Stephen King: The policy to print money is right but we must be told how it works

There is something wonderfully quirky about the way in which a major change in monetary arrangements is announced in the UK. Not for us a detailed paper outlining the new monetary process, the intermediate and ultimate measures of success, the longer-term implications and the possible exit strategies. Instead, we get an exchange of letters. