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Tuesday, 13 October 2009

QE: What is it for?

Back in March the Bank of England thought they would tell us about quantitative easing. It went like this:

Quantitative Easing Explained

Quantitative Easing ExplainedIn March 2009, the Monetary Policy Committee announced that, in addition to setting Bank Rate at 0.5%, it would start to inject money directly into the economy in order to meet the inflation target. The instrument of monetary policy shifted towards the quantity of money provided rather than its price (Bank Rate). But the objective of policy is unchanged – to meet the inflation target of 2 per cent on the CPI measure of consumer prices. Influencing the quantity of money directly is essentially a different means of reaching the same end.

Significant reductions in Bank Rate have provided a large stimulus to the economy but as Bank Rate approaches zero, further reductions are likely to be less effective in terms of the impact on market interest rates, demand and inflation. And interest rates cannot be less than zero. The MPC therefore needs to provide further stimulus to support demand in the wider economy. If spending on goods and services is too low, inflation will fall below its target.

The MPC boosts the supply of money by purchasing assets like Government and corporate bonds – a policy often known as 'Quantitative Easing'. Instead of lowering Bank Rate to increase the amount of money in the economy, the Bank supplies extra money directly. This does not involve printing more banknotes. Instead the Bank pays for these assets by creating money electronically and crediting the accounts of the companies it bought the assets from. This extra money supports more spending in the economy to bring future inflation back to the target.

Assessing the Impact of Asset Purchases

It will take time to assess the extent to which the MPC's asset purchases have stimulated nominal spending. The impact is inevitably uncertain, but over time increasing the amount of money in the economy should boost spending. The MPC is monitoring the situation closely to assess how firms and households respond to the extra money injected into the economy. It 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.

They even printed a booklet

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Quantitative Easing Explained Pamphlet
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Did that make sense? The Bank of England was going to buy lots of gilts off the banks which would make them flush with cash so they would spend it. Read the pamphlet and it tels you that buying up gilts pushes up the price of gilts so the banks make a profit on their holding of gilts which bolsters their tier 1 equity and makes them full of cash.

Well not quite because in a new speech, Charlie Bean says forget about the bit about making the banks flush with cash. No that isn't the point at all. The idea is to boost the value of gilts, forget about the idea of filling the banks with cash equivalent reserves, apparently that was not the point at all, even though that was what they said in March.

Now this is where it gets interesting because Mr Bean was addressing the London Society of Chartered Accountants, who understand a thing or two about bookkeeping but wouldn't necessarily have a clue about markets, so no tricky questions on that from them. But what Mr Bean did tell them was that the Asset Purchase scheme is booked off the balance sheet of the Bank of England, because all the risk in the structure is taken by the government.

So if the QE programme isn't on the Bank's books, where does it go. With the government's accounts in theory. In practice the government auditors will probably let the balance sheet just float off into space, just like National Rail and a whole lot more, but any analyst would say the government now holds £175 billion of its own paper (which can be netted against the liability), but it also has a £175 billion liability for the deposits created at the Bank of England. So in net asset terms nothing has changed for the government.

On the other hand, maybe it has affected the market price of gilts by taking £175 billion out of the market? Well if that really did have an effect, we would expect the opposite effect from the £175 billion of additional gilts issued into the market to fund the deficit. And so it turns out. As Chart 2 shows at the back of Mr Bean's speech, yields in October 2009 for the 3,5,10 & 20 year gilts are about the same as the yields in January 2009. In other words, no change in yield and thus no change in the value of securities held by the banks.

So that was a £175 billion waste of time.


Steven_L said...

There seem to be three main theories circulating on why they are doing the QE.

1) To bring/hold down interest rates
2) To fund the gvt deficit
3) To cause more inflation

On 1, I was under the impression that central banks had to push more cash into the banking system in order to reduce interest rates, that this was normal (especially in the US where the Fed pay no interest on deposits but target the interbank overnight rate) and they usually just called this 'open market operations'.

On 2, I've seen charts suggesting that there aren't enough foreign purchasers of gilts to fund the gvts borrowing requirements.

