The US Federal Reserve bank has launched a third round of quantitative easing, dubbed QE3. The hope is that the resulting growth in money supply will stimulate spending and thereby increase growth and employment.
Ben Bernanke, the Fed Chairman, had already said that the stagnation of the labour market is of grave concern because of “the enormous suffering and waste of human talent it entails, but also because persistently high levels of unemployment will wreak structural damage on our economy that could last for many years”. Not, surprisingly, the markets were expecting strong action – and that is what they got.
Under QE3, the Fed will buy mortgage-backed securities of $40bn per month. And this will go on for as long as it takes for the employment market to show significant improvement. It is this open-ended commitment which makes QE3 different from QE1 and QE2. Under these earlier rounds of quantitative easing, the Fed purchased a fixed amount of assets – $2.3tn of bonds.
QE3 also comes on top of a policy in operation since September 2011 of buying long-term government bonds in the market and selling shorter-dated ones. This ‘funding’ operation is known as ‘Operation Twist’.
The markets responded favourably to the announcement of QE3, especially to the fact that its size and duration would depend on the state of the real economy. Nevertheless, there are real questions about its likely effectiveness. The most important is whether the increase in narrow money will translate into an increase in borrowing and spending and hence an increase in broad money; or whether the rise in narrow money will be offset by a fall in the velocity of circulation as banks seek to increase their liquidity ratios and to recapitalise.
The following articles look at the details of QE3 and whether it is likely to achieve its desired result. Will the Fed be forced to raise asset purchases above $40bn per month or to introduce other measures?
Federal Reserve to buy more debt to boost US economy BBC News (14/9/12)
Bernanke takes plunge with QE3 Financial Times, Robin Harding (14/9/12)
US monetary policy at an important turning point Financial Times, Gavyn Davies (2/9/12)
Cliffhanger The Economist (22/9/12)
Your flexible Fed BBC News, Stephanie Flanders (13/9/12)
Back Ben Bernanke’s QE3 with a clothes peg on your nose The Telegraph, Ambrose Evans-Pritchard (23/9/12)
QE3 Stimulus from Federal Reserve Drives Mortgage Rates Down to Record Lows TellMeNews, Sharon Wagner (24/9/12)
Helicopter Ben Bernanke: The Problem With QE1, QE2, QE3 and QE Infinity TellMeNews, Martin Hutchinson (18/9/12)
QE: More bang than buck Business Spectator, Stephen Grenville (18/9/12)
QE3: What it Really Means PBS NewsHour, Paul Solman (20/9/12)
US Money Stock Measures Federal Reserve Statistical Release
Data Releases Board of Governors of the Federal Reserve System
Civilian Unemployment Rate (UNRATE) FRED Economic Data
- What distinguishes the Fed’s QE3 from its QE1 and 2?
- What will determine the likely success of QE3 in stimulating the real economy?
- Why has there been a huge surge in liquidity preference in the USA? What would have been the impact of this without QE1 and QE2?
- Explain what is meant by ‘portfolio balance effects’ and how significant are these in determining the success of quantitative easing?
- Does QE3 suggest that the Fed is pursuing a type of Taylor Rule?
- Why might QE3 be a “pro-cyclical” blunder?
- To what extent would monetarists approve of the Fed’s policies on QE?
- How is QE3 likely to affect the dollar exchange rate and what implications will this have for countries trading with the USA?
Between December 2007 and March 2009, the Bank of England reduced Bank Rate on several occasions in order to stimulate the economy and combat recession. By March 2009, the rate stood at a record low of 0.5%. Each month the Monetary Policy Committee meets to decide on interest rates and since March 2009, the members’ decision has consistently been that Bank Rate needs to remain at 0.5%.
Although the UK economy has been making tentative steps towards recovery, it is still in a very vulnerable state. Last month, the Bank of England extended its programme of quantitative easing to a total £325bn stimulus. This, together with the decision to keep interest rates down and with the shock fall in manufacturing output contributing towards first quarter growth of just 0.1%, is a key indication that the UK economy is still struggling, even though the central bank thinks it unlikely that the UK will re-enter recession this year.
Monetary policy in the UK has been very much geared towards stimulating economic growth, despite interest rates typically being the main tool to keep inflation on target at 2%. The problem facing the central bank is that economic growth and inflation are in something of a conflict. Low interest rates to stimulate economic growth also create a higher inflation environment and that is the trade-off the economy has faced. Inflation has been well above its target for some months (a high of 5.2% in September 2011), and the low interest rate environment has done little to deflate the figure. After all, low interest rates are a monetary instrument that can be used to boost aggregate demand, which can then create demand-pull inflation. However, inflation is now slowly beginning to fall, but this downward trend could be reversed with the sky high oil prices we are recently experiencing. If inflation does begin to creep back up, the Monetary Policy Committee will once again face a decision: keep Bank Rate low and continue with quantitative easing to stimulate the economy or increase Bank Rate to counter the higher rate of inflation.
