When the Bank of England's Monetary Policy Committee meets this week it will have to answer two straightforward questions.
First, is policy of “quantitative easing”, the creation of new money in the economy, working? And, secondly, do we need more of it? Though it may have passed you by, the Bank of England has pretty much completed its plan for quantitative easing (QE).
The £125bn committed thus far has been spent, mostly on buying gilts and some private sector commercial paper and corporate bonds. There is £25bn left over from the total budget of £150bn approved in March, but that is neither here nor there. The real question is whether the Bank goes for a much more extensive QE programme again. That £125bn represented about 9% of Britain's gross domestic product, so it was no small exercise.
The idea is that the money the Bank pays for these gilts and other securities finds its way into the banking system and that the cash then, in turn, gets spent and lent, boosting demand and, in due course, bringing inflation back to the Bank's 2% target (from the lower rates it is likely to hit in coming months).
That is the ostensible point of the policy, although one cannot help noticing how handy it is for a government strapped for money and issuing gilts on an unprecedented scale to have such a willing customer for its IOUs as the Bank of England.
The importance of this moment is that if the Bank does nothing, even that will represent a tightening of monetary policy because it will be an absence of a stimulus previously applied. There is no “neutral” stance, so this week could well mark a turning point in the monetary cycle.
The big question, is what good has the £125bn done so far? It is difficult to be precise. We don't have ceteris paribus — where other things remain equal. At home, we have the continuing effects of fiscal stimulus and the political pressures on the banks to lend; from abroad, the effects of other nations' policies and a gradual improvement in markets, trade and confidence. It also has to be said that QE is young: even the most impatient might want to give the experiment six months before drawing conclusions either way.
That said, you can see why the Bank might feel things are going to plan, and a further boost to policy may not be immediately necessary. Those awful second-quarter GDP figures — a shrinkage of 0.8% on the quarter, far worse than feared — were essentially “pre-QE”, and therefore of limited use in judging whether the policy has worked. And, by the way, the figures were not that far out of line with the Bank's predictions in its last Inflation Report, though certainly on the low side (at a 5.6% annual rate of decline they would be).
In the most recent economic data, there are both signs of life and signs that QE is doing its work. The housing market is just starting to stabilise. Though more price falls are likely, the trend in lending and mortgage approvals is more positive than it has been; so is business, consumer confidence and retail sales. The banks also say they will be more willing to lend in future, although they're seeking better credit risks and are pushing their margins back to normal levels, rather than profiteering.
Equity and other capital markets have revived as risk appetite has returned, and the returns on gilts seem increasingly unattractive by comparison with other investments, which is another result of QE pushing the gilts yield lower than it would otherwise be. This also means larger companies can bypass the banking system altogether, leaving more bank credit for smaller outfits. Highly leveraged firms threatened with collapse a few months ago are finding it easier to manage debts. Sterling, too, is probably weaker than it would have been otherwise, as foreign owners of gilts have sold them and have moved into other currencies. That too will help the UK economy.
You might think the easiest way to track the success of the QE policy is through the money supply numbers; after all, it is a type of monetary policy. Yet these are quite opaque. The Bank has recently tried to strip out the creation of money that takes place in the “shadow banking” system, which distorts the numbers, while trying to keep an eye on what's happening in the wider financial system. A money supply series has been devised that can approximate to this and it is indeed encouraging, when the monthly fluctuations are smoothed out.
The forbiddingly entitled “M4 lending excluding intermediate OFCS (other financial companies)” removes the merry-go-round of SIVs and SPVs and all that, and is the nearest we have to a gauge of what is going on when money meets the real economy. It is indeed good news. Certainly, the worst of the worst monetary contraction seen last winter is behind us, and it cannot be coincidence that this has happened since QE was launched.
So the MPC would be well justified in believing its policy is starting to yield results, and it might be justified in pausing (but also making clear it will ask the Chancellor for more “budget” to be used if necessary; the notional amount could be quite large) if it were accompanied by a clear signal that it may never be used. That “contingency philosophy” could be set out in the next Inflation Report.
In any case, the real test of QE is to imagine what a mess we might be in if the Bank (and the US Fed) had not gone down this path. Credit conditions would surely be even worse, bankruptcies and unemployment even higher and we might now be looking at another “great contraction” in the real economy as a result of fundamental errors in monetary policy by the authorities: a classic asset price deflationary spiral. After all, that is what the high priest of monetarism, Milton Friedman, always said helped cause the Great Depression in the 1930s. Unlike some modern-day pundits banging on about the inflationary dangers of QE, Friedman's wisdom in these matters is good enough for me.