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Hermes economist says potential Brexit may drive BofE to reactivate QE

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Group Chief Economist at Hermes Investment Management, Neil Williams, has published his June views on how the UK is looking post-election and looks forward to a potential Spring 2016 interest rate hike, and the implications of quantitative tightening and a Brexit, the UK leaving the EU.

“The UK’s EU referendum by the end of 2017 will be the big ‘known unknown’ for UK assets. Logic suggests the unlikelihood of the UK wanting to risk weaker ties with its main trading partner (46 per cent of export value, 53 per cent of imports), foreign direct investment forgone, and a diluted relationship with the US. But, the uncertainty leading up to 2017 will doubtless at some stage take the shine off the pound” he says. 

The threat of a Brexit, Williams believes, may even drive the Bank of England to reactivate QE.

“In the event of Brexit (which I see only as a risk case), long-term conventional gilts may benefit initially from the perceived hit to growth. But this could be short lived, given that more than one third is backed by international investors sensitive to currency and ratings risk. In which case, it is not beyond reason that dealing with a Brexit and a hit to growth may in extremis need the BoE to again be the biggest sponsor of gilts, by reactivating QE,” Williams says. 

“Meantime, it’s ‘back to business’ for a BoE now able to look past May’s election and the bulk of the oil price fall. The economic recovery is broadening, yet the MPC’s adherence to a 2 per cent CPI inflation target makes a rate hike difficult before 2016.”  

Hermes UK inflation projections suggest that, with oil’s base-effect from June, and inflation driven by the less exchange-rate-sensitive services sector (an underlying 2.25 per cent year on year) the CPI could drift back to target as early as next spring. Williams believes the RPI meantime should be supported by house prices.  

“A Spring 2016 hike would end seven years of keeping Bank rate at a record low 0.5 per cent. Oil’s base-effect should likewise lift the US CPI, though the Fed’s dual mandate, focussing explicitly on job creation, should allow it to move earlier, in H2 2015.”

Williams believes that the Bank of England has another weapon in its arsenal in a bid to keep the ‘peak’ rate down.

“Our analysis suggests two things. First, with the UK’s CPI so low, the MPC can ‘sit on its hands’ through 2015. Yet, with the economy reviving, slack to be closed “within the year”, and both the election uncertainty and oil slump out of the way, some of the more hawkish MPC members could soon vote for a hike. We expect their ‘wings’ to be raised soon, possibly around the August Quarterly Inflation Report.”

The second reaction Williams predicts is that when the MPC does tighten, it can deliver a lower-than-normal ‘peak’ rate by pulling on the other lever – quantitative tightening (QT). This is achieved by first letting the Bank’s stock of (conventional) gilts run down, by no longer reinvesting the proceeds from maturing bonds. QT by natural causes alone would take till 2065. In which case, the Bank after 2017 (assuming limited referendum disruption) could reinforce this by gradually selling back some gilts. 

“We attempt to quantify QT, based on the Bank’s estimate that GBP200 billion in QE in 2009 was akin to taking 150bp off the Bank rate. Extrapolating, the cumulative GBP375 billion QE implies a policy rate of -2 per cent. Assuming this is symmetrical, an around GBP130 billion erosion of QE would be needed to deliver a peak Bank rate of 2.25%, which is lower than the near 5 per cent historic average.”

The MPC now awaits the post-election Budget on 8 July, which gives the Chancellor scope for correcting at a politically advantageous time (the start of the term) an estimated GBP10-15 billion spending slippage relative to plans. 

Williams believes that assessing the impact will be seen as another reason to hold off on rate hikes till spring 2016. 

“By then of course, the MPC will be looking back on seven years of an unchanged, 0.5 per cent bank rate. This is a record low, but the duration does have precedent. And, compared to the 18 years of unchanged rates around WWII and the over-100-years after the South Sea Bubble, seven years may in time be considered short lived,” he concludes

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