Europe’s monetary authorities remained reluctant to extend their use of unconventional tools, whose impact is harder to gauge, making them inherently risky. While the U.S. Federal Reserve announced on Wednesday it will buy at least $600 billion of bonds and Japan has also restarted quantitative easing, neither the European Central Bank nor the Bank of England pledged such moves. But as the recovery slows in the euro zone and fiscal budgets tighten, central banks may be forced to resume unorthodox action.
Global Economic Insight and Analysis thinks the European Central Bank and the Bank of England may keep their interest rates at current record lows of 1% and 0.5%, respectively, until late 2011. Slowing economic growth will ensure borrowing costs remain low. Fiscal austerity will hit household and business demand for domestically produced goods and services as well as imports. Given that intraregional trade dominates trade flows in Western Europe, reduced demand will weigh heavily on export growth.
Moreover, European currencies are likely to remain strong in the near term. The euro surged against the dollar following the Fed’s announcement and has gained around 19% since the start of the summer. The pound sterling has also risen strongly, gaining about 13% against the greenback in the same period. This will dampen extraregional trade.
Although the European Central Bank's medium-term strategy is to phase out its extraordinary measures, renewed economic difficulties could slow plans. The bank may have no choice but to provide unlimited short-term liquidity for longer than it now plans because of significant banking problems. Furthermore, although the European Central Bank’s €60 billion covered bond purchase programme ended in July, the bank has been active in the government bond market. European Central Bank President Jean-Claude Trichet said that the bank has been purchasing the government bonds of struggling economies such as Ireland. These purchases are likely to continue, especially when countries are forced to return to the market next year to meet their new funding needs.
The Bank of England is likely to restart its asset purchase programme if growth concerns start to outweigh inflation concerns as 2011 progresses. The central bank ceased buying bonds—financed by the issuance of its reserves—in February, as it had exhausted the £200 billion available and the economy was showing signs of recovering. Over 99% of the available funding was spent on gilts, with the remainder spent on corporate bonds. Central bankers would likely once again focus on purchasing mostly long dated government bonds in order to inject liquidity into the economy and prevent a double dip recession. Global Economic Insight and Analysis expects a further £50 billion of assets could be purchased in 2011.
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