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 been quietly building up a cash asset mountain, which at £58bn in March is roughly five times the norm of the last two decades, and possibly the largest total in history. In any case the cash pile is bad news, especially since QE was meant to encourage lending.
Overall the financial system might be more stable, but its institutions are still desperately trying to shrink their exposure to risk, raise new capital, and wean themselves off securitisation as a means of borrowing. And while the economy may be pulling out of its winter nosedive, it is still a long way from recovery.
Sceptics have another fear. America, Japan and most recently the EU might have joined Britain's easing push, but the policy remains controversial. Inflation hawks still worry that the policy could lead to a burst of inflation in two to three years, leading to sharp interest rate rises and, perhaps, another recession. The same critics question the evidence of deflation, noting that the British consumer price index (CPI) has gone up by 2.3 per cent in the year to April.
Yet these worries are complacent. The current absence of deflation is not evidence that it won't happen. The CPI might still be positive year on year, but prices have been dropping sharply; trends likely to continue if demand is not pumped up. And deflation, once entrenched, is notoriously difficult to dislodge.
There is no danger of Britain experiencing inflation remotely on the scale of Weimar Germany or Zimbabwe. But sooner or later (though perhaps not for another year or more) the economy will begin to grow again, and the Bank of England's take on inflation risk will change. By then it will need an exit strategy that hoovers up cash from the economy and raises interest rates. These policies are not without their own risks. But it will be better to meet them head on tomorrow than struggle powerlessly against a more destructive deflation today.
