UK: Impact of Quantitative Easing to Growth, Inflation and Sterling

Apart from reducing interest to 0.5%, the lowest level since the central bank was established, the BOE announced a quantitative easing policy worth up to 150B pounds. We would like to analyze how this policy will affect the UK's economic growth, inflation as well as performance of sterling.

The policy: The Treasury has approved the MPC to buy up to a total of 150B pound of bonds through the creation of central bank's money. This represents 10% of GDP, 7.5% of broad money supply (M4), 12.3% of M4 by households and non-financial corporate and around 3% of the total assets of UK banks. The Chancellor also requested that among the 150B pounds, 50B pounds of which should be used to purchase private sector assets.

In the coming 3 months, the BOE will deploy the initial 75B pound in medium- to long- term gilts (outstanding maturities of 5- 25 years). The purpose of such policy is to boost broad money supply and credit and thus raise 'the rate of growth in nominal spending to a level consistent with meeting the inflation target in the medium term'.

The impact: Whether BOE's QE can eventually revive economic growth depends on whether commercial banks are willing to lend out the additional money they receive. As the commercial banks' liquidities are increased after receiving extra reserve created by QE, they may feel more comfortable to lend money to companies and households and this helps boost spending and investment. However, banks may choose to hold the extra reserve as buffer and earn interests (albeit low) instead. In this case, the QE may not achieve its purpose as it only creates more reserve, the narrowest definition of money supply.

In fact, this is the situation happening in the US. In the speech delivered by the Fed Chairman Ben Bernanke last month, he mentioned that the Fed's lending has resulted in a large increase in bank reserves as the banks chose to leave their excess reserves idle. The Fed's credit easing has currently produced $670B of excess reserves at commercial banks and other financial institutions in the US, around 4.7% of the nation's annualized GDP.

The BOE will use around 50B pound to buy private sector assets but what they buy and how the sellers will use the money they receive are crucial. For the sellers, the less cash-like the assets are purchased, the more effective they can help the economy. If the central bank purchases some long term assets, the sellers, using the cash received, can buy some commercial bonds and other long term investments. Therefore, BOE's plan of using the initial 75B pound to buy medium- to long- term gilts is positive in our views.

Another question is whether this money creation will lead to inflation. In the post-meeting statement, the BOE said there's substantial risk for CPI to undershoot the 2% target in the medium term. Therefore, we believe the Committee would like to use this 150B pounds to maintain inflation at the 2% level. However, history suggests it's hard for country to use QE to successfully avoid deflation without falling into high inflation. In other cases, such as Japan, whether QE has successfully pulled a country out of deflation is still uncertain. For UK, QE will lead to inflation only if the Government increases expenditure, commercial banks greatly relax lending and costs of doing mortgage are lowered. However, we do not expect the above-mentioned situations can be achieved with the current size of QE.

The sterling fell sharply against the dollar after BOE's announcements of rate cut and QE Thursday as increasing money supply is generally bad for a currency. In the medium- to long-term, the pound should remain under pressure. While traders are choosing among short GBP/USD or long EUR/USD, we would recommend the former. First, the dollar has been strong as investors seek for safe-haven assets - Treasury bonds are dollar-dominated. Second, after reducing policy rate to 1.5% last week, the ECB signaled further rate cuts in coming meetings. However, the Fed has already lowered interest rates to virtually zero months ago. Interest rate differential is in favor of the dollar.