Bank stimulus options eyed as economy weakens

A statue is seen outside the Bank of England in the City of London February 8, 2011.

LONDON (Reuters) - Faced with a stalling economy and a fiscal straitjacket, Bank of England policymakers may spend an unusual amount of time this week discussing what might be done should the recovery fail to pick up.

At the start of the year, the question was when, not if, interest rates would rise. Now a rate rise this year looks highly unlikely, and the question is whether more stimulus is needed.

Most economists expect the central bank to stick with its current policy settings, leaving rates at 0.5 percent on Thursday and keeping the option of a second wave of asset purchases -- so-called quantitative easing (QE) -- up its sleeve.

Nevertheless, August is one of the Bank's quarterly "inflation report" months, when the Bank has traditionally been more twitchy, and the run-up to the meeting has been marked by a run of surprisingly weak data, both from Britain and overseas.

GDP figures showed Britain's economy barely grew in the second quarter following six months of stagnation and surveys this week suggest the third quarter has not got off to a good start.

Manufacturing in Britain contracted in July, according to survey of purchasing managers, and barely grew in either the euro zone and or the United States.

The Bank will publish its verdict at 12 p.m. on Thursday, but will not provide any details of the discussions until later this month.

Former Bank rate-setter Sushil Wadhwani described the recent slew of weak data as "perturbing."

"If I were on the committee, for the first time this year I would be voting for more QE," he told Fathom Consulting's Monetary Policy Forum. "We've essentially got a global slowdown that is well in train."

BALL IN BOE'S COURT

Britain's government, elected last year on a deficit-fighting mandate, has made clear that stimulus needs to come from monetary not fiscal stimulus.

Its "No Plan B" mantra would make any U-turn on its austerity programme politically difficult, despite the International Monetary Fund's recommendation this week that tax cuts might be warranted if the economy continues to stagnate.

UK interest rates have stood at a record low 0.5 percent for more than two years -- already the longest period of inertia since World War Two.

Given the weakness of the recovery, investors do not expect rates to rise for at least another year and one of four economists polled by Reuters last week predicted more QE would be needed.

The BoE bought 200 billion pounds of assets, mainly government bonds, with new money between March 2009 and February 2010 in an attempt to reduce borrowing costs and boost the supply of credit.

Whether a second round of bond purchases would be effective, however, is questionable. Gilt yields are already at record lows -- 10-year yields hit 2.76 percent on Tuesday -- so it is hard to see how a further decline would give the economy much of a boost.

"More QE is certainly possible but I think the impact might be more through confidence than lower gilt yields," said Jonathan Loynes at Capital Economics. "There might also be merit in purchasing greater quantities of corporate bonds or even equities."

Adam Posen, the most dovish member of the BoE's nine-member Monetary Policy Committee, has voted for more QE since the end of last year and also advocated "credit easing" by aiming to cut borrowing costs in specific areas of the economy. It remains to be seen whether he can convince his colleagues.

Two of the members have voted for higher rates for much of this year, worried that inflation -- which is running at more than twice the Bank's 2-percent target -- could lead to a wage-price-spiral. However, recent surveys have indicated that price pressures are close to peaking.

(Reporting by Christina Fincher, editing by Mike Peacock)