BoE inflation report sets stage QE4

BoE Gov King’s summary of the situation was pithy:

our biggest trading partner, the euro area, is tearing itself apart without any obvious solution

Given the situation in Europe, the Bank of England’s May inflation report set the stage for an increase in the BoE’s asset purchase programme, most probably from the current GBP325bn to GBP375bn at their 7 June policy window.

The May inflation report showed CPI falling to ~1.6%y/y in 2yrs time (down ~20bps, from ~1.8%y/y in the Feb report). Two years is at the longer end of the the relevant horizon for policy – forecasts that far out are not worth much – so it does not demand immediate action (and hence, the BoE was on hold at their May 10 window).

Inflation’s decline is a little slower than they projected in February (they had expected inflation of ~2%y/y by Q4’12 in Feb, and that now occurs in Q2’13). I suspect that it is this slower decline of inflation which had ‘doves’ such as Posen hold back from voting for more QE at the prior BoE meeting.

The growth fan chart shows a modest downward revision from February, and has the ONS data at the lower part of the central band for current GDP – suggesting that the BoE thinks that the ONS data understates GDP. In any case, the outlook is for two more years of sub-trend growth.

With the outlook darkening, you would have to judge that the risks to the growth forecast are to the downside – and that the inflation forecast is therefore most likely to be revised down. This is how you get from the May report’s balanced case – and the BoE’s policy hold – to QE in June.

Gilts rallied (10yr -7bps to 1.83%), and GBPUSD fell around a big figure, on the release of the report – both are re-tracing the initial move just now, but seem likely to resume their immediate post-BoE paths if there is no resolution of the Greek issue.

The natural response to events in Europe is for the BoE to undertake further policy easing. The main tool they have left is bond buying, so it’s natural that this should be more QE.

That the BoE would do more QE should come as no surprise, as Europe is their largest trading partner. Reflecting this worry, BoE Gov King spent much of the press conference talking about the grave developments in the Eurozone.