Stephen King: Experiments that could blow us up

It is bad enough explaining to people what quantitative easing is, let alone what it actually does. Part of the problem lies with the different approaches adopted by central banks on either side of the Atlantic. The Bank of England deliberately intends to increase the supply of money, whereas the Federal Reserve has, so far, made no such commitment. Both central banks are, though, supposedly engaged in quantitative easing.

Meanwhile, commentators are absolutely divided over the benefits and costs of quantitative easing. Some believe that, at best, it might reduce the threat of deflation and, if we're lucky, pave the way towards an economic recovery. Others regard quantitative easing as the Devil's work. On this interpretation, it won't be long before deflationary fears are replaced by hyperinflationary reality, leaving Messrs Bernanke and King burning in monetary hell.

So how should we make sense of what's going on? The different approaches from the various central banks say more about what quantitative easing isn't, rather than what it is. In recent times, central banks have adjusted monetary policy through setting a target for the overnight interest rate. By doing so, policymakers hope to have an indirect influence more broadly on the costs of borrowing and rewards for saving by affecting interest rates on longer- dated government debt, mortgages, credit cards and corporate debt.

This approach is no longer working. Overnight rates are near enough to zero to leave central banks without their usual monetary ammunition. Meanwhile, the gap between the interest rates at which governments borrow and rates more generally is currently very wide, highlighting the massive risk aversion associated with the financial crisis.

The Bank of England's response has been to start creating money from nothing. It has taken the very simple view that the creation of additional money will make other assets look more attractive. The Bank will buy existing gilts from pension funds and other institutions at inflated prices. The money received by those institutions will then, hopefully, be invested in riskier assets which should, in turn, lower the cost of raising funds for companies and households. The idea, then, is to get money directly into the economy without relying on a banking system which, for now, is moribund.

The Fed's response, at least until now, differs in one key sense. Rather than creating more money, the Fed has so far been happy to borrow existing money and use it for the purposes of boosting the economy.

Imagine, for example, that banks are extraordinarily risk averse and only want to hold very liquid assets. Believing that the US government is never likely to default, the banks happily invest in short-dated government paper called Treasury Bills while limiting their lending to companies and households. Recognising this preference, the Treasury issues more of these T-Bills. The funds raised are then given to the Fed to purchase a range of assets which banks have turned their noses up at. These include, most obviously, mortgage-backed securities, credit card debt and commercial paper. This way, the Fed allows credit to spread through the economy more widely.

Last week, the Federal Reserve also announced it would be buying Treasuries (longer-dated government paper). Unlike the Bank of England, though, the Fed hasn't spelt out precisely how it intends to fund these purchases. It might simply ask the Treasury to issue more T-bills, which implies the Fed is borrowing from the Treasury at short-term interest rates to lend back to the Treasury at long-term interest rates (a similar policy was adopted 50 years ago when, via "operation twist", the US authorities attempted to lower long-term interest rates in the hope of spurring capital spending). Alternatively, it might decide to follow the Bank of England's example by creating new money with which to purchase Treasuries. Either way, the intention is to keep long-term rates as low as possible. Following last week's announcement, the 10-year Treasury yield dropped from over 3 per cent to just 2.5 per cent.

Whether quantitative easing is funded through printing money or by mopping up and then lending out existing money which would otherwise sit idly within the banking system, the approach rests on the idea that the banking system itself is unable to pump money around the economy. Either you take money away from the banking system to give to others (the Fed's Robin Hood approach) or, instead, you leave the existing money within the banking system and create some more to give to others (the Bank of England's alchemist approach). The Fed's approach – so far at least – redistributes existing money while the Bank's approach creates new money.

I suspect those who worry about hyperinflation think the Bank's approach is a lot more dangerous than the Fed's. They'd be wrong. Excess inflation can be created either by printing more money (an increase in the money supply) or by making sure the existing stock of money is spent more frequently (an increase in the velocity of money). Either way, there should be upward pressure on output and prices. When, though, an economy is operating well below its full employment potential, it is more likely that quantitative easing, under any guise, will have an impact on output alone and not prices.

The US economy, for example, has already experienced both a huge increase in unemployment and an extraordinary drop in capacity utilisation which, in manufacturing, is now at a new post-war low. Getting money to slosh around the economy more readily should, in these circumstances, help to lift activity and spirits without threatening inflation. Indeed, with activity so depressed at the moment, the important thing is not to worry about inflation but, instead, to ward off the danger of deflation. Now that interest rates so low and debt levels so high, deflation is, surely, the biggest single economic threat facing our nations. Already, an absence of company pricing power is leading to collapsing profits and surging unemployment. Worse may be to come.

Nevertheless, despite my guarded enthusiasm for quantitative easing in its various guises, I recognise that we have reached one of those extraordinary milestones in our monetary arrangements. If central banks are now buying Treasuries and gilts, they no longer look quite so independent. As they seek to bypass the banking system, their influence over capital markets is rising, for good or bad. And, in the international sphere, the endgame is still a long way off. The dollar took a major tumble last week as investor nervousness over the US currency's safe-haven status began to increase. The Swiss authorities have intervened heavily to prevent their franc from becoming the safe-haven currency of choice. And emerging market central banks are increasingly fretting over their holdings of dollar assets in a world where the Federal Reserve is thinking about turning on the printing press.

