Were you one of the many who got popcorn ready to watch an anticipated twist to the Bank of England's (BOE) interest rate decision last week? Sorry bro! You must have been sorely disappointed! As expected, the central bank didn't make any changes to its 325 billion GBP asset purchase program nor did it cut interest rates.
Instead, the BOE's quantitative easing program will end this month after seven consecutive months of purchasing, including 50 billion GBP over the past three. Meanwhile, interest rates will remain steady at 0.50%.
Some economists believed that the BOE would surprise the markets with more purchases, pointing to declining economic conditions both in and out of the U.K. Industrial and manufacturing production dropped 0.3% and 0.9% respectively in March. In addition, consumer confidence is down and the UK economy is now in a double-dip recession. With all the concerns surrounding the euro zone (take your pick: Spain, Greece, or the Netherlands?), some naysayers felt that the BOE would be proactive and inject some liquidity into the markets.
So what's stopping the BOE?
Remember, while low interest rates and high liquidity can help boost the economy, it can lead to a sharp rise in inflation, which would have detrimental effects such as eroding the purchasing power of the local currency. With inflation hanging around 3.5% - which, by the way, is way above the central bank's target of 2.0% - the BOE doesn't want to risk entering a situation where growth is sputtering while inflation shoots off even higher.
I think the markets understand that the BOE isn't out of the woods yet, and this can be seen on the charts.
Once news hit the airwaves that the BOE wouldn't be implementing any additional quantitative easing measures, GBP/USD popped higher, breaking through resistance around 1.6150. However, the gains were short-lived, as Cable soon trickled back lower.
One reason why the markets may have been hesitant to start loading up on long pound positions is because they haven't completely discounted further easing later this year. The BOE is in a tough spot right now, as cutting back on liquidity measures may send the U.K. into a deeper rut. The problem, of course, is that they risk the possibility that inflation rises like a Marge Simpson hairdo.
For now, we'll have to keep an eye on the next few major reports from the U.K., with the next one being BOE inflation report due Wednesday, May 16.
If the report shows that the BOE expects inflation to remain above its target for the remainder of the year, then perhaps we can lower any expectations for more QE.
On the other hand, if the report shows that inflation could tone down over the rest of 2012, then it may give the central bank the room it needs in order to inject more liquidity into the U.K. economy.
I also suggest setting reminders on your phone for when the CPI report (May 22) and MPC meeting minutes (May 23). The CPI should give more insight on the state of inflation, while word on the street is that a few MPC members actually voted for more QE measures! Pound playas, we should be in for an exciting couple of weeks!
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