The data over recent months has been truly inconsistent. Some indicators suggest improvements in the economy and the financial environment, whereas others indicate an economic situation that is moving very quickly in the wrong direction. A key factor is that the direction the UK economy takes is very much dependent on the world economy and, in particular, on how events in the eurozone unfold. The following articles consider some of the latest economic developments.
UK economy grew 0.1% to avoid recession, says NIESR Guardian, Katie Allen (5/4/12)
UK interest rates held at 0.5% BBC News (5/4/12)
UK just about avoided recession in Q1, NIESR says Telegraph, Angela Monaghan (5/4/12)
Bank of England keeps interest rates on hold at 0.5pc Telegraph (5/4/12)
UK economy ‘weak but showing signs of improvement’ BBC News (3/4/12)
Bank of England holds on quantitative easing and interest rates Guardian, Katie Allen (5/4/12)
Faith on Tories on economy hits new low Financial Times, Helen Warrell (6/4/12)
- Which factors will the Monetary Policy Committee consider when setting interest rates?
- Using a diagram to help your answer, illustrate and explain the trade-off that the MPC faces when choosing to keep interest rates low or raise them.
- What is quantitative easing? How is it expected to boost economic growth in the UK?
- Which factors are likely to have contributed towards the low growth rate the UK economy experienced in the first quarter of 2012?
- Explain the trends that we have seen in UK inflation over the past year. What factors have caused the figure to increase to a high in September and then fall back down?
- What do you expect to happen to inflation over the next few months? To what extent is your answer dependent on the MPC’s interest rate decisions?
- Although the official figures suggest that the UK avoided a double-dip recession, do you agree with this assessment? Explain your answer.
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.
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)
Quarterly Bulletin (2011, Q3)
- 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?
In a statement to the House of Commons on 9 February 2011, the Chancellor announced that banks would extend their new lending to SMEs (Small and Medium-Sized Enterprises) from £179 billion in 2010 to £190 billion in 2011. An important question is the extent to which this initiative, which forms part of a series of initiatives in conjunction with the banking sector known as Project Merlin, will impact on economic activity.
Let’s begin by thinking about the role that credit plays in an economy. Firstly, it serves a short-term role by enabling individuals and firms to ‘bridge the gap’ between their income and their spending. Secondly, it can, depending on the size and terms of the credit, help to fund longer-term investments. In the case of firms, for instance, it can help to fund capital projects such as an expansion of premises or the installation of new equipment or production processes.
The extension of credit is the main source of growth in the money supply. If the credit which is extended by financial institutions is spent it increases economic activity. The size of the increase in economic activity will depend on how many times the credit is passed on from one firm or individual to the next. In other words, it depends on the velocity of circulation of money – often referred to simply as V. If the initial credit funds a series of purchases and the recipients of these monies, i.e. those from whom the purchases are made, then use their increased deposits to fund purchases themselves, the expansion could be sizeable.
There is every indication that the additional credit for SMEs will be welcome and it seems reasonable to assume that this will positively impact on spending. But, by how much is not entirely clear. This is what fascinates me about macroeconomics, but, perhaps understandably, may well frustrate others! Once the payments for the purchases made using the newly available credit become new deposits, how will these recipients respond? Will other credit-constrained firms use this liquidity to engage in purchases themselves? But, what if these recipients use the monies to increase or rebuild their own financial wealth? In this last scenario – a pessimistic scenario – the velocity of circulation will increase relatively little and economic activity little too.
The corporate sector, of course, does not exist in isolation of other sectors of the economy and, in particular, of the household sector. As some of the income from the expanded credit flows to them in the form of factor payments (i.e. wages and profits) – though by how much is itself debtable – how will they respond? Again will credit-constrained households look to spend? Alternatively, will they hold on to these liquid balances perhaps using them as buffer-stock savings? This is not an unrealistic possibility given the leverage of households and the need to rebuild wealth, especially so in times of incredible economic uncertainty? But, who knows!
So while Merlin may have waved his wand, the full extent of its impact, though probably positive, is far from clear. Time will tell. Isn’t macroeconomics wonderful!
