QE2, whose maiden voyage seemed to have been postponed indefinitely, is ready to be launched. That, at least, seems to be the considered judgment of the market. Sterling has tested $1.57 this week, its lowest since January after touching $1.65 when markets thought rate hikes were in the offing. That coexists with new lows in gilt yields – a combination that suggests bond purchases are in the offing (and little fear about the UK’s solvency).
Inflation expectations, long a bane of the UK, now allow the central bank to be more aggressive. The “break-even” inflation rate, derived from comparing the yields on fixed and index-linked 10-year gilts, suggests that UK inflation will average about 2.6 per cent over the next decade. That is its lowest since last September, when QE2 in the US reawakened inflation concerns, and shows that the market now believes the Bank of England will be able to keep inflation within its targeted band of 1-3 per cent. Expectations are well below their pre-crisis levels.
Bond traders regard central bank bond purchases as an unalloyed positive. So is their optimism justified? Unemployment is disappointing. August saw the largest rise in unemployment in two years, with austerity cuts biting into public sector employment and outbalancing a gain in private sector jobs. This looks like a case for more stimulus, and thus for gilts.