Quantitative Teasing

01/10/2010 at 1:33 pm 4 comments

Three days ago, a member of the Bank of England’s Monetary Policy Committee called Adam Posen let slip in a speech that he favoured further asset purchases under the Bank’s programme of “quantitative easing” (QE). He backtracked somewhat on this yesterday, perhaps due to signs of sterling weakness following his comments. Nevertheless, he has given us the opportunity of assessing the effectiveness of quantitative easing so far.

The policy is not well understood (the Bank provides a somewhat rosy summary here). As they note, it consists mostly of purchasing government bonds in the open market, paid for by new money created by the Bank.

The idea is pure monetarism. Like Milton Friedman’s famous “helicopter drop”, the injection of money into an economy where the supply of goods and services is largely unchanged is expected to exert upward pressure on the price of those goods and services.

Even the money dropped by Friedman’s helicopter would need spending to have any effect, however. If those standing under the helicopter simply stashed the notes under their beds, prices wouldn’t be forced up.

This is where QE tends to get a little too much credit. The Bank undertook purchases of some £200bn worth of government bonds beginning in March 2009 before formally suspending the programme at that level in February of this year. Now by pure coincidence, from the end of February 2009 to end Feb 2010, the size of the UK government bond market, as measured by the nominal amount of gilts outstanding, increased by about £200bn.

In other words, just as the Bank waded in to the gilt market to swap bonds for its newly minted cash – which it hoped would then filter into circulation – the government waded in to swap the cash for bonds again.

Let’s return to the image of the helicopter drop. Imagine that you were in the crowd underneath the helicopter and had managed to scramble successfully for £50. Then, as the helicopter flies away and you are about to put the money into your wallet, you feel a tap on your shoulder. You turn to see a man standing in front of you with a knife, who mugs you for it. Would you feel like the beneficiary of a windfall and embark on an inflationary spending bonanza, or would you put your wallet away in bewilderment, feeling as if the whole exercise had been an elaborate distraction?

Of course in this case the mugger could go and spend the £50, but when it comes to QE the government did not expand their budget in response to the windfall: they would have borrowed and spent the same amount of money whatever the complexion of participants in the gilt market. The best that can be said is that the contribution of the Bank’s policy to a downward movement in gilt yields will have saved them some money in debt interest payments, but that will have amounted to a small fraction of £200bn.

This analysis may seem strange in light of occasional fevered commentary about hyperinflation. But QE’s lack of effectiveness can be confirmed by reference to the Bank’s own measures of success listed on its website under, “Assessing the Impact of Asset Purchases“:

The MPC … will pay close attention to the growth rate of broad money, the cost and availability of corporate borrowing, measures of inflation and inflation expectations, and developments in nominal spending growth.

So … The growth rate of broad money? 1.9% on the year to August, down from 17% when the Bank began QE. The cost and availability of corporate borrowing? Much improved if you look at the corporate bond market, but not so much if you go by the Bank’s periodic surveys of UK credit conditions. Inflation? Up 3.1% on the year to August on the CPI measure as against a near-identical 2.9% in March ’09.

In reality, then, what looks like a very dangerous policy has only had relatively minor, indirect effects. Which is not to say that a Bank keeping interest rates at emergency levels in the face of price behaviour that has already become problematic, and whose officers go about talking the currency down at the same time isn’t taking risks with inflation. Just remember that the next time a policymaker teases us with the prospect of more QE, it doesn’t necessarily do to get all that excited.


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