BoE to announce critical decision on QE future

The Bank of England will decide whether to expand its quantitative easing program later on Thursday, and economists are split down the middle over the central bank's choice.

The outcome of Thursday's policy decision is the least certain this year, as the effectiveness of the 125 billion pounds of QE asset purchases to date remains unclear and Britain's economy is showing tentative signs of recovery.

Halting the QE process too early could prolong Britain's worst recession in decades, but doing too much risks setting the stage for an inflation surge in several years time.

QE is shrouded in uncertainty, said Simon Hayes, economist at Barclays Capital. It is not clear what quantity of asset purchases is necessary to ensure that the inflation target is hit because the strength of transmission from asset purchases to inflation is unknown.

When the BoE launched QE in March with an initial 75 billion pounds in funds, it aimed to boost spending and bank lending by buying up financial assets with newly created money, which it hoped would then circulate through the economy.

But evidence of how well this process is working is limited. The BoE's preferred measure of money supply grew only slightly faster in the second quarter of 2009 than the first, and its policymakers have warned it could take another six months before the picture gets much clearer.

A Reuters poll on July 30 showed economists were split 31-32 on whether the BoE would raise the QE total to 150 billion pounds this Thursday -- the maximum sum possible without getting additional finance ministry approval.

The only area of certainty was that the BoE would keep rates at the record low 0.5 percent set in March before it began QE.

If anything, economists have shied further away from expecting more QE in the days since the poll, as data ranging from industrial output to service-sector purchasing managers' reports have surprised on the upside.

We think the Monetary Policy Committee is unlikely to ignore these straws in the wind, said David Page, economist at Investec.

The services PMI is a survey that the BoE places a lot of faith in, and it is likely to further the Committee's confidence in the short-run momentum of the economy. This is true of better than expected manufacturing data as well.

Nonetheless, Britain's economy is in far from good shape. Total output fell a bigger-than-expected 0.8 percent between April and June, and is 5.6 percent lower than a year ago.

Unemployment rose to 7.6 percent in the three months to May, and is expected to increase further, while inflation at 1.8 percent puts the BoE under no immediate pressure to act.

The central bank's inflation target is 2 percent.

The uncertainty about the BoE's policy decision -- and its direct bearing on future gilt purchases -- means there is likely to be a significant market reaction whatever the Bank decides.

Yields on benchmark 10-year gilts could rise by up to 30 basis points if the BoE decisively rules out more QE, while prices could recoup much of the past month's losses if July's shock decision not to smoothly expand QE before the funds ran out proves to have been a mere hiatus in the program.

However, a decisive statement about the future of QE could prove elusive, with a strong likelihood that the BoE will not announce more purchases but leave the door open for a future increase.

We expect a 'soft halt', said Barclays Capital's Hayes. The MPC will make it clear that its assessment of QE is ongoing, and that the policy could be extended if the economy does not recover as the MPC expects ... rather than a 'hard halt' (where) the next decision is when to tighten policy.

(Editing by Andy Bruce)