The Bank of England recently caught the entire investing world by surprise when it decided to deviate from the more restrictive policy that central banks all over the world are employing to combat surging inflation, and returned to quantitative easing (QE).
QE is when a central bank buys bonds, typically in the form of government-backed debt or mortgage-backed securities. In doing so, a central bank is increasing a country's money supply and effectively pumping money into the economy, which creates more liquidity. This "easy-money" policy, which has been used by central banks since the Great Recession, is typically done to stimulate an economy when interest rates are already extremely low.
It's also seen as generally supportive of the stock market because more money in the economy can lead to more assets being inflated. With the Bank of England doing a quick pivot on monetary policy, is it only a matter of time before the Fed follows suit? Let's take a look.
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Why the Bank of England pivoted
The move by the Bank of England caught markets by surprise because the central bank had been trending in a somewhat similar direction as the Fed, due to some of the highest levels of inflation seen in 40 years.
The Bank of England raised its benchmark base rate from 0.1% last December to roughly 2.25% now, which included a 0.50% rate hike in August, the largest rate hike it has done in 27 years.
Furthermore, the Bank of England is in the early stages of reducing its balance sheet in a move known as quantitative tightening (QT), which is the opposite of QE when a central bank allows its bond holdings to mature without reinvesting the proceeds or sells bond holdings.
The Bank of England had begun to let some of its bond holdings mature and had also planned to soon begin selling bonds as well. The overall goal is to reduce the balance sheet, which stands at 857 billion pounds, by about 80 billion pounds over the next year.
But problems have arisen recently in the foreign exchange markets, with a surging U.S. dollar and falling British pound sterling. The pound weakened more after British Prime Minister Liz Truss introduced a series of tax cuts that many investors worried would exacerbate already high inflation.
With the pound approaching parity with the dollar, the Bank of England stepped in to try to stabilize the currency by saying it would buy $65 billion of long-term pounds up until Oct. 15. However, the Bank of England also reiterated its long-term strategy of shrinking the balance sheet.
Image source: Getty Images.
Will the Fed follow suit?
On the day the Bank of England announced QE, the Dow Jones Industrial Average jumped nearly 550 points higher, implying that investors -- at least on that day -- thought the Fed was capable of such a reversal.
Some, like ARK Invest founder Cathie Wood, say they believe the surging dollar will force the Fed to pivot because the strength of the currency is going to hurt the ability of the U.S. to compete, as exports become too expensive and thus unattractive to other countries. But remember, the Bank of England was reacting to a currency crisis that some say was necessary to avoid the failure of a large pension fund or financial entity.
Unless there is a similar crisis in the U.S., Fed Chairman Jerome Powell has been crystal clear that the Fed will continue to raise rates until there is enough evidence to show that inflation is on the decline. The Fed's median forecast for rates implies another 125 basis points (1.25%) of rate hikes before the end of the year. I also do think the Fed will want to decrease its balance sheet, which is currently around $8.8 trillion in assets.
With that said, I believe we will start to see inflation show more clear evidence of peaking and declining soon, which could lead the Fed to slow or reverse rate hikes. If there is a more severe recession next year, it will also be difficult for the Fed to press ahead with rate hikes and potentially QT as well, although I think the impact of QT is harder to predict right now.
So, while I do not see a Fed pivot as imminent, I could see it happening in 2023 depending on how the economy shapes up.
