Markets watching for shifts in monetary policy

The European Central Bank and the Bank of England’s Monetary Policy Committee meet this week to review monetary policy operations in their respective economies.

Interest rates are expected to be kept at historically low levels in Britain and the eurozone but the markets will still watch for signs that the ECB and the Monetary Policy Committee are prepared to do more to support activity in both areas.

Though there have been some uplifting economic indicators in recent weeks, the risks remain firmly to the downside. There will be plenty of interest in what the ECB president has to say about the crisis in the euro area but it would be surprising if he were prepared to indicate a change in the ECB’s overall stance of non-standard monetary policy measures. Prospects for more immediate stimulatory measures are greater in Britain, however, with the markets anticipating an announcement on Thursday.

At its January policy meeting, the Monetary Policy Committee left British interest rates on hold at 0.50%, while keeping its asset purchases at a total of £275 billion. The vote was unanimous. This was in line with expectations, as the Monetary Policy Committee has indicated that any further policy changes were unlikely until the current programme of quantitative easing (QE), which began in Oct 2011, was completed in early February.

The minutes of the January Monetary Policy Committee meeting showed that the committee believed British economic output would be broadly flat in the first quarter of 2012. There were considerable risks to the downside from the global economy, while there were also substantial risks in terms of domestic activity.

Britain’s recovery from its worst recession in decades, which saw output contract by 7.1% peak to trough, remains modest and even.

Provisional GDP data for the fourth quarter of 2011 show that the economy contracted by 0.2% in the final three months of last year. This followed quarterly growth of 0.6%, 0.0% and 0.4% in the previous three quarters of 2011. For 2011 as a whole, GDP growth in the British economy averaged just 0.9%.

While we have little to go on as yet in terms of leading indicators for 2012, fears of a double-dip recession have eased of late.

After an unexpected rise in December, the manufacturing PMI picked up considerable pace in January, rising to 52.1 from 49.8. This took the headline index back to its best level since May 2011. Meanwhile, recent economic data from the US have been generally encouraging, with a number of eurozone leading indicators also surprising on the upside. Having said that, there are still considerable downside risks from both an internal and external perspective for Britain and we expect average GDP growth of less than 1% in Britain again this year.

In terms of inflation, the general view was that there had been little change to the balance of risk over the medium term. The annual rate of inflation fell to 4.2% in December, down from 4.8% in the previous month. This marked the third monthly fall and the biggest decline since April 2009.

Another big drop is expected in the January numbers as last year’s VAT rise falls out of the index. The CPI averaged 4.7% in the final quarter of last year and 4.5% for 2011 as a whole.

Thus, with the October quantitative easing programme now all but complete, the likelihood is that the Monetary Policy Committee will vote for additional asset purchases at Thursday’s policy meeting.

Recent comments from Mervyn King suggest that he is in this camp and December’s sharp fall in the CPI rate could certainly encourage his more dovish colleagues to vote with him.

John Beggs chief economist AIB