With economic growth in the UK stalling and growing alarm about the state of the world economy, the Bank of England has announced a second round of quantitative easing (QE2). This will involve the Bank buying an extra £75 billion of government bonds (gilts) in the market over the following four months. This is over and above the nearly £200 billion of assets, mainly gilts, purchased in the first round of quantitative easing in 2009/10. The purchase will release extra (narrow) money into the economy. Hopefully, this will then allow more credit to be created and the money multiplier to come into play, thereby increasing broad money by a multiple of the £75 billion.
In his letter to the Chancellor of the Exchequer seeking permission for QE2, the Governor stated:
In the United Kingdom, the path of output has been affected by a number of temporary factors, but the available indicators suggest that the underlying rate of growth has also moderated. The squeeze on households’ real incomes and the fiscal consolidation are likely to continue to weigh on domestic spending, while the strains in bank funding markets may also inhibit the availability of credit to consumers and businesses. While the stimulatory monetary stance and the present level of sterling should help to support demand, the weaker outlook for, and the increased downside risks to, output growth mean that the margin of slack in the economy is likely to be greater and more persistent than previously expected.
… The deterioration in the outlook has made it more likely that inflation will undershoot the 2% target in the medium term. In the light of that shift in the balance of risks, and in order to keep inflation on track to meet the target over the medium term, the Committee judged that it was necessary to inject further monetary stimulus into the economy.
But will increasing the money supply lead to increased aggregate demand, or will the money simply sit in banks, thereby increasing their liquidity ratio, but not resulting in any significant increase in spending? In other words, in the equation MV = PY, will the rise in M simply result in a fall in V with little effect on PY? And even if it does lead to a rise in PY, will it be real national income (Y) that rises, or will the rise in MV simply be absorbed in higher prices (P)?
According to a recent article published in the Bank of England’s Quarterly Bulletin, The United Kingdom’s quantitative easing policy: design, operation and impact, the £200 billion of asset purchases under QE1 led to a rise in real GDP of about 2%. If QE2 has the same proportionate effect, real GDP could be expected to rise by about 0.75%. But some commentators argue that things are different this time and that the effect could be much smaller. The following articles examine what is likely to happen. They also look at one of the side-effects of the policy – the reduction in the value of pensions as the policy drives down long-term gilt yields and long-term interest rates generally.
Articles
Bank of England launches second round of QE Interactive Investor, Sarah Modlock (6/10/11)
Britain in grip of worst ever financial crisis, Bank of England governor fears Guardian, Larry Elliott and Katie Allen (6/10/11)
Interview with a Governor BBC News, Stephanie Flanders interviews Mervyn King (6/10/11)
The meaning of QE2 BBC News, Stephanie Flanders (6/10/11)
Bank of England’s MPC united over quantitative easing BBC News (19/10/11)
Bank of England’s QE2 may reach £500bn, economists warn The Telegraph, Philip Aldrick (6/10/11)
‘Shock and awe’ may be QE’s biggest asset The Telegraph, Philip Aldrick (6/10/11)
Quantitative easing by the Bank of England: printing more money won’t work this time The Telegraph, Andrew Lilico (6/10/11)
BOE launches QE2 with 75 billion pound boost Reuters, various commentators (6/10/11)
Shock and awe from Bank of England Financial Times, Chris Giles (6/10/11)
More QE: Full reaction Guardian, various commentators (6/10/11)
Quantitative easing warning over pension schemes Guardian, Jill Insley (6/10/11)
Pension schemes warn of QE2 Titanic disaster Mindful money (6/10/11)
Calm down Mervyn – this so-called global recession is really not that bad Independent, Hamish McRae (9/10/11)
Bank of England publications
Asset Purchase Facility: Gilt Purchases Bank of England Market Notice (6/10/11)
Governor’s ITN interview (6/10/11)
Bank of England Maintains Bank Rate at 0.5% and Increases Size of Asset Purchase Programme by £75 billion to £275 billion Bank of England News Release (6/10/11)
Quantitative Easing – How it Works
Governor’s letter to the Chancellor (6/10/11)
Chancellor’s reply to the Governor (6/10/11)
Minutes of the Monetary Policy Committee meeting, 5 and 6 October 2011 (19/10/11)
Inflation Report
Quarterly Bulletin (2011, Q3)
Questions
- Explain how quantitative easing works.
