Sunday, June 10, 2012
Britain needs a lot more monetary oomph
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.

A week can be a long time. A plunge in May manufacturing activity nine days ago, measured by the sector’s purchasing managers’ index, had prompted some City economists to predict dramatic action from the Bank of England on Thursday.

The Bank’s monetary policy committee (MPC), however, had other ideas. Despite a call from the International Monetary Fund for it to consider cutting interest rates, it left Bank rate unchanged at 0.5%, as it has since March 2009.

This was not too surprising. Anything is possible but the Bank thinks it has good reasons, partly to do with the operation of the money markets, for having 0.5% as a minimum official interest rate.

The debate over whether to add to the existing £325 billion of quantitative easing (QE) was no doubt closer, with some votes in favour. But the Bank, like the European Central Bank the day before, decided to keep its powder dry.

With so much uncertainty around, including next Sunday’s Greek elections and the on-off rescue of Spain and her banking system, discretion was seen as the wiser option. You may say that uncertainty adds to the need for central bank activism but there is an announcement effect as well as a practical impact as far as monetary policy is concerned.

The Bank, in other words, had it announced more QE on Thursday, would have been under pressure to announce even more in a month, should the aurozone be deteriorating further at the time.

As it was, better-than-expected data for services and construction, in their purchasing managers’ surveys, and for May retail spending, allowed the Bank to stay its hand. The economy is far from strong but it is not collapsing either.

That said, it is badly in need of some monetary “oomph”. I apologise for taking readers on a journey that to some will sound like an excursion along the motorway network, and to others will sound like an echo of the monetarism, as in monetary targeting, under Margaret Thatcher in the 1980s.

M4, the broadest measure of the money supply, is the one to think about in the context of efforts by the Bank to get the economy moving again by monetary means. On the face of it, those efforts are so far failing very badly.

In April, the M4 money supply measure was down nearly 4% on a year earlier, having been falling on an annual basis since autumn 2010, the time official figures say the economy stopped recovering.

To put this into perspective, M4 growth never turned negative in the early 1990s, while the problem for the Thatcher government in the early 1980s was too much, not too little, broad money growth.

The crude number may overstate how weak the money numbers are. The Bank prefers to adjust M4 for lending to so-called intermediate other financial corporations (OFCs). Think of it as banks’ lending to off balance sheet and other subsidiaries, which boomed in the years leading up to the crisis - the financial sector lent huge sums to itself - but has since gone into sharp reverse.

Adjusting for this has M4 up by 3.8% on a year ago, a significant acceleration on the spring of last year, when it was rising by just 1.5%. The latest bout of QE, it seems, has made a difference.

We should not, however, get carried away. The Bank’s rule of thumb was that you needed annual M4 growth of 9% for trend growth of 2.5% or so and inflation at the 2% official target. Even adjusted, M4 is growing less than half that rate.

Not only that but alongside adjusted M4 figures, the Bank produces statistics for adjusted M4 lending. These show, when you take out the financial sector distortion, lending into the economy is currently rising by 1.3% on an annual basis. That is better than a year ago, when it was not growing at all, but it is still pitifully weak. Both the money supply and bank lending are too weak to support recovery.

So what should the Bank do? One route is just to continue what it has done so far, implementing QE overhelmingly through the purchase of UK government bonds (gilts) but do so on an even greater scale.

David Miles, now the most aggressive proponent of QE on the Bank’s MPC, said in a recent speech that “exceptionally expansionary monetary policy” was the right course in current circumstances.

Michael Saunders of Citi, the bank, believes that there is much more to come - up to an eventual £500 billion - from the Bank in the form of conventional QE.

Or perhaps, I would argue, the Bank could do things differently. One thing that jumped out at me from the IMF’s recent assessment of the British economy was its recommendation that “options to further boost demand through credit easing measures that utilize the government’s balance sheet should be explored”.

It suggested purchasing private-sector bonds, on a significant scale, to support a greater volume of both mortgage lending and loans to business, particularly small and medium-sized firms. It also urged the Bank to provide longer-term bank funding facilities against a broader range of collateral, to ease funding pressures and get more lending into the economy.

This, to me, is what the Bank should be doing, suitably indemnified for any losses by the government. Adam Posen, soon to leave the MPC, suggested some months ago that the Bank should be buying securitized (bundled) small and medium-sized enterprise (SME) loans, a cry taken up by the British Chambers of Commerce.

We have just passed the fourth anniversary of my first suggestion that the Bank should buy new mortgage-backed securities - bundles of mortgages - to overcome the crisis’s abrupt loss of wholesale funding that continues to restrict housing activity to recessionary levels.

The government has just launched its £20 billion credit easing schemes for SMEs. It is a step in the right direction but does not go far enough. The global financial crisis saw many things go from feast to famine but nothing as dramatically as the availability of credit. And, to repeat a previous message, an economy starved of credit will always struggle to grow. Smarter monetary easing is needed.