Sunday, November 01, 2009
Bank should prime the pump with another £30 billion
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

pump.jpg

To QE or not to QE? It is the big question for the Bank of England’s monetary policy committee (MPC) this week, and it is a big question for the economy.

After those unexpectedly weak gross domestic product figures nine days ago, showing that officially the economy remains in recession, the onus is on the Bank to do more quantitative easing (QE) this week. Will it, and by how much?

The story so far is that the Bank has done £175 billion of quantitative easing: buying assets, mainly government bonds or gilts. The MPC, while not claiming it has solved everything, is upbeat about its effects.

David Miles, who joined in June, said recently: “I believe the evidence is that QE is having an impact and that it is relevant to economic conditions right across the country. And not just in financial markets in London, but in high streets and factories and homes throughout the UK.”

Kate Barker, another MPC member, said a few days ago that it had helped ease the recession in the housing market, thus supporting house prices.

I don’t suppose many people discuss quantitative easing before sitting down to watch EastEnders but if the Bank is right, they should. It is as important in its way as changes in interest rates and the guide on the Bank’s own website provides a simple explanation why.

The Bank, it says, “boosts the supply of money by purchasing assets like government and corporate bonds”, adding: “Instead of lowering Bank rate to increase the amount of money in the economy, the Bank supplies extra money directly. This does not involve printing more banknotes.

“Instead, the Bank pays for these assets by creating money electronically and crediting the accounts of the companies it bought the assets from. This extra money supports more spending in the economy.”

It goes on to say that this extra spending is necessary to get inflation back to its target — inflation is the Bank’s only target — but I suspect most people would rather see the economy boosted in a more straightforward way, such as getting unemployment down and preventing firms going bust.

The question is when the process should stop. Is £175 billion enough, or should the Bank go further? Let me first offer a guide to how the MPC would like us to think of its approach to policy, then offer my view.

There will come a time, though perhaps not for quite a while, when the Bank raises interest rates. At least some of the headlines that will accompany that announcement will be something like: “Worried Bank slams on the brakes”.

That is not, however, how the Bank would see it. Interest rates are very low, the lowest in the 315 years of the Bank’s existence. At 0.5%, Bank rate is a tenth of what I would regard as the modern-day norm, 5%.

So the way the Bank sees it is that as long as rates remain below 5%, then even if they are rising, monetary policy remains expansionary. So the right headline when, say, Bank rate goes up from 0.5% to 0.75%, would be: “Bank eases off the accelerator.”

The same applies, though in a slightly more complicated way, to quantitative easing. There are three ways any decision on interest rates can go: up, down or sideways.

There are also three ways this week’s decision on quantitative easing could go. The equivalent of a cut in rates would be announcing more easing, in other words more asset purchases.

Sticking with the existing £175 billion but not committing to any more would be like an interest rate “hold”.

An announcement that some of the gilts and other assets were to be sold back into the markets would be the equivalent of a rate hike, though it could still be argued that the policy would remain expansionary until they have all been sold back.

No such sell-off announcement will happen this week. The debate is about whether the Bank announces further easing or stops at what it has done so far.

It is of intense importance in the City, where the programme of asset purchases is seen to have helped lift markets (which the Bank acknowledges and welcomes). A halt would bring an immediate adverse reaction, most notably by pushing up the yields on gilts and corporate bonds.

It is also very important, if Miles and Barker are right, in high streets, factories, estate agents and homes up and down the country.

It matters too for the pound. The Bank’s aggressive easing programme has helped push sterling lower against other currencies though, as I shall try to explain, that might be a perverse reaction.

What will it be? MPC-watchers say October’s meeting offered few clues, merely putting off the decision until this month, when the existing programme runs out.

The shadow MPC, which operates under the auspices of the Institute of Economic Affairs, has been keen on quantitative easing from the start and thinks it would be a mistake to stop now.

Tim Congdon, one of its members, did an impassioned presentation at a recent meeting, arguing that Britain stood out in its policy response.

The easing programme had lifted growth in the money supply at a time when it was heading down worryingly in both the euro area and America. On his analysis, the currency markets should be concerned about recovery in Europe and America, not Britain.

A more cautious note is struck by Chris Williamson, chief economist at Markit, which produces the monthly purchasing managers’ surveys. He is convinced on the basis of these surveys that the economy has been recovering for some months.

The danger, he suggests, is that the Bank pumps in more money at a time when the economy does not need it, risking that the inflation already present in asset prices extends to other parts of the economy.

He has a point, which is why I think the Bank, which also has its doubts about the official statistics, needs to proceed with caution. It is too soon to stop the asset purchases altogether, not least because of the adverse reaction in markets that would result.

It is fair to argue, however, that the economy needs less of a boost than it did. At its peak, the Bank was doing £25 billion of easing a month. In August it slowed the monthly rate to £17 billion-£18 billion. I would slow it further, to perhaps £10 billion, implying that the Bank should announce a further £30 billion of purchases this week. Let’s see what it does.

PS: Many have written books on the credit crunch — I’m just putting the finishing touches to one — but not many people have written two. So I take my hat off to Graham Turner, founder of GFC Economics, for his second; No Way to Run an Economy.

He has always advocated dramatic policy measures to lift Britain and other economies out of the crisis and criticised policymakers for their timidity. His latest book is no exception.

Some think Britain and America have been irresponsible in allowing their budget deficits to rise too much. He argues that they should have been bolder in their fiscal stimulus efforts and allowed deficits to rise much more.

The parallel he draws is with wartime. During the second world war, America’s budget deficit rose to 28.1% of gross domestic product, while Britain’s was just behind at 26.1%. Debt and deficits fell sharply in peacetime, when full employment was re-established.

By “socialising” the banking industry’s losses, he argues, governments have been unable to offer a proper Keynesian response to the crisis. As you might expect, he is not optimistic about the outlook.

From The Sunday Times, 1 November 2009