The central bank may acquire securities such as corporate bonds and commercial paper to bolster lending to companies and consumers as banks rebuild balance sheets damaged by the global financial crisis, King said late yesterday. The bank said today officials opted not to cut its key rate by one percentage point this month on concern it might unsettle markets.
“There remains a risk that inflation will fall below 2 percent,” the target rate even after the recent round of rate cuts, King said in a speech in Nottingham, England. “It is sensible for the Monetary Policy Committee to prepare for the possibility -- and I stress that we are not there yet -- that it may need to move beyond the conventional instrument” of the bank’s benchmark interest rate.
While the Bank of England has cut the rate by 3.5 percentage points to the current 1.5 percent since October, that won’t prevent an economic contraction in the first half of the year, he said.
King backed Prime Minister Gordon Brown’s plan to give the Bank of England unprecedented powers to buy securities, unveiled on Jan. 19 along with a 100-billion pound ($140 billion) bailout for banks. Those tools may later be expanded to fight deflation as the British economy faces a recession this year that may be the worst since the aftermath of World War II.
“This is a momentous speech that sets the policy agenda for the next decade,” said Lena Komileva, an economist at Tullett Prebon in London. “More rate cuts are likely but before long, the Bank of England may reach the point of using quantitative easing to target inflation, in effect to prevent deflation.”
Corporate bonds in pounds rose today after King’s remarks. The Markit iBoxx Sterling Corporates index climbed 0.41 to 81.65 as of 10:25 a.m. in London, the first increase in five days. The index is made up of 757 bonds issued by companies including Barclays Bank Plc, Vodafone Plc and Unilever Plc.
The pound today fell to a record low against the yen and the weakest since 2001 versus the dollar on concern the U.K. slump will deepen and the central bank will ease monetary policy further. As of 11:02 a.m. in London, the currency was at 123.85 yen from 125.01 yen late in New York yesterday. It declined to $1.3736 from $1.3928.
Oil Prices, Pound
“Since the summer, the exchange rate has fallen by almost 20 percent, and oil prices have fallen by around two-thirds, both of which will boost demand,” King said in the speech.
“A pronounced contraction in spending and output is under way,” King said. “Total output in the fourth quarter is expected to have fallen sharply. In the first half of this year, the rate of contraction is likely to continue to be marked.”
The inflation rate declined to 3.1 percent in December from 4.1 percent the month before, the biggest drop since records began in 1997. The economy may shrink 2.7 percent this year, the most since 1946, the Ernst & Young Item Club said this week. Figures today showed U.K. unemployment rose at the second- fastest pace since 1991 in December.
“The bank is almost ready, but very willing, to engage in unconventional monetary policy techniques,” said Philip Shaw, chief economist at Investec Securities in London. “There is still some room for interest rates to come down. But there’s a good chance they’ll use this facility.”
‘High Quality’ Assets
The Treasury said this week that the central bank can make asset purchases of up to 50 billion pounds and the government will indemnify the bank against any losses, starting on Feb. 2. King said officials “will consider purchasing only high-quality assets” and that any such actions would seek “to complement and stimulate private demand, not substitute for it.”
“In each case the bank will keep the market fully informed,” King said. “It will be a matter of weeks not days before a program of purchases can begin, but it will be weeks and not months.”
Bank of England Deputy Governor Paul Tucker said today that turmoil in financial markets may make it harder for officials to carry out so-called quantitative easing as U.K. rates near zero.
“How such operations effect aggregate demand and inflation would however depend on conditions in the financial economy,” Tucker wrote in comments to lawmakers. “The transmission would be dampened although not eliminated by conditions in the banking system.”
Any purchases by the Bank of England would follow similar moves by the U.S. Federal Reserve, which has started buying securities after cutting its benchmark interest rate to a target range of zero to 0.25 percent.
Policy makers will watch measures of lending to non- financial companies to gauge how well the asset purchases and the government’s capital injections and loan guarantees are working, King said.
The measures “are not designed to protect the banks,” King said. “They are designed to protect the economy from the banks.”
The economy may still take some time to recover, he said. “The lags in economic policy are notoriously long and unpredictable. But well-designed policies implemented within a consistent policy framework will eventually work,” said King.
The Bank of England’s minutes of the Jan. 8 rate decision showed that officials voted 8-1 to lower the rate by a half point of 1.5 percent, rejecting a proposal from David Blanchflower for a full-point cut. They also discussed leaving the rate unchanged.
“The markets had priced in a cut of 50 basis points,” the minutes cited the majority of the panel as saying. “Either leaving bank rate unchanged this month, or implementing a larger-than expected cut, could damage confidence further in both financial markets and the real economy.”
And in the Financial Times ("Bank of England to buy up corporate bonds"):
The Bank of England will start to buy corporate bonds in large quantities within weeks, Mervyn King, its governor, said on Tuesday night as he explained the next steps to be taken to limit the severity of the recession.
Borrowing from Donald Rumsfeld, the former US defence secretary, he said such purchases would be “unconventional unconventional measures” designed to increase liquidity and trading and reduce the spread of corporate bond yields over government bonds.
These differed from “conventional unconventional” policy, in which the Bank created money to buy assets with the aim of increasing the stock of money in the economy and the availability of credit while also raising spending. Although the Bank’s monetary policy committee was not ready to use this weapon yet, he said, if inflation was likely to remain too low the MPC “might wish to adopt these unconventional measures as an instrument of monetary policy”.
Speaking to employers at a CBI dinner in Nottingham, Mr King followed the prime minister’s lead in turning up the heat on the banks. He insisted that all the official efforts to restore health to the banking system “are not designed to protect the banks as such. They are designed to protect the economy from the banks.”
“A pronounced contraction in spending and output is under way,” he added, predicting “in the first half of this year, the rate of contraction is likely to continue to be marked”.
The banks needed to reduce the size of their balance sheets, but he insisted this reduction should not come at the expense of lending to non-financial companies and deepening the recession. Instead, he hoped banks would reduce their loans to other parts of the financial system.
“There is scope for a reduction in the leverage of banks without restricting lending to the ‘real’ economy,” he said, insisting that the necessary “netting” of exposures needed to take place in an international setting, since many of banks’ assets and liabilities were foreign.
Mr King acknowledged that recent policy from the authorities had appeared contradictory, with officials urging banks to reduce the size of their balance sheets while continuing to lend freely. Consumers had been urged to spend while encouraged to reduce their dependence on debt. “Almost any policy measure that is desirable now appears diametrically opposite to the direction in which we need to go in the long term,” he said.
Unusually for the Bank governor, he even came close to a mea culpa, for policy mistakes the Bank had made. “It is clear that policy did not succeed in preventing the development of an unsustainable position.”
But this failure was more one of circumstance than one of error in setting interest rates, he continued. To prevent the build-up of credit while inflation was under control in future, Mr King called for the Bank to be given “an additional policy instrument to stabilise the growth of the financial sector balance sheet”.