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Saturday, October 17, 2009

British pound crisis?

WSJ questions whether UK's central bank really knows what it is doing. I think this applies to the US too, only to a lesser degree.  Without curing the capital holes on banks' balance sheet, it's just a game of catch-22: let's hope government's heavy spending can revive market confidence so bank lending can gradually resume; otherwise, if buget deficits reach to an unstainable level before market confidence comes back, we might really have a currency crisis.

What has quantitative easing ever done for us? For the British who ask that question, the list offered by the Bank of England seems to lengthen every day: lower government-bond yields, the revival of the corporate-bond market, lower unemployment and the rally in the stock market -- in fact, pretty much anything good happening in the U.K. right now short of the balmy autumn weather. All that is missing from the list is a revival in bank lending and an increase in the money supply, the very things the BOE originally said its policy of buying government bonds was supposed to deliver.

[Easing]

The BOE's endlessly shifting justification for its easing policy is fueling fears in the markets that the BOE doesn't really know what it is doing or how to stop. The uncertainty is partly to blame for the recent weakness in the pound. As a result, next month's meeting of the Monetary Policy Committee, when it must decide whether to expand or halt its £175 billion ($284.7 billion) program, is taking on particular significance. The BOE's credibility and independence is increasingly at stake.

With the economy recovering and inflation proving surprisingly sticky, any decision to expand quantitative easing will need careful explanation. So far, the BOE has stressed that the amount of slack in the economy will keep a lid on inflation. But many economists now predict inflation will be above the BOE's 2% target next year, suggesting that policy may soon need to be tightened.

The BOE has confused the market by repeatedly focusing on lower yields on gilts -- government bonds -- as a key measure of quantitative easing's success. To the extent that this easing raises inflation expectations, ultimately pushing up gilt yields and requiring the BOE to print yet more money, this is a dubious argument. It also reinforces the suspicion that the BOE's implicit aim is to use quantitative easing to support the government's borrowing.

This would hardly be surprising. The budget deficit is likely to hit 13% of GDP next year, the second highest after Ireland in the industrialized world. Gilt issuance in 2008-10 is projected to be greater than in the previous 10 years combined. The market may be able to absorb issuance on this scale without quantitative easing. Private-sector saving is rising rapidly, creating funds for investment, and new liquidity rules will force banks to buy more gilts. But with 30% of demand for gilts typically from overseas, the BOE must fear what happens if foreign demand dries up.

Absent any serious attempt to address the fiscal position, stopping quantitative easing risks at best a rise in market rates and at worst could lead to a sterling crisis. Perhaps it can duck the issue next month by announcing a pause. But if inflation continues to rise, this will be a temporary respite. Sooner or later, the BOE must come off the fence.