- What is likely to determine its effectiveness in stimulating the economy?
- Why does the Bank of England prefer to inject new money into the economy by purchasing gilts rather than by some other means that might directly help small business?
- Explain how QE2 is likely to affect pensions.
- What will determine whether QE2 will be inflationary?
- Why is the perception of the likely effectiveness of QE2 one of the key determinants of its actual effectiveness?
National debt has increased rapidly over the past few years. In 2006/7 general government debt was £577.8bn or 42.9% of GDP. In 2009/10 it was £1000.4bn or 71.3% of GDP. It is set to go higher, with government debt forecast to be around 87% of GDP in 2011. This compares with forecasts of 82% for Germany, 87% for France, 103% for the USA, 134% for Greece and 195% for Japan.
Getting the deficit and debt down has, not surprisingly, become an issue in many countries. In the UK it has become the major current pre-occupation of the Coalition government and on 20 October it is set to announce major public spending cuts as a means of achieving this.
To get a flavour of the government’s thinking and the message that ministers are putting out to the electorate, the following are quotes from the Prime Minister’s and then the Chancellor’s speeches to the Conservative Party Conference:
This year, we’re going to spend £43 billion pounds on debt interest payments alone. £43 billion – not to pay off the debt – just to stand still. Do you know what we could do with that sort of money? We could take eleven million people out of paying income tax altogether. We could take every business in the country out of corporation tax. That’s why we have acted decisively – to stop pouring so much of your hard-earned money down the drain. We are already paying £120m of interest every single day thanks to the last Labour government. (David Cameron)
It’s the borrowing that doesn’t go away as the economy grows, and we have £109bn of it. It’s like with a credit card. The longer you leave it, the worse it gets. You pay more interest. You pay interest on the interest. You pay interest on the interest on the interest. We are already paying £120m of interest every single day thanks to the last Labour government. Millions of pounds every day that goes to the foreign governments we owe so they can build the schools and hospitals for their own citizens that we aren’t able to afford for ours. How dare Labour call that protecting the poor? (George Osborne)
Let’s unpick this a bit. Who earns the interest? The answer is that it is paid to holders of government debt in the form of government bonds (gilts), national savings certificates, premium bonds, etc. In other words it is paid to savers, whether individuals or pension funds or companies.
Does it all go abroad? In fact 29% of gilts are held abroad. The rest are held by British residents. Thus some 70% of the interest rate paid on government debt goes to British residents and supports pensions and savers. It can thus be seen as a transfer from taxpayers to savers.
Because of the record low interest rates many pensioners who rely on savings interest have seen their incomes fall dramatically. Others draw income from a ‘self-invested personal pension’. The amount that can be drawn each year is based on tables according to a person’s age and the current 15-year Treasury gilt yield (currently 3.45%). Thus the lower the rate of interest, and the less the yield, the less that can be drawn.
So who are the gainers and losers from high general government debt and attempts to get it down? Read the following articles and look at the data and then try answering the questions.
Articles
Britons have donated £7m to help pay off the national debt (but that’s a drop in the ocean) Mail Online, Daniel Martin (9/10/10)
A trillion and rising: Britain’s £1,000,000,000,000 debt means it is now paying as much in interest as it does for defence Mail Online, Hugo Duncan (1/10/10)
Spending cuts “not enough”, say small firms Telegraph, James Hurley (8/10/10)
UK public finances post record August deficit Guardian, Julia Kollewe (21/9/10)
Another paradox of thrift The Economist, Buttonwood (16/9/10)
Data
The gilt market UK Debt Management Office
Gilt market data UK Debt Management Office
Overseas gilt holdings UK Debt Management Office
Public sector: current position ONS (30/9/10)
Public sector finances ONS Statistical Bulletin (21/9/10)
Government deficit and debt under the Maastricht Treaty ONS Statistical Bulletin (30/9/10)
Contributions to the government deficit and debt ONS Statistical Bulletin (31/3/10)
Questions
- Explain the difference between central government, general government and public-sector deficits and debt.
