against this backdrop all these factors have raised the prospect that policy might soon change.

Hence, if recessionary forces are decelerating and credit is becoming more available the prospect for rising interest rates has moved a step nearer.  Could this explain the strength of the pound and the weakness of the gilt market?

Not surprisingly, the Bank of England is expected to stick to its target of £125bn for Quantitative Easing. Interestingly the futures market foresees interest rates taking the following shape:

Month/Year     Base Rate %
Sept 2009        1.12
Dec 2009        1.31
March 2010    1.48
June 2010        1.81
Sept 2010        2.21
Dec 2010        2.66

Conditions remain very difficult for income seekers.  Record issuance, rising inflation, slow growth, downgrades in credit ratings have left investors bewildered yet, for capital protection we suggest looking at the 2.5 percent Treasury Index-Linked 2016.

- Adrian Kidd is financial planner at Unleash Advice. He was voted 50th Most Influential IFA in the UK by Professional Adviser magazine 2008. The opinions expressed are his own.-

The Bank of England tells us that their 75 billion pound quantitative easing programme will start the banks lending again (despite the banks saying that they are already lending, this is not strictly true). The programme works by the Bank buying securities from the banks and then this money can be loaned to consumers. The question is, does and will this work? Is 75 billion pounds enough?

The answer thus far is that we do not know yet, just as we do not know if the series of aggressive rate cuts have started to take effect. It usually takes around 12-18 months for an interest-rate hike or cut to be noticed in the monetary systems, but as the cuts were regular and steep they may filter through quicker than normal.

Quantitative easing usually happens when base rates are at or close to zero since interest rate cuts can effectively go no lower. The last time we saw quantitative easing was in Japan in the 1990s. Analysts said it stopped their economy from worsening, although it can be argued that Japan has taken 15 years or so to recover from this and that perhaps we are the next Japan (very low rates for a long period of time with little place to manoeuvre on fiscal and monetary policy).

What can happen if this does not work? We could see two scenarios. The first is what is known as the “helicopter drop” where the Bank drops money into the economy without the buying of any assets.

This could be done by giving all of us “one-off” payments to encourage us to start spending (they did this in Taiwan previously) or the government could change the rules on the banks in which it has large stakes and force them to lend more money, although the chances of this seem slim.

They could also buy more assets and increase the quantitative easing programme, but the government also has its own problems in balancing the books as it puts us further and further into the red - more than any other government in history.

Could the Conservatives do any better? I would like to think they could, but I am doubtful. It would be like saying they can resolve our current state pension or NHS issues. They are so far gone that all they can do would be to better manage them, but these problems will take a lifetime to resolve - if in fact they will ever be resolved.

So, although we may see a change in government, it would remain to be seen if things get any better under a new regime and I am sure the Obama administration is seeing the same over the pond. His tenure, I am sure will be spent resolving the immediate debacles he has been left by the previous administration before he can truly make his desired changes.

The one thing that is different in our current situation from the Great Depression of the 1930s, is the global decisions to act and act as one. This could be and should be a saving grace that will help us see the road to recovery in the second half of 2010 (and not at the end of this year as our Chancellor suggests). Also, the fact that regulation will have to made to work as it has clearly failed us again.

If we are clever, we will all learn and come out of this better and we should as human beings learn from our excessiveness, both at consumer and corporate levels. As the famous saying goes “Fool me once shame on you, fool me twice shame on me”.

- Edward Menashy is chief economist at Charles Stanley. The opinions expressed are his own. -

Not exactly shock and awe as the MPC keeps base rates on hold at 0.5 percent while the most recent financial surveys have been unanimous in expecting a no change decision for some time now. It was always going to be an MPC meeting to discuss whether or not to persevere with quantitative easing. The difficulty for the MPC is that it is too early to judge the effectiveness of the quantitative easing. Clearly the Bank of England would prefer to wait at least until it publishes new quarterly growth and inflation forecasts to explain how it wishes to proceed.

Observers, who have questioned the success of the Bank’s tactics, point to the fact that much of the easing has been leaking to overseas investors, hedge funds and investment banks.

Furthermore, pension funds which the bank had hoped would be the biggest recipients of newly created money received far less than expected. Other observers note an opportunity of making a profit by buying Government debt from the Debt Management Office (DMO) before selling it on to the Bank and that it may not be advisable to create additional liquidity that would feed through into an already strong equity market rally and create yet another bubble.

Nevertheless having decided to go down the path of quantitative easing the MPC could well feel it was obliged to pursue the experiment to the hilt and inject the full 150 billion pounds. After the DMO statement at the time of the budget regarding gilt supply, investors are bracing themselves for a deluge of gilt issuance, made more acute by the fact that the Bank will feel compelled to sell back eventually to the market the stock they have purchased.

Fixed interest investors face a daunting choice. Investors requiring capital preservation should consider Treasury Indexed Linked 2.5 percent 2016 but equities may now be a better bet.

– Neil Collins is a Reuters columnist. The opinions expressed are his own –

LONDON, April 23 (Reuters) - The UK Government needs to raise four billion pounds a week, every week, in the financial year to next April, to bridge the gap between its tax income and its spending.

Raising such stupendous sums — getting on for 15 percent of each week’s British national output — has never been tried before, and nobody really knows whether it can be done.

The optimists point to the financial year just ended, in which the government raised 146.5 billion pounds, as evidence that this year’s plan for 220 billion pounds can be met.

But during last year’s financial panic, savers decided that the return of their money was more important than the return on their money.

This year will be different. Given the dire outlook for the economy, UK government stocks look horribly overpriced. The benchmark five-year issue returns 2.54 percent, and the corresponding 10-year stock 3.45 percent.

These miserable yields are a consequence of the “flight to safety” coupled with the Bank of England’s desperate programme to inject cash into the economy. Its chosen route of Quantitative Easing has led it to buying existing government debt to prevent the money supply falling.

This has produced the bizarre spectacle of the government’s Debt Management Office issuing stocks which are virtually identical to those the Bank is buying. Essentially, the UK Treasury is selling paper to itself, with the traders making hay from the price difference.

Already the doubts are creeping in about whether this expensive circle makes sense, and next month the Bank has promised to review it.

The best plan would be to follow the example of the Americans in Vietnam, to declare victory and go home. At that point, or when QE is finally abandoned, the DMO will be on its own, leaving Britain’s finances at the mercy of the international bond markets.

While the UK’s credit holds, even four billion pounds a week is not too much for this vast, global market to find. Yet as the western world’s banks discovered last year, if your credit is not considered good enough, the markets can close to you almost overnight.

The DMO has no experience of anything like this. Those at the Bank who can remember when the UK government last had a credit crisis have either retired, or were fired when Gordon Brown wrenched management of the market from the Bank and created the DMO in 1998.

It promises to be a steep learning curve. Selling gilts when they look like a safe haven is one thing, selling them into a buyers’ strike is quite another, and a buyers’ strike is only too likely once the true cost of Alistair Darling’s fantasy Budget becomes apparent.

Prices would collapse as the yields demanded by the buyers rose, raising his borrowing costs still further. Transmitted to the currency, this vicious spiral is a threat to sterling itself.

Like the traders themselves, the DMO should make hay while the sun shines. Its simple wish list of stocks might be blown clean away when the weather changes, so at the very least, it should lock in those low yields now by issuing partly-paid stocks, with balancing payments due later in the financial year — or even next, since the financing problem is not going away. The deeper question is whether the DMO has the guile and low cunning to take on the traders from a position of extreme weakness, but at least showing some imagination would be a start.