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Market Comment
Stagflation means Bank of England QE decision is on a knife-edge
10 May 2012
Conall Mac Coille
Having completed £325bn of purchases of UK government gilts through the creation of central bank money, the Bank of England's Monetary Policy Committee (MPC) meets today to decide whether to extend its quantitative easing programme. On balance, markets expect the MPC not to extend its asset purchase target, as concern about the persistently high CPI inflation rate outweighs renewed concerns on UK growth prospects.
However, the MPC's decision will be finely balanced. Recent developments suggest that the outlook for UK growth has deteriorated significantly. GDP growth in Q1 was below zero, confirming that the UK economy is in a double-dip recession following two quarters of negative growth through the turn of the year. And short-term indicators such as the purchasing manager indices for the manufacturing and services sectors suggest that output may contract again in Q2. Indeed, today's UK industrial production data are expected to show a marginal fall in March, so that output in Q1 as a whole will have declined by 0.3%.
Set against the outlook is the persistently high CPI inflation rate; this was 3.5% in March, well above the Bank of England's 2% target. That said, CPI inflation has fallen sharply from its 5.2% peak in September 2011. The downward pressure on CPI inflation has reflected the waning impact of higher oil prices and the 2 percentage point increase in VAT in January 2011.
However, the fall in CPI inflation has not been as sharp as expected. And with CPI inflation exceeding the bank's 2% target in 48 of the 54 months since the beginning of 2008, the MPC's creditability may come into question should it continue to overshoot through 2012. So, for that reason the MPC may hold its current level of asset purchases at today's meeting despite the weakening outlook for the economy.