Shock and awe from Bank of England

 

Shock and awe was the order of the day from the monetary policy committee on Thursday as it cranked up the electronic money printing presses and set them whirring faster than anyone expected. By promising to buy £75bn in gilts with money created by the central bank over four months, the Bank of England showed its willingness to look beyond Britain’s immediate inflation problem towards the underlying weakness of the economy. Adam Posen, the most dovish MPC member, had called for a purchase of £50bn at the previous meeting. More ON THIS STORY Bank of England increases QE by £75bn Lex Bank of England’s QE2 Pound falls after Bank launches more QE London stocks boosted by fresh Bank stimulus Bank of England statement The Bank’s statement was clear about the aims of QE2 and why it was justified. Current high inflation notwithstanding, weak global growth and the gathering eurozone sovereign debt and bank funding crisis “has made it more likely that inflation will undershoot the 2 per cent target in the medium term,” it said. Buying gilts was necessary to boost economic growth “in order to keep inflation on track to meet the target in the medium term”. Clarity of ambition does not guarantee success. Officials say QE works by encouraging people to switch out of gilts into other assets, raising the price of those and putting downward pressure on sterling; it has an automatic effect improving commercial banks’ funding; it lowers market interest rates by directly raising the price of gilts and it improves confidence. Judging by the market reaction immediately after the announcement, the Bank will be pleased by the initial reactions to its move. Equity prices rose, sterling fell sharply and the yield on gilts tumbled too. Economists are nonetheless unsure of the effects of QE on growth and inflation. The best rules of thumb come from a recent article published by the Bank itself, in which it estimated that the £200bn of assets purchased under the original QE programme had the same effect as a reduction in interest rates of between 1.5 and 3 percentage points. Applying the same conversion factor, the Bank thinks Thursday’s action is equivalent to a rate cut of 0.5 percentage points and 1.1 percentage point, an easing of monetary policy that would qualify as large in the MPC’s record. The same rules of thumb suggest that the Bank expects this round of QE to boost economic output by up to 0.75 per cent and to raise inflation by 0.3 to 0.6 percentage points in the medium term. One of the unsung effects of quantitative easing is the direct effect the policy will have on bank financing, MPC members think. With banks experiencing difficulty in obtaining funding, every pound of electronic money created will buy a gilt, and the recipient will deposit that money in a UK bank. Bank funding is therefore automatically boosted by the £75bn purchase – and possibly further enhanced if banks use the money to finance lending. Inside the Bank, officials are privately dismissive of the chancellor’s “credit easing” efforts at improving funding to small companies directly. They say that QE trumps credit easing because the holders of gilts will seek to buy other corporate assets such as corporate bonds, thereby encouraging greater bond and equity issuance and allowing companies to bypass the banks. They point out that four-fifths of business investment is financed by large companies so action here is most important for growth. Small companies are already griping. John Walker, chairman of the Federation of Small Businesses, said it was important that small companies “can directly benefit from this cash injection and that the banks use it to decrease the costs of credit and to increase the availability of lending”. Even with these rules of thumb regarding QE2, MPC members privately acknowledge that the most important effect of the policy is the least predictable. Will it improve general confidence? If it does, companies will invest and households will decide to spend now in the hope that the Bank has got a grip on Britain’s economic woes. On this, the Bank will not have an answer for some time. But in moving hard and early, the Bank has already created expectations of more QE action to come. Andrew Smith of KPMG, the accountants, said the move “is likely to prove just the first instalment of a larger injection”, while Richard Barwell of the Royal Bank of Scotland said “actions speak louder than words, so we forecast another £50bn in February”.