Expect fireworks as the Monetary Policy Committee meets on Guy Fawkes Day

Published on Saturday 31 October 2009 13:55

GORDON Brown should be congratulated for this achievement at least: his handling of recession is now consistent with the FILO accounting convention, First In, Last Out.

Germany is out. France is out. Canada is out. Japan is out. Now America is out. And Italy is poised to come out. That leaves the UK – "well placed to withstand the buffeting of global headwinds" as Alistair Darling was wont to describe it – still stuck in recession.

And this is after a degree of government and central bank emergency measures unrivalled in modern times. We have had fiscal stimulus, a VAT cut, a car scrappage scheme, underpinning for homeowners in trouble, record low interest rates, a 175 billion programme of quantitative easing, billowing public debt – and, of course, the biggest ever intervention to save two of our biggest high street banks.

It seemed just a few weeks ago that the market's big worry was over the Bank of England's withdrawal strategy – raising of interest rates early next year and a "pull-back" of QE to avoid an inflation take-off.

But then came persistent signs that, despite all the hype, "green shoots" in the economy were looking decidedly pallid, where, that is, they could be found at all. The final nail in the coffin of the 'quick recovery' school was the worse than expected GDP number for the third quarter. Far from showing we had moved out of recession as 33 economists in a Reuters poll suggested, they were all wrong, with the economy contracting by a further 0.4 per cent.

This has set up the Bank of England's Monetary Policy Committee with a true fireworks of a meeting this Thursday – Guy Fawkes Day.

Interest rates will almost certainly remain at their ultra-low level of 0.5 per cent. The key focus will be on whether the bank sticks with the level of QE, currently at 175bn, or authorises a 25bn addition. Some are even talking of a 50bn uplift.

A few weeks ago an increase looked most unlikely. Now the debate within the MPC is more finely balanced. In addition to notably weak manufacturing output figures – and that 'flash' forecast for third quarter GDP which caught out the economists – came disappointing news last week on UK credit conditions. The broad measure of money supply growth, M4, actually fell by 0.9 per cent in September.

This suggests that QE has had little effect to date in stimulating business spending and economic recovery. Ongoing muted bank lending to companies, puts serious pressure on the MPC to further extend the QE programme. The Centre for Economics and Business Research expects to see an increase of 25bn this week, taking the total to 200bn. And Howard Archer, chief economist at Global Insight, agrees.

"While a lot of uncertainty surrounds the accuracy of the preliminary national accounts data that show the UK economy unexpectedly contracted by 0.4 per cent in the third quarter, we believe that the GDP fall tips the odds in favour of the Bank of England extending QE by a further 25bn to 200bn."

Much critically depends on how the MPC reads the inflation risks. But here there are real problems in data analysis and interpretation. The confirmation in the minutes of the last meting that members could not agree on how the balance of inflation risks had shifted suggests they no longer have a common approach to analysing incoming data, let alone a unified view on how best to frame the forecast.

The debate centres on the "output gap". This has a crucial role in the bank's forecasting model. Broadly, the greater the degree of slack in the economy, the more downward pressure on inflation the model will forecast. But this assumes that it is practicable to measure the scale of idle resources in the economy. Both of these propositions, says Stephen Lewis of Monument Securities, are questionable.

"MPC members appear not to have considered the possibility that, in an extreme economic and financial environment, companies' pricing behaviour is transformed. When credit is scarce and the survival of competitors is far from assured, companies may be far less averse to risking loss of market share.

"Further, when companies can no longer turn to their banks for funds, they may well see their customers as the sole remaining source of short-term financing, to be tapped through raised selling prices. In these conditions, a forecasting model based on the output gap would give the wrong results... If the MPC cannot say how much slack there is, then it cannot project, on the basis of an estimate of the slack, the future course of inflation."

Financial markets are now less clear about the MPC's "reaction function", to judge from recent poll results suggesting market participants are equally divided between those thinking the meeting will result in the MPC's pausing in its QE, those thinking the programme will be expanded by 25bn and those foreseeing a 50bn rise in the limit on the bank's asset purchases.

As the MPC has never explained satisfactorily how it calibrates its QE decisions in the light of the inflation target, it will now be under increasing pressure to do so. And if the bank's credibility comes under fire, we could be in serious trouble.