On December 6 the Bank of England voted not to extend asset purchases as a form of monetary stimulus. This is despite prevailing weakness in the British economy and sentiment expressed in the BOE November minutes indicating that members of the policy committee still believe that asset purchases fundamentally are an effective policy tool. Nevertheless, the BOE voted not to extend stimulus and effectively halted a policy of counteracting fiscal austerity with monetary stimulus. The lingering question for the global economy is whether the Fed will follow a similar course of inaction.
Despite the fact that the American financial news media was quick to latch onto the fiscal austerity measures put in place by the British government, the BOE's quantitative easing policies have maintained a lower profile. By the end of summer 2012, the Bank of England had engaged in quantitative easing to the tune of £375 billion (roughly $600 billion) since the crisis began in 2008. That may not sound like much compared to the roughly $1.9 trillion in balance sheet growth the Fed had undergone to that point, but it is about 50% more per capita. However, the U.K. is now on track for a triple-dip recession and the BOE elected not to pursue further asset purchases. Bank officials claim that this is because of the diminished stimulative effect of asset purchases and the fact that the British economy has seen signs of rising inflation. The real question is whether this lack of BOE action is really a move to force the government's hand.
As Ben Bernanke continually reminds us, "monetary policy is not a panacea." Perhaps BOE officials, particularly departing Governor Mervyn King, saw this as an opportunity to coax some fiscal policy action. At present, we have seen no such move from the British government. Last week Chancellor of the Exchequer George Osborne had to announce that British growth had fallen into negative territory once again, but instead of announcing a bold new stimulus plan, the Conservative Party has stuck to their austerity plans. The only real changes to fiscal policy that Osborne announced were public sector staff and benefit cuts to pay for moderate infrastructure improvements. Essentially, this amounts to no net fiscal stimulus on the principal that stimulus now would somehow spook markets.
Unfortunately, the markets might already be spooked. As monetary policy remains insufficient in bolstering the British economy in the headwinds provided by the European crisis and their own austerity measures, commentators have already begun speculating about a British debt downgrade. Such a downgrade would signal that austerity in the face of economic crisis harmed the British economy so severely as to offset any confidence it instilled about the long term solvency of the British government. Further, it would signal the precise limits of stimulative monetary policy in counteracting austere fiscal policy.
It is crucial to note that unlike the U.K., the U.S. did implement initial fiscal stimulus in the wake of the crisis. It is also worth note that the U.S. government has not explicitly undergone austerity measures; rather it has been wrapped in fiscal gridlock, unable to engage in any substantive changes to fiscal policy. All the while, the Fed has been acting in drips and drabs (some very large drips and drabs) to continually stimulate U.S. economic growth, and the U.S. economy is growing. So, the U.S. situation is fundamentally different, but that does not mean that the Fed may not follow suit with the BOE when they meet this week.
Right now, the Treasury bond market suggests that investors are speculating on upcoming Fed stimulus. If such a Fed policy were to occur, it would be a move to offset the conclusion of Operation Twist at year end, thereby bolstering the continued asset purchase plan (QE3). With the fiscal cliff looming, some investors might be speculating that the Fed wants an insurance policy of sorts against a deep and damaging recession. However, Fed officials have been very clear that they do not have the policy capacity to offset the effects of the fiscal cliff with monetary stimulus.
The most likely outcome is that the Fed will neither follow the BOE's example, nor provide the additional stimulus on which some investors are betting. Rather, the Fed is likely to mitigate pervasive market uncertainty by doing their best to eliminate one minor aspect of it, interest rate uncertainty. Simply, when the Fed meets this week, investors should not expect a massive new stimulus plan; they should expect substantive changes to the way forward guidance is communicated. While this may initially disappoint markets, investors will take some solace in the fact that QE3 is still ongoing, and then they will turn their full attention back to the fiscal cliff negotiations where every word uttered by Congressional leadership or a White House official continues to move markets.