Interest rates: A quantum of easing

On 5 March, the Bank of England effectively abandoned the course it had steered for the past 12 years and embarked on a novel double-header for monetary policy. It cut interest rates to an historic low of 0.5% and unveiled plans to flood the economy with up to £150bn of new money in a bid to unblock credit markets and jumpstart economic recovery.

The new policy, known as ‘quantitative easing’, has no single, easy definition, but the aim is to change the quantity of money when interest rates are so near to zero that it is impossible to change its price. It often involves pumping cash into the economic system by expanding the central bank’s balance sheet.

Money drought
The reason for the radical action is that the money supply – the lifeblood of an economy – has dried up. Annual growth in households’ money supply – cash, deposits and loans – has slowed from 10% to 4.6%, but for businesses it is negative – falling by 4.6%. Since the money supply constrains the (nominal) growth in the economy, the Bank must arrest the decline in the quantity of cash, bank deposits and other monetary components.

Meanwhile, yields on more risky corporate bonds have soared, in some cases to 32% from 8% before the financial crisis took hold.

Quantitative easing is meant to solve both problems and here is the (dismal) science bit: the Bank buys assets from commercial banks and pays for them by crediting the accounts those banks hold with it, creating new money just as if it were printing new notes. Newly flush with low-yielding cash, banks should want to lend more money, creating new credit through the so-called multiplier effect.

At the same time, the central bank’s purchase of private and public sector bonds pushes up their prices, lowering the yield – a move that feeds through to lower market interest rates.

The plan is based on the existing Asset Purchase Facility by which banks can offload such things as syndicated loans and asset-backed securities, swapping them for treasury bills instead. Now, however, the Bank of England is, in effect, going to buy these assets with cash (which counts as part of the definition of money supply) rather than T-bills (which don’t), hence the “quantitative easing”. The Bank will also be allowed to buy in gilts.

The numbers are huge: up to £100bn of gilts and £50bn of private sector assets. In February, Governor Mervyn King asked Chancellor Alistair Darling for permission to let decisions about asset purchases be part of the Monetary Policy Committee’s monthly remit and in March it was granted. As a result, the MPC decided in March that the first tranche of £75bn will be injected into the banking system over the coming three months.

Risky move
But will it work? That’s the £150bn question. This is a large amount of money – 10% of annual GDP and 12% of the money supply, so it is bound to have some effect at some point. Government and corporate bond yields did drop sharply after the news (see page 36) but it will take months to see the impact on the money supply and on nominal demand in the economy.

Meanwhile, there are two things to worry about. First, banks may simply hoard the cash to restore their balance sheets. Second, printing money can lead to inflation as too much money chases too few goods.

These are risks, but the government is right to take them. Even if some of the cash is hoarded, banks are likely to lend some of it. And while inflation is a medium-term threat, a deflationary trap such as the one Japan was mired in for a decade is a more immediate danger.

As Danny Gabay of Fathom Consulting and a former Bank of England economist puts it, “Like a driver ascending a steep hill in an old banger, when traction is low the only answer is to press the pedal to the floor.”