Quantitative easing is risky, but it's better than deflationby George Magnus / June 4, 2009 / Leave a comment
Published in June 2009 issue of Prospect Magazine
In mid-March the Bank of England unveiled a radical departure from conventional monetary policy. With interest rates at a record low of 0.5 per cent, it announced plans to buy up $75bn of government bonds in a process that became known as quantitative easing (QE). Two months later the bank expanded the programme further, this time to £125bn. The move surprised some in the City, and was widely seen as indicating scepticism over the much anticipated economic green shoots. But what is the real goal of the easing policy?
Conceptually, easing is designed to stop a deflationary spiral. A collapse in credit and asset prices lowers wealth, which leads to falls in consumption, which in turn lowers asset prices again. Ultimately prices and wages begin to fall. Easing works by expanding the money supply directly, encouraging banks to start lending, stabilising demand, and encouraging investors to stop hoarding cash.
That’s the theory. Is it working? We don’t yet know. The original easing announcement caused gilt-edged security yields to fall sharply, in anticipation of the bank buying up lots of government bonds. But they have recently bounced back, driven in part by the recent stock market rally.
The latest data shows the broadest money supply measure—known as M4—up 17.8 per cent in the last year. But if you strip out the money that financial institutions are lending just to each other, the rise was only 2.5 per cent. In other words, households and businesses are still in the process of retrenching. The bank’s May 2009 quarterly inflation report, meanwhile, seemed doubtful about an early recovery, even if it did imply that the risk of deflation was declining.
Pumping up the money supply is only half the battle. Easing needs a functioning banking system to turn new bank reserves into loans. Banks, however, are only lending to creditworthy borrowers, and remain worried about the cost of future losses. They have also…