Heightened international monetary tension is, generally speaking, not a good thing for economic progress. The collapse of the gold standard in the 1930s led to a series of unco-ordinated and possibly damaging shifts in exchange rate regimes, all accompanied by deflation. The collapse of Bretton Woods at the beginning of the 1970s equally led to major exchange rate volatility but, then, the key problem was inflation. The deflation versus hyperinflation debate will go on for months but, in the meantime, the more our central bankers carry out their localised experiments, the more likely we are to see the return of extreme currency volatility.



Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

News
A model of a Neanderthal man on display at the National Museum of Prehistory in Dordogne, France
science
News
Richard Dawkins dedicated his book 'The Greatest Show on Earth' to Josh Timonen
newsThat's Richard Dawkins on babies with Down Syndrome
Arts and Entertainment
Eye of the beholder? 'Concrete lasagne' Preston bus station
architectureWhich monstrosities should be nominated for the Dead Prize?
Extras
indybest
PROMOTED VIDEO
News
ebooksAn evocation of the conflict through the eyes of those who lived through it
Travel
Dinosaurs Unleashed at the Eden Project
travel
Arts and Entertainment
music
Sport
football
Life and Style
This month marks the 20th anniversary of the first online sale
techDespite a host of other online auction sites and fierce competition from Amazon, eBay is still the most popular e-commerce site in the UK
News
i100
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating
and  

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Quantitative Analyst (Financial Services, Graduate, SQL, VBA)

£45000 per annum: Harrington Starr: Quantitative Analyst (Financial Services, ...

Application Support Engineer (C++, .NET, VB, Perl, Bash, SQL)

Negotiable: Harrington Starr: Application Support Engineer (C++, .NET, VB, Per...

AIFMD Business Analyst / Consultant - Investment Management

£450 - £600 per day: Harrington Starr: AIFMD Business Analyst / Consultant - I...

Business Analyst Solvency II SME (Pillar 1, 2 & 3) Insurance

£450 - £600 per day: Harrington Starr: Business Analyst Solvency II SME (Pilla...

Day In a Page

Middle East crisis: We know all too much about the cruelty of Isis – but all too little about who they are

We know all too much about the cruelty of Isis – but all too little about who they are

Now Obama has seen the next US reporter to be threatened with beheading, will he blink, asks Robert Fisk
Neanderthals lived alongside humans for centuries, latest study shows

Final resting place of our Neanderthal neighbours revealed

Bones dated to 40,000 years ago show species may have died out in Belgium species co-existed
Scottish independence: The new Scots who hold fate of the UK in their hands

The new Scots who hold fate of the UK in their hands

Scotland’s immigrants are as passionate about the future of their adopted nation as anyone else
Britain's ugliest buildings: Which monstrosities should be nominated for the Dead Prize?

Blight club: Britain's ugliest buildings

Following the architect Cameron Sinclair's introduction of the Dead Prize, an award for ugly buildings, John Rentoul reflects on some of the biggest blots on the UK landscape
eBay's enduring appeal: Online auction site is still the UK's most popular e-commerce retailer

eBay's enduring appeal

The online auction site is still the UK's most popular e-commerce site
Culture Minister Ed Vaizey: ‘lack of ethnic minority and black faces on TV is weird’

'Lack of ethnic minority and black faces on TV is weird'

Culture Minister Ed Vaizey calls for immediate action to address the problem
Artist Olafur Eliasson's latest large-scale works are inspired by the paintings of JMW Turner

Magic circles: Artist Olafur Eliasson

Eliasson's works will go alongside a new exhibition of JMW Turner at Tate Britain. He tells Jay Merrick why the paintings of his hero are ripe for reinvention
Josephine Dickinson: 'A cochlear implant helped me to discover a new world of sound'

Josephine Dickinson: 'How I discovered a new world of sound'

After going deaf as a child, musician and poet Josephine Dickinson made do with a hearing aid for five decades. Then she had a cochlear implant - and everything changed
Greggs Google fail: Was the bakery's response to its logo mishap a stroke of marketing genius?

Greggs gives lesson in crisis management

After a mishap with their logo, high street staple Greggs went viral this week. But, as Simon Usborne discovers, their social media response was anything but half baked
Matthew McConaughey has been singing the praises of bumbags (shame he doesn't know how to wear one)

Matthew McConaughey sings the praises of bumbags

Shame he doesn't know how to wear one. Harriet Walker explains the dos and don'ts of fanny packs
7 best quadcopters and drones

Flying fun: 7 best quadcopters and drones

From state of the art devices with stabilised cameras to mini gadgets that can soar around the home, we take some flying objects for a spin
Joey Barton: ‘I’ve been guilty of getting a bit irate’

Joey Barton: ‘I’ve been guilty of getting a bit irate’

The midfielder returned to the Premier League after two years last weekend. The controversial character had much to discuss after his first game back
Andy Murray: I quit while I’m ahead too often

Andy Murray: I quit while I’m ahead too often

British No 1 knows his consistency as well as his fitness needs working on as he prepares for the US Open after a ‘very, very up and down’ year
Ferguson: In the heartlands of America, a descent into madness

A descent into madness in America's heartlands

David Usborne arrived in Ferguson, Missouri to be greeted by a scene more redolent of Gaza and Afghanistan
BBC’s filming of raid at Sir Cliff’s home ‘may be result of corruption’

BBC faces corruption allegation over its Sir Cliff police raid coverage

Reporter’s relationship with police under scrutiny as DG is summoned by MPs to explain extensive live broadcast of swoop on singer’s home