The move by the Bank of England's Monetary Policy Committee to reduce the official bank rate by 50 basis points to a record low 0.5 per cent underlies the substantially weak state of the UK economy. It is no exaggeration that the UK economy is one of the worst affected globally from the financial crisis, underlying in part its over-reliance on the financial services sector.
Highlighting the precarious position of the economy, it has undertaken an unprecedented £75 billion (Dh388bn) asset purchase programme in addition to the aggressive monetary policy move. The new asset strategy will be financed by the issuance of central bank reserves. The bank will pay for these assets by creating new money, electronically. The freshly-created cash paid to the banks for these assets will be credited to their Bank of England accounts. In turn, the banks should be able to make new loans to businesses and consumers backed by this increased funding.
The bank would focus initially on purchases of corporate bonds and commercial paper. The hope is that large increases in the money supply will lead investors to rebalance portfolios, stimulating investment and consumption and other economic activity. The central bank attempts to hold down yields on a range of government securities, making borrowing cheaper, and cutting the costs of an expansionary fiscal policy.
The fall in consumer spending together with manufacturing output has been startling and the outlook for the economy is alarming. International financial markets remain weak and still largely frozen and, for businesses and consumers, the access to credit is for all intense or purpose remains closed. Demand for both big and small ticket items has fallen significantly. The UK housing market remains weak. In regard to UK unemployment, the outlook is very worrying. The unemployed numbers are now above two million but this could well approach three million by the year-end.
In order to try and inject credit and liquidity into the system, the bank will buy medium- and long-maturity conventional gilts in the secondary market. The ultimate aim is also to improve spending within the economy and hence return the economy to growth. However, any improvement will unlikely be seen for some time.
The substantial asset purchase or quantitative easing programme is, in effect, a euphemism for a government's strategy of printing money – often seen as a last resort move for economies in desperate positions or having exhausted interest rate reductions. This is the position the UK economy finds itself in. Its recession is likely to be both deep and long, possibly lasting right through 2009. The central bank hopes the move to quantitative easing will arrest the sharp decline in output. However, even with this latest move, the UK's GDP is expected to still decline by more than four per cent on an annual basis. A few months back the four per cent was the bank's worst case scenario but is now more probable. Most observers believe that the UK will see the sharpest down turn of any of the world's major economies.
Although the move to record low interest rates combined with the substantial injection of money is being seen in some quarters as a fuel for inflation and much higher interest rates as possible pent up demand is unleashed at a later date, the reality is that the economy will see deflationary pressure for up to two years. Some economists are forecasting that the UK consumer price index will be below one per cent until 2012.
The financial turmoil has led to steep declines in stock markets and house prices, and a likely big rise in unemployment over a long period, with falling output, and rising government debt. Research shows that often the aftermath of severe financial crises share three factors. First, asset market collapses are deep and prolonged. House prices decline on average by 35 per cent over a period of six years, while equity prices fall on average by 55 per cent over a period of three-and-a-half years. Second, the unemployment rate rises on average by seven percentage points over the down phase of the cycle, which lasts on average over four years. Output falls, from peak to trough, on average by over nine per cent, although the duration of the downturn, averaging around two years, is considerably shorter than for unemployment. Third, the value of government debt explodes, rising on average by over 80 per cent.
No-one can be sure if this new quantitative easing strategy will work. It did not work in Japan and is yet to be proven in the US. The Bank of England cannot be sure how much money it needs to create to make a difference. Too little and there will be no impact. Too much and it may lead to high inflation.
The Bank of England's move on quantitative easing is the first in its 300 year history. The unprecedented action will create liquidity for the banks but there is no guarantee that banks will channel funds to the real sector.