HM Treasury Press Release
Government welcomes banks’ statement on lending by 15% more to SMEs, and on pay and support for regional growth, HM Treasury, 9 February 2011
Statement to the House of Commons by the Chancellor
Statement on banking by the Chancellor of the Exchequer 9 February 2011
Banks sign lending and bonus deal BBC News (9/2/11)
Banks agree Project Merlin lending and bonus deal BBC News (9/2/11)
Osborne’s plans arrive too late for the economy Independent, Sean O’Grady (11/2/11)
Project Merlin ‘could weaken UK banks’ Telegraph, Harry Wilson (11/2/11)
Nothing wizard about Project Merlin Guardian UK, Nils Pratley (7/2/11)
Softball: Britain’s banks make peace with the government – for now The Economist (10/2/11)
Smaller firms insist banks must change their attitude The Herald (11/2/11)
- Detail the various roles that financial institutions play in a modern-day economy.
- Do the activities of banks carry with them any risks? How might such risks be reduced?
- What is meant by the velocity of circulation or the velocity of money?
- What factors do you think could affect the velocity of money?
- How does credit creation affect the growth of the money supply?
- What do you understand by individuals or firms being credit-constrained?
- What factors are likely to affect how credit-constrained an individual household is?
- What do you think might be meant by buffer-stock saving? What might affect the size of the buffer-stock held by a household?
In March 2009, the Bank of England’s base rate was slashed to 0.5% in a bid to boost aggregate demand and stimulate the UK economy. And there it has remained for almost 2 years and as yet, no change is in sight. In the February 2011 meeting of the Monetary Policy Committee (who are responsible for setting interest rates to keep inflation on target), the decision was to keep interest rates at 0.5% rather than raise them to tackle high and rising UK inflation. Those in favour of keeping interest rates at this record low argue that any increase could damage the UK’s ability to recover and may lead to the dreaded double-dip recession. This is of particular concern given the economy’s performance in the last quarter of 2010.
However, one group that will certainly not be happy is the savers. With instant-access savings accounts paying on average just 0.84% before tax and with inflation at 3.7%, savers aren’t just not gaining much interest, but are actually seeing the value of their money in real terms fall. Howard Archer of HIS Global Insight said:
“For now, we retain our view that the Bank of England will hold off from raising interest rates until the latter months of the year. Even if interest rates do rise in the near term, the likelihood is still that they will rise only gradually and remain very low compared to past norms.
Monetary policy will need to stay loose for an extended period to offset the impact of the major, sustained fiscal squeeze. Consequently, we retain the view that interest rates will only rise to 2pc by the end of 2012.”
Following some speculation that the Bank of England may succumb to the pressure of inflation and hike up interest rates (markets had priced in a 20% chance of a rate rise), sterling did take a hit, but after the decision to keep rates at 0.5%, sterling recovered against the dollar. There is a belief amongst some traders that rates will rise in May, but others believe rates may remain at 0.5% until much later in 2011, as the country aims to avoid plunging back into recession. Of 49 economists that responsed to a poll by Reuters, three quarters of them said that rates would rise by the end of 2011, with median forecasts predicting a rise around November. This is certainly a space to watch, as it has implications for everyone in the UK and for many in countries around the world.
BOE leaves bank rate unchanged at 0.5% at Feb meeting Automated Trader (10/2/11)
Economists predict interest rates will rise in November Telegraph, Szu Ping Chan (11/2/11)
UK May rate hike view holds firm after BOE Reuters, Kirsten Donovan (10/2/11)
Interest rates: What the economists say Guardian (10/2/11)
Fixed rate mortgages becoming more expensive BBC News (10/2/11)
Bank rate: savers’ celebrations on hold Telegraph, Richard Evans (10/2/11)
Inflation fears turn up heat ahead of bank rate decision City AM, Julian Harris (10/2/11)
Sterling takes BOE in its stride, higher rate talk aids Reuters, Anirban Nag (10/2/11)
Bank of England holds interest rates of 0.5% Telegraph, Emma Rowley (10/2/11)
- Why are interest rates such an important tool of monetary policy? Think about which variables of aggregate demand will be affected by the Bank of England’s decision.
- What is the relationship between interest rates and inflation?
- What explanation is there for the fall in the value of sterling following speculation that interest rates may rise? Why did sterling recover after the Bank of England’s decision?
- How has the recent speculation affected fixed rate mortgages?
- What does the Telegraph article about “savers’ celebrations on hold” mean about the ‘real value’ of money and savings?
- What are (a) the arguments for keeping interest rates at 0.5% and (b) the arguments for raising interest rates? Who wins and loses in each case?
- Are there any other government policies that could be used to combat inflation, without creating the possibility of a double-dip recession? Why haven’t they been used?