BoE holds steady but further easing looks likely

The Bank of England decided to keep interest rates on hold at 0.1%, having cut rates from 0.75% in two steps in March. Its quantitative easing programme (QE) has been left unchanged at £645 billion, though two of the nine members of the monetary policy committee (MPC) voted to increase it by £100 billion.

Yesterday’s proceedings had many firsts. It was Andrew Bailey’s first Monetary Policy Report (MPR) presentation as governor, and it was the first presentation and press conference conducted remotely. It was also the first time the MPR was presented alongside the Financial Stability Report (FSR), which we think helps strengthen the synergy between the two areas of work.

High degree of uncertainty to BoE’s scenarios

Interestingly, this is the first MPR where the Bank’s forecast fan charts are missing since they were introduced in the 1990s. This is because the forecasts have been replaced with a “plausible illustrative scenario”, highlighting the high degree of uncertainty at present.

The scenario shows UK GDP falling 3% in the first quarter of this year, followed by a 25% fall in the second quarter, before rebounding. GDP in the scenario falls by 14% in 2020 before rising 15% in 2021. The scenario also has the unemployment rate rising from just under 4% in 2019 to 9% in the second quarter of this year, before falling back.

Though the Bank was at pains to stress that this is not its forecast but only a set of working assumptions, it did explain that it expects the recovery to resemble a “V-shape”, which appears optimistic compared to other forecasts. However, Governor Bailey explained the recovery is likely to be much faster than a normal recession as the cause of the loss in activity is policy-driven to fight the Covid-19 virus. The Monetary Policy Committee (MPC) expect some long-term damage to the economy, and some sectors will take years to recover, but in their best judgement, these are unlikely to have a meaningful impact on price stability, which is the primary target of the Bank.

The two MPC members that voted for an increase in QE reflect the balance of risk. In the absence of a vaccine, the signal from the Bank is that the risks appear to be skewed to the downside owing to changes in behaviours in the post-crisis economy. A rise in precautionary savings from households would suggest reduced demand going forward. Also, most of the spending forgone during the crisis is assumed to be saved.

Another glaring point is that the Bank has not considered a scenario of a second wave of infections and a return to lockdowns later in the year. The MPR does include some sensitivity analysis to how the economy may be impacted by an extension to lockdowns, but the more negative scenario of a “W-shaped” recovery has been omitted from the analysis.

The Bank’s inflation assumptions from its illustrative scenario would see inflation fall to near-zero in the short-term, before returning to the 2% target by 2021. No aggressive growth or inflation is assumed in the economy after the crisis, suggesting the Bank is unlikely to be in a hurry to raise interest rates.

In terms of the outcome from the Financial Policy Committee (FPC) report, banks are expected to see material losses during the crisis. The new stress tests show that banking credit losses are expected to reach £80 billion which causes them to draw down on less than half of their capital buffers. Therefore, banks have the capacity to withstand even larger losses of output than currently assumed by the illustrative scenario.

Conclusions

Overall, though some investors will be disappointed that QE was not increased at the May meeting, the signal from the MPC is clear that the next move from the committee is likely to be one of further easing rather than tightening. However, it is clear that the efficacy of monetary policy is running out, and the lack of analysis of a scenario with a second wave leaves a lot of questions unanswered.

The Bank also needs to start considering the risk of a no-deal Brexit at the end of the year, given trade talks have not progressed as well as had been hoped.

If there is one positive message from the proceedings, it is that the banking system is in a good position to cope with the crisis.