On 3, this is what King says he is doing (to some extent) and what some commentators (i.e. Liam Halligan) accuse him or doing to a larger extent. However, with commodities priced in $, globalisation, spare capacity and weak trade unions I can't see how it will work.

What do this the idea is then Alex? 1? 2? 3? All of the above? Or have a missed one?

Alex said...

The usual idea behind quantitative easing is that it performs a similar role to short-term interest rate management in controlling the money supply, but when interest rates have fallen to near zero, instead of dropping interest rates the central bank buys in a lot of assets and puts a lot of new money into the reserve accounts of the selling banks.

In theory the banks take this money and lend it out stimulating the economy. The problem is that the banks were never constrained by their liquidity (or rather the ones that were B&B/NR hit the wall a while back).

The banks are constrained from more lending by a shortage of Tier 1 capital, and their lives are not made any easier by the FSA/Govt insisting that they have a hier Tier 1 ratio.

So on the one hand you have one side of the Treasury pumping cash into the banks, and on the other another part of the Treasury is telling them they need to lend more and a third is telling them they need to have more capital to lend more.

All in all a bit of a bugger's muddle, but par for the course from this administration, and I think it is quite clear that the changing justification for QE comes about because nobody in government has a clear idea of what they are doing and why it is supposed to work.

Sterence said...

Your last remark in the comment above is surely right. But as to the conclusion of the main article: yes, maybe gilt yields are approx. where they were before QE began, and in that sense the programme hasn't achieved the aim of increasing gilt prices (if indeed that was really the aim). But imagine what gilt yields would be now if all that new money hadn't gone into the market to offset the level of issuance. I reckon the best part of 1% higher at the long end, and rising. Now begin to imagine what yields will be like once the QE programme closes down, with the deficit running at £4bn per week...
With that in mind QE must have had a pretty substantial effect on yields - and will continue to do so until they turn the tap off (the QE tap not a Friday afternoon gilt mkt tap). I wonder if the end of QE will more or less coincide with the General Election?

Alex said...

Assuming that the value of QE is not going to go much higher, then the total value of QE at less than 20% of GDP is very relatively small compared to the value of planned gilt issuance even if you go with the government's most optimistic forecasts, so I don't think it will have had that much impact on gilt yields.

What I don't know is what is supposed to happen at the "end" of QE. Does the BoE sell gilts into the market to repay its funding or does it just continue with the status quo (down, down, deeper down - I must use that as a headline some day).

Steven_L said...

One thing we're all wondering, is, how would the markets react is the gvt annouced they were cancelling the gilts held by the B of E.

After all, if there is no serious £ price/wage inflation threat, why do they need to hold the debt to push back in.

And even if there is, surely they can print the debt as easy as the cash?

I've come to the conclusion (in hindsight) that the way to 'solve' this 'financial crisis' would have just been to seize the banks, print enough money to put into the assets column of their balance sheets to arrest the insolvency, then float them again and destroy the cash raised.

I mean, we seem to be doing this the slow and painful way whilst paying off a load of useless pen-pushers and snake-oil peddlers on the way.

If politicians were going to try and micro-manage the nations balance sheets to keep the homeowning vote on side surely this would have been the way to do it?

Or would people have realised how the illusion of wealth works in some sort of sharp shock that would have rocked the world worse?

Now that we (well everyone who is interested) knows it is all a crazy illusion - but better than communism - why not just cancel the gvt debt at the BofE?

Bill Bell said...

Your posts and subsequent comments would be much more readable if they weren't so politically biased.

The BOE is independent of the government. You can't blame Brown for everything they do, including changing their rationale for QE.

Nobody really knew what was going to happen with QE. It was all entirely theoretical before we started doing it so when it turns out to have a slightly unanticipated impact you can't blame them for reconsidering their stance.

Alex said...

Bill, I don't think I was blaming Brown for the actions of the Bank of England, although I think there is ample evidence that the BoE is only nominally independent from government.

Indeed the government often points to QE as one of the actions it is taking, and until now has claimed that the primary purpose has been to increase liquidity and promote growth. The BoE has also quoted that as a purpose of QE, but also gage the purpose of supporting asset prices. Now the Bank has dropped the government's most often stated reason for QE.