ECB and BoE Get Liquid

Both the Bank of England and European Central Bank cut their policy rates by 50bps today. For the BoE, this takes rates down to 0.50%, which the central bank has seemed to indicate is the floor. For the ECB, President Trichet's remarks, whose level of dovishness was quite unexpected, clarified today that the current 1.50% level is not a floor. It is the "alternative" monetary policy announcements, however, that were truly the focus. The BoE announced it will begin quantitative easing (QE), while the ECB extended their current program to provide unlimited liquidity to Eurozone economies at the prevailing policy rate until at least the end of 2009. The ECB also admitted that they have now begun to discuss other nonstandard measures. While the BoE announced they will begin their twice weekly QE purchases on March 11th, they also acknowledged it may take up to three months to reach their targeted level, so we do not expect any change in policy rate or QE target at their meeting next month. Given the dovish turn in the ECB, we believe the Governing Council may reduce rates to 1.00% in April, with some risk that they may not reach that level until May.

QE Basics

So what exactly is QE and how will it be carried out in the UK? Existing asset purchase plans have the BoE and UK Treasury purchase private sector assets (commercial paper, corporate bonds, asset-backed securities, etc), and finance these purchases by issuing government bonds. So someone in the private sector buys a bond from the government, gives the government the cash, and the government uses that cash to purchase a credit instrument. So the cash in the economy just moves from the person who wanted to hold a government bond to the person who wanted to sell some other kind of instrument. This program will remain operational.

But now, the BoE over the next three months will begin to slowly buy up to GBP 75bn in additional assets with two big differences. First, most of what the BoE buys will be government bonds (gilts on the secondary market with remaining maturities between 5-25 years). Second, the BoE will effectively print the cash to buy these bonds, so while the net wealth in the economy will remain unchanged (a swap of cash for bonds), more of that wealth will be held in cash, and ostensibly deposited with commercial banks.

However, quantitative easing is a largely untested and uncertain economic science. The important question will then revolve around whether this cash is transformed into new lending by commercial banks. If that cash is not lent out, perhaps because banks have plenty of cash but not enough capital, then there would be no impact on the economy. The BoE has made clear they are not undertaking QE in order to impact credit markets or recapitalize banks, but rather because they believe they could significantly undershoot their inflation target, with inflation projected to be running at just a 1% pace at the end of 2011 - just half their target.

BoE learning by doing

There was some speculation the BoE would focus on buying short-term gilts, but instead they have opted to focus on the medium- and long-term, and we can think of three reasons. The BoE may feel the short-term is already "cash-like" and they could have a bigger liquidity impact by swapping long-term assets for cash. Also, this seems to imply the BoE is not as concerned about the secondary potential for QE to indirectly stimulate lending by lowering benchmark interest rates as this would have argued for focusing on bringing down rates on the shorter end of the curve. Lastly, the BoE has said that lowering the Bank Rate below 0.50% could strain bank profitability, but by buying long-term bonds, they will flatten the yield curve and presumably have the same effect. They must feel that the floor of 0.50% on rates is enough to offset this potential drag.

Two other quick points are worth mentioning based on the communications published between Chancellor Darling and Governor King. First, the government stated these actions will in no way change their debt management or issuance plans, which remain focused on reducing interest costs for taxpayers. Second, it would appear the Chancellor has actually authorized the BoE to purchase up to GBP 100bn in assets, so the BoE would appear to have the ability to increase their asset purchases by a further GBP 25bn before asking the Chancellor to lift the purchase ceiling. The BoE's statements that they will "in the first instance" finance GBP 75bn in purchases could merely reflect this untapped but available resources, as well as insinuate, as we believe, their readiness to scale these purchases up even more should the initial GBP 100bn prove insufficient.

ECB lags a little less

Last month, the ECB appeared sharply divided over whether risks to inflation were to the upside or downside and how much further rates would need to fall. This month, the Governing Council said inflation would be well below 2% in both 2009 and 2010, and this jived with staff inflation projections that now see a midpoint forecast for inflation at just 0.4% in 2009 and just 1.0% in 2010. More shocking to us was exactly how much of the downside economic risks the new staff projections encapsulated, with the economy expected to contract by 2.7% this year and deliver 0% growth in 2010. This is slightly more optimistic than our own forecasts but much closer than we expected. On those risks, President Trichet did say that he thought it was very important that the framework for Eurozone membership was followed and that current economic weakness in a non-member Central and East European economy was no reason to fast-track membership and skip these rules. While principled and fully understandable, we do think there needs to be more assistance provided to CEE economies than has been provided to date in order to minimize the risks their current CEE economic crisis poses to Western European economies.

There is still a question of how low they will eventually go, and while we know some ECB Governing Council members such as Weber have said 1.00% is his absolute floor, we do see strong potential for the ECB to cut to a 0.50% base eventually, even though the decision may not be unanimous, particularly if we see limited adverse reaction to every other G-7 central bank that now has rates at or below this level. We also think we will eventually see the ECB move to QE similar to the UK's actions today, and the UK's announcement actually helped to lower yields on Eurozone bonds, as well, so there is some help by association.

TD Bank Financial Group

The information contained in this report has been prepared for the information of our customers by TD Bank Financial Group. The information has been drawn from sources believed to be reliable, but the accuracy or completeness of the information is not guaranteed, nor in providing it does TD Bank Financial Group assume any responsibility or liability.