By David Williams
12 November 2009
Despite three batches of ‘quantitative easing’, the UK economy is continuing to contract. So will the latest cash injection finally save the day? David Williams examines the evidence
The news that the Bank of England was to expand its radical quantitative easing programme – colloquially known as ‘printing money’ – came as research indicated that the UK economy was continuing to shrink.
Data published by the National Institute of Economic and Social Research on November 5 showed that gross domestic product fell by 0.4% in the three months to October. It suggested there had been no improvement on the month before, and that the UK economy was stalling as its global peers were pulling clear of recession.
All this, eight months after the Bank’s Monetary Policy Committee brought interest rates to an historical low of 0.5% and signed off an initial £75bn of QE to jump-start the economy. Two £50bn injections followed in May and August. The latest £25bn batch, announced on November 5, will be released over the next three months.
Under QE, the central bank creates new cash, which it spends on assets such as corporate and government bonds. The policy was pioneered by the Bank of Japan in 2001 to fight deflation. The US Federal Reserve used a similar mechanism last year to acquire mortgage-based assets during the global finance crisis.
In the UK, the Bank has overwhelmingly bought government bonds – or gilts – from bodies with substantial investments such as pension funds and banks. In theory, the new liquidity finds its way into the wider economy, opening up the flow of credit.
Fears that the measure would lead to Weimar Germany-style hyperinflation have so far proved unfounded. QE has been credited with the partial reversal of last year’s house price crash but its most obvious effect has been to push up asset prices. This has led to a rally in the
stock markets that some believe is unsustainable as it is significantly at odds with the performance of the wider economy.
So it was perhaps surprising that economists have broadly welcomed the latest announcement. Liberal Democrat Treasury spokesman Vince Cable provided a rare voice of dissent, accusing banks of ‘hoarding’ the cash, which he said was preventing it trickling down to the grass roots.
Roger Bootle, economic adviser to financial consultancy Deloitte, says the strategy is helping, and that there are few other options. ‘If the government could put together a programme to make people more confident, there might well be more lending and borrowing and spending,’ he told Public Finance.
‘But it’s not easy to do that. In terms of broad macroeconomic levers, or buttons you can push, there are none available apart from QE.
‘Could the public sector spend a lot more, or give tax cuts? It could, but then you get into the problems of deficit. The point about QE is that it does not affect the deficit, at least not directly. It’s not affecting the solvency of the state.’
Strangely, QE appears to be making markets more confident – despite sending out a strong signal that the economy is so stricken that it requires stronger stuff even than holding the Bank of England base rate at an all-time low for months on end.
Charles Davis, senior economist at the Centre for Economics and Business Research, concedes that the policy might not yet have boosted bank lending to households and small businesses. But, he says, it is encouraging investors to be a little more adventurous – partly reversing the extreme risk-aversion that led to the stock market freeze a year ago.
Davis says that in buying up large amounts of gilts, QE has lowered the yields on those bonds – in effect, raising the price of them, making them less attractive to investors. ‘It encourages the private sector appetite for slightly more risky assets rather than piling into government bonds, which may be very safe, but you won’t drive growth by allocating capital there.
‘[The Bank] hopes that if firms invest in things like a new share issuance by Shell, that will lead to a big capital investment and that might then lead to new jobs.’
But, he says, it is unrealistic to expect the policy to cause an instant 180-degree turn in the UK’s financial performance. The economy’s structural problems – rooted in huge corporate and consumer debt – were too great even for the £200bn of extra liquidity to fix on its own.
Dawn Holland, a senior research fellow at the NIESR, says the Bank’s £1.36bn investment in corporate bonds has also had a significant impact. Although it accounts for less than 1% of the total QE programme, it has helped stabilise corporate bond markets. But, she adds: ‘If they had put a bigger portion towards the corporate bond market and started a year ago, it would have been more effective in getting the money to where it was needed.’
Nevertheless, she says, QE was broadly the right move, and she backs the MPC’s decision to extend it. Stopping the programme now would reverse the progress of the past few months.
‘Corporate bond spreads [which show how risky the market considers private sector investment to be] would probably jump back up again, and lending costs would rise. The recovery in investment that looks like it might be ready to get under way could be delayed.’
Holland adds that one of the challenges is in knowing when to stop QE. Continuing to pump money in could lead to a surge in corporate investment, leading to another unsustainable bubble and an inevitable crash. The £25bn extension of QE has been widely read as an attempt to wean the economy off the easy liquidity, as it accounts for only half of what the MPC has been authorised to release by Chancellor Alistair Darling.
Whether that will be the final cash injection could depend on what the government plans to do in the next Parliament. Fiscal tightening will affect not only public services and government debt but also the wider economy.
Davis argues that if next year’s general election returns a Conservative government eager to slash spending as hard and as quickly as possible, more unorthodox measures could result.
‘The effect will be to push the economy into reverse, so interest rates will have to stay lower, and there could possibly be more QE.’
Another crucial decision for the MPC will be when to sell off all the gilts it has acquired. Bootle says the Bank bought them at a premium this year, when they were attractive because of low confidence in corporate paper. But it might have to sell them at a lower price, during a recovery in which their value drops as investors begin to favour corporate bonds again.
‘There’s got to be a chance that the public sector will register a massive loss,’ he says.
All we can be sure of is that no-one can predict the full outcomes of QE. ‘There’s always uncertainty over the time lag of conventional monetary policy – reducing interest rates,’ says Davis.
‘For something where we have very little historical precedent, it is difficult. It is really a major experiment.’
12 November 2009
Despite three batches of ‘quantitative easing’, the UK economy is continuing to contract. So will the latest cash injection finally save the day? David Williams examines the evidence
The news that the Bank of England was to expand its radical quantitative easing programme – colloquially known as ‘printing money’ – came as research indicated that the UK economy was continuing to shrink.
Data published by the National Institute of Economic and Social Research on November 5 showed that gross domestic product fell by 0.4% in the three months to October. It suggested there had been no improvement on the month before, and that the UK economy was stalling as its global peers were pulling clear of recession.
All this, eight months after the Bank’s Monetary Policy Committee brought interest rates to an historical low of 0.5% and signed off an initial £75bn of QE to jump-start the economy. Two £50bn injections followed in May and August. The latest £25bn batch, announced on November 5, will be released over the next three months.
Under QE, the central bank creates new cash, which it spends on assets such as corporate and government bonds. The policy was pioneered by the Bank of Japan in 2001 to fight deflation. The US Federal Reserve used a similar mechanism last year to acquire mortgage-based assets during the global finance crisis.
In the UK, the Bank has overwhelmingly bought government bonds – or gilts – from bodies with substantial investments such as pension funds and banks. In theory, the new liquidity finds its way into the wider economy, opening up the flow of credit.
Fears that the measure would lead to Weimar Germany-style hyperinflation have so far proved unfounded. QE has been credited with the partial reversal of last year’s house price crash but its most obvious effect has been to push up asset prices. This has led to a rally in the
stock markets that some believe is unsustainable as it is significantly at odds with the performance of the wider economy.
So it was perhaps surprising that economists have broadly welcomed the latest announcement. Liberal Democrat Treasury spokesman Vince Cable provided a rare voice of dissent, accusing banks of ‘hoarding’ the cash, which he said was preventing it trickling down to the grass roots.
Roger Bootle, economic adviser to financial consultancy Deloitte, says the strategy is helping, and that there are few other options. ‘If the government could put together a programme to make people more confident, there might well be more lending and borrowing and spending,’ he told Public Finance.
‘But it’s not easy to do that. In terms of broad macroeconomic levers, or buttons you can push, there are none available apart from QE.
‘Could the public sector spend a lot more, or give tax cuts? It could, but then you get into the problems of deficit. The point about QE is that it does not affect the deficit, at least not directly. It’s not affecting the solvency of the state.’
Strangely, QE appears to be making markets more confident – despite sending out a strong signal that the economy is so stricken that it requires stronger stuff even than holding the Bank of England base rate at an all-time low for months on end.
Charles Davis, senior economist at the Centre for Economics and Business Research, concedes that the policy might not yet have boosted bank lending to households and small businesses. But, he says, it is encouraging investors to be a little more adventurous – partly reversing the extreme risk-aversion that led to the stock market freeze a year ago.
Davis says that in buying up large amounts of gilts, QE has lowered the yields on those bonds – in effect, raising the price of them, making them less attractive to investors. ‘It encourages the private sector appetite for slightly more risky assets rather than piling into government bonds, which may be very safe, but you won’t drive growth by allocating capital there.
‘[The Bank] hopes that if firms invest in things like a new share issuance by Shell, that will lead to a big capital investment and that might then lead to new jobs.’
But, he says, it is unrealistic to expect the policy to cause an instant 180-degree turn in the UK’s financial performance. The economy’s structural problems – rooted in huge corporate and consumer debt – were too great even for the £200bn of extra liquidity to fix on its own.
Dawn Holland, a senior research fellow at the NIESR, says the Bank’s £1.36bn investment in corporate bonds has also had a significant impact. Although it accounts for less than 1% of the total QE programme, it has helped stabilise corporate bond markets. But, she adds: ‘If they had put a bigger portion towards the corporate bond market and started a year ago, it would have been more effective in getting the money to where it was needed.’
Nevertheless, she says, QE was broadly the right move, and she backs the MPC’s decision to extend it. Stopping the programme now would reverse the progress of the past few months.
‘Corporate bond spreads [which show how risky the market considers private sector investment to be] would probably jump back up again, and lending costs would rise. The recovery in investment that looks like it might be ready to get under way could be delayed.’
Holland adds that one of the challenges is in knowing when to stop QE. Continuing to pump money in could lead to a surge in corporate investment, leading to another unsustainable bubble and an inevitable crash. The £25bn extension of QE has been widely read as an attempt to wean the economy off the easy liquidity, as it accounts for only half of what the MPC has been authorised to release by Chancellor Alistair Darling.
Whether that will be the final cash injection could depend on what the government plans to do in the next Parliament. Fiscal tightening will affect not only public services and government debt but also the wider economy.
Davis argues that if next year’s general election returns a Conservative government eager to slash spending as hard and as quickly as possible, more unorthodox measures could result.
‘The effect will be to push the economy into reverse, so interest rates will have to stay lower, and there could possibly be more QE.’
Another crucial decision for the MPC will be when to sell off all the gilts it has acquired. Bootle says the Bank bought them at a premium this year, when they were attractive because of low confidence in corporate paper. But it might have to sell them at a lower price, during a recovery in which their value drops as investors begin to favour corporate bonds again.
‘There’s got to be a chance that the public sector will register a massive loss,’ he says.
All we can be sure of is that no-one can predict the full outcomes of QE. ‘There’s always uncertainty over the time lag of conventional monetary policy – reducing interest rates,’ says Davis.
‘For something where we have very little historical precedent, it is difficult. It is really a major experiment.’