- Who loses from a rising public-sector debt? Who gains?
- Conduct an international comparison of (a) the level of the government deficit and debt and (b) their rate of growth over the past few years.
- What is meant by the ‘yield’ on a particular gilt?
- If gilt yields fall, does this mean that the government pays less on existing gilts? Is it likely to pay less on new gilt issues? Explain.
- How do cuts affect the distribution between savers and borrowers?
What will happen to interest rates over the next two or three years? There is considerable disagreement between economists on this question at the moment.
There are those who argue that recovery in the UK, the USA and Europe is faltering. With much tighter fiscal policy being adopted as countries attempt to claw down their deficits, there is a growing fear of a double-dip recession. In these circumstances central banks are likely to keep interest rates at their historically low levels for the foreseeable future and could well embark on a further round of quantitative easing (see Easy money from the Fed?). But what about inflation? With demand still expanding in developing countries and commodity prices rising, won’t cost pressures on inflation continue? Those who forecast that interest rates will stay low, argue that the pressure on commodity prices will ease as global demand slows. Also, in the UK, now that sterling is no longer depreciating, this will remove a key ingredient of higher inflation.
These views are not shared by other economists. They argue that interest rates could soar over the next two years. In fact, one economist, Andrew Lilico, the Chief Economist at Policy Exchange argues that interest rates in the UK will reach 8% by 2012. Central to their argument is the role of the money supply. The monetary base has been expanded enormously through programmes of quantitative easing. And yet, consumer credit has fallen. When the economy does eventually start to recover strongly, Lilico and others argue that there is a danger that consumer credit and broad money will expand rapidly, thereby fuelling inflation. But won’t the spare capacity that has built up during the recession allow the increase in aggregate demand to be met by a corresponding increase in output, thereby keeping inflation low. No, say these economists. A lot of capacity has been lost and output cannot easily expand to meet a rise in demand.
It’s not uncommon for economists to disagree! See, by reading the articles below, if you can unpick the arguments and establish where the disagreements lie and whose case is the strongest.
Articles
America’s century is over, but it will fight on Guardian, Larry Elliott (23/8/10)
Rates to remain low for foreseeable future Interactive Investor, Rhian Nicholson (18/8/10)
BoE gets benefit of doubt on inflation – for now Reuters, Christina Fincher (19/8/10)
BGilts reflect continued uncertainty AXA Elevate, Tomas Hirst (23/8/10)
A bull market in pessimism The Economist (19/8/10)
Interest rates ‘may hit 8%’ by 2012 says think tank BBC News (22/8/10)
Interest rates ‘may hit 8pc’ in two years Telegraph, Philip Aldrick (21/8/10)
Bernanke Must Raise Benchmark Rate 2 Points, Rajan Says Bloomberg, Scott Lanman and Simon Kennedy (23/8/10)
Inflation, not deflation, Mr. Bernanke Market Watch, Andy Xie (22/8/10)
Inflation comes through the door and wisdom flies out of the window Telegraph, Liam Halligan (21/8/10)
Data
British Government Securities, Yields Bank of England
Bankstats: Data on UK money and lending Bank of England
Questions
- Summarise the arguments of those who believe that interest rates will stay low for the foreseeable future.
- Summarise the arguments of those who believe that interest rates will be significantly higher by 2010.
- What factors will be the most significant in determining which of the two positions is correct?
- Why are the yields on long-term bonds a good indicator of people’s expectations about future inflation and monetary policy?
- Why has consumer credit fallen? Why might it rise again?
- Why may unemployment not fall rapidly as the economy recovers? Is this an example of hysteresis?