Sunday, February 05, 2012
To QE or not to QE? That is the question
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

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My regular column is available to subscribers on www.thesundaytimes.co.uk This is an excerpt.

The ducks, it seems, are all lined up in a row. Gross domestic product fell in the final quarter of last year, inflation is falling and the money supply is weak.

Sir Mervyn King gave a broad hint in his first big speech of the year that he and colleagues on the Bank of England’s monetary policy committee (MPC) stand ready. It will be s surprise if there is not an announcement on Thursday at noon.

I am talking about the Bank deciding to increase its asset purchases, to add to the £275 billion of quantitative easing (electronically creating or “printing” more money) to boost the economy.

Since October, when the MPC announced an additional £75 billion of quantitative easing (QE), in response to “increased downside risks” for both growth and inflation, the markets have been waiting for this moment.

In 2009, the worst post-war year for the world and British economies, the Bank reached into its filing cabinet marked unconventional monetary policy and unleashed £200 billion of QE, overwhelmingly by buying gilts; government bonds.

Bank rate had been cut as much as was thought desirable - 0.5% represents easily the lowest in the Bank’s 318-year history - and more monetary oomph was needed. Hence the £200 billion of QE in these exceptional 2009 circumstances which, on the Bank’s estimates, added between 1.5% and 2% to the level of gross domestic product and 0.75% to 1.5% to inflation.

For the Bank’s view on how it did so, a paper “The UK’’s quantitative easing policy: design, operation and impact”, is on its website. It has also published some recent working papers which offer supportive evidence on the impact of the policy.

2009 was special because it was so very weak. To announce another £75 billion of QE in October reflected the Bank’s deep concern over the impact of the eurozone crisis, and its fear the economy was going into reverse. It said as much about the economy as any indicator.

The significance of this week’s MPC meeting is that the £75 billion announced in October has been done. In meetings since then committee members have said they would decide on wtether to do more when that point was reached.

The moment has arrived and the fact this is a month in which the Bank publishes a new quarterly inflation report means trhe markets will be surprised if there is not more this week.

A “cautious” MPC will announce a further £50 billion, according to Philip Shaw of Investec and Nick Stamenkovic of Ria Capital. Shaw cites evidence of operational constraints on the Bank - its appetite for gilt purchases may be grater than the markets’ willingness to sell - while Stamenkovic points to the Bank’s January minutes as signalling that some members are uneasy about repeating the October dose.

But both Michael Saunders of Citi and Geoff Dicks of Novus Capital, think it will be another £75 billion. Saunders thinks the Bank can carry on buying until QE reaches £600 billion, nearly 40% of GDP. That would leave £800 billion of gilts still in circulation, enough for institutional investors such as pension funds.

The shadow MPC, under the auspices of the Institute of Economic Affairs, is more restrained. Only three of its members favour an immediate extension of QE.

Could the Bank do anything else as an alternative to QE? Vicky Redwood of Capital Economics floats the idea of the Bank cutting the interest rate paid on commercial bank reserves to zero or even a negative 0.25% rate, as in Sweden. In theory, a penalty rate would encourage banks to boost lending rather than sit on these reserves.

The Bank, however, ran through alternatives last September. They included a cut in Bank rate below 0.5% and setting out guidance on the future path of interest rates, as the Federal Reserve has done. It seems unlikely to revisit those options now.

So it looks like more QE. Having opposed it in the autumn, am I still against it now? On the face of it, the Bank has been vindicated, particularly in its concerns over the weakness of the economy in the final few months of last year.

Some of that weakness, reflected in the 0.2% fourth quarter drop in gross domestic product, was not conducive to a money injection by the Bank. The Old Lady of Threadneedle Street does not have the power to vary the weather and boost energy consumption, or prevent North Sea oil output from falling.

Most surveys suggest, in contrast to the very sharp fall in activity the economy was enduring in 2009, when it did its first £200 billion of QE, a gentle pick-up is under way. Manufacturing appears to have shrugged off some of last year’s weakness. The service sector grew strongly in December and even more strongly in January.

This should be a prelude to stronger growth in the second half of the year, as falling inflation boosts real incomes. Were I at the Bank I would want to make doubly sure of this fall in inflation, particularly after the overshoots of recent years. Worrying about an undershoot of the 2% target in a couple of years’ time, given the forecasting record, seems self-indulgent.

Not only that but the route from QE through to stronger growth in the economy is much less obvious than it was in 2009. Gilt yields are already very low at about 2% and, while this partly reflects the expectation of more QE, it reduces the impact of further purchases.

There is also the question of the eventual unwinding of the policy. That is a long way off but at some stage the Bank will have to sell these gilts back, possibly into a very weak market because interest rates will also be rising. The more the Bank adds to that £275 billion, the more it will have on its books to unload when the time comes. That makes me uncomfortable.

But the Bank, which is not always very good at managing expectations, has given the impression it will do more. To avoid a destabilising policy lurch it probably has to do so. That to me means £50 billion this week and a “final” £25 billion in May. Let us see what happens.

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