U.K. may cut interest rates to zero before the end of QE

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U.K. may cut interest rates to zero before the end of QE

- The Bank of England may move a step closer to tightening monetary policy by unwinding 900 trillion pounds government bond purchases while also opening the possibility that borrowing costs could be pushed below zero.

Although inextricably linked the two decisions might pull in opposite directions, they can prove inextricably linked. They feed into the debate over which policy levers the U.K. central bank will pull first when the time comes to tighten monetary policy.

Officials led by Governor Andrew Bailey have signaled that they want interest rates higher than their current level before selling some of the government bonds built up through their quantitative easing program. Adopting negative rates as a potential policy tool could enable them to bring forward the moment when they scale back their bulging balance sheet. They could also prepare the ground for bolder action.

'It makes sense for them to come out and let the market know what their new guidance is, sooner rather than later, said John Wraith, chief of UBS Group AG's U.K. and European rates strategy. 'The simplest thing, he said, would be for the BOE to lower the 1.5% threshold for where rates should start before bond sales start - a possibility with acknowledgement that rates could slip into negative territory.

Officials, set to announce their latest policy decision on Thursday. They're expected to give a very short timeframe to keep their stance unchanged at 0.1%, but with some dissenting voices calling for an early termination of bond purchases. The current QE program envisages 150 billion pound bond purchases this year. While the U.K. has recovered from its pandemic recession, central bankers are likely to hold back on tightening until more of the 1.9 million people on the Government's furlough program are back at work! This measure of supporting wages closes September last. It is probable that the unemployment rate will surge in the next few months.

Some people on the furlough used to work in retail or air travel, said Elizabeth Martins, senior economist at HSBC. There are also signs that the U.K. economy may have seen the best of the rebound, according to George Buckley, chief U.K. and euro-area economist at Nomura International. Real-time indicators showed more of a pop than a boom on January 19 from the end most restrictive measures. Businesses are wary of the spread of new virus variants, which put a chill on the outlook of purchasing managers.

Much of the conversation in the past few months has been dominated by a spike in inflation, both in the UK and around the world. Consumer price growth rose 2.5% from a year ago in June, highest since 2018 and a half point higher than the target of BOE.

While Governor Andrew Bailey and the majority of other MPC members have repeatedly said that much of the increase is likely to prove temporary, bank now estimates that inflation will exceed 3% this year. A sharp increase in the bank's forecast of price growth could provide a hint that tightening may be required sooner than expected.

After unifying on the need for stimulus last year and in the early months of 2021, policy makers are starting to diverge on when to tighten. Michael Saunders, an MPC member, is likely to vote against completing the QE program in full. It could be joined by Deputy Governor Dave Ramsden. Both made hawkish comments in recent weeks.

'Markets are expecting a vote split 6 - 2, said Robert Wood, chief U.K. economist at Merrill Lynch International, adding that further dissent would constitute a surprise.

Traders have increased bets on Rate increases. They are pricing in 13 basis points of hikes by the middle of 2022, versus as few as 7 point last month.

Talk about tighter policy has sharpened the focus on how and when the MPC will act. Officials began a review earlier this year and the BOE will provide some updates on that discussion.

Most economists expect the bank to lower the level of interest rates needed for QE to begin unwind. At the moment, the bank has suggested that rates need to move to 1.5% before they sell bonds. Opening up the possibility of negative rates would allow the BOE to intervene before rates rise to that level.

Bailey suggested last year he was open to a major shift and was ready to reduce the institution's balance sheet before raising interest rates.

Still, not everyone expects that the review is imminent, with RBC economists suggesting it may not come until November.

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