Goodbye QE?

For some, the latest Bank of England Quarterly Inflation Report may be a non-event but I shall be concentrating on a potentially highly significant sub-plot.

  • While the report itself will surely be silent on the subject Mr Carney will be harried for clues for the date of the first increase in Base Rates. He is unlikely to oblige other than to point out that the Bank is basing its forecasts on market expectations for spring 2015.
  • It seems clear that a majority of the MPC want to hold off for as long as possible. The economy may be faring unexpectedly well but it is still likely to be held back by major public spending cuts and prolonged stagnation in Europe.
  • Another reason for holding off might be the planned revision of the National Accounts, which will affect GDP, business investment, savings and government debt. These are intended to be accounting adjustments only but could dramatically change the perception of the UK economy by businesses, consumers, investors and even economists (including those on the MPC).
  • The main objective remains to encourage companies and consumers to borrow, invest and spend with the confidence that rates will remain low for several years. However, low Base Rates can also provide lenders, especially the major banks but also new market entrants such as ‘crowdfunders’, with higher margins.
  • The attraction of encouraging lenders takes on added significance in the context of two Bank staff papers to be included in the Q1 Report but which have already been published. These papers set out to explain ‘money and money creation in the modern economy’. In particular, they seek to correct two ‘common misconceptions’.
  • The first correction is that it is bank loans that drive fractional reserve banking and money creation and not customer deposits. The second correction is that it is the banks themselves that determine the level of reserves at the Bank of England and the latter is therefore, not able to apply a so-called ‘money multiplier’ to generate directly more bank lending and create more money.
  • These corrections are important as they explain why the MPC has been so anxious to encourage bank lending and, more controversially, why the QE programme has been held at £375bn since July 2012. There appears to be little point in the Bank’s buying more assets if the resulting bank deposits would not lead to more bank loans to finance investment and consumption. This is central to a sub-plot that may come to the fore in the coming months and not just in the UK.
  • The key question now is what have the sellers of the gilts to the Bank done with the proceeds? Clearly, the money is not fuelling cost inflation as QE is supposed to do but at least some of it has fuelled increases in real estate and share prices to an extent that some people call ‘bubbles’.
  • Many so-called inflation ‘hawks’ are calling for immediate interest rate rises to prick the asset price bubbles and also head off future cost inflation. While the MPC is unlikely to oblige the hawks for the time being on interest rates the Committee may well be moving to a position where there will be no more QE. There could even be a further twist in that the current practice of replacing any holding within the £375bn portfolio would be ended before the first interest rate rise, which could then be delayed further in 2015 and perhaps beyond.

Of course, the Bank’s QE programme is small beer compared to that in the US. Most people, including me, deem that the FOMC’s interventions in 2008-9 staved off an even more calamitous financial collapse than that which occurred. Since then various economists have raised increasingly controversial criticism:

  • QE may or may not have helped in the first shock of the crisis but has been irrelevant since. It should be said that this is in direct contradiction to two MPC papers claiming that both GDP and the CPI were boosted in the UK
  • QE has not generated sufficient feelings of well-being amongst companies to make them invest and hire or amongst ordinary consumers to borrow and spend.
  • QE has been consistently ineffective in combatting disinflation but instead the proceeds of asset sales have been applied to real estate and equities, creating potential price bubbles.
  • The real beneficiaries of QE have been banks (which have applied sale proceeds to bolster their capital base rather than increase lending), companies (which have taken advantage of initially soft shares prices to apply profits to buy-backs rather than new investment and/or hires) and the super-rich (whose appetite for more houses, cars and yachts are clearly finite).
  • Cranking up the controversy, some economists assert that the fact that none of QE beneficiaries (banks, companies and the super-rich) have actually been spending their proceeds has fed through to disinflationary if not outright deflationary expectations, which in turn are discouraging consumption and business investment.
  • Just for good measure, a recent paper from the St Louis Fed has raised the theoretical possibility that holding official rates at minimal levels for a prolonged period may also start to fuel deflationary expectations and discourage consumption and business investment.

Understandably, the central bankers are not willing to admit publicly that they have made mistakes. However, as discussed above, it does seem that the MPC has turned its back on more QE and the taper suggests that the FOMC is heading that way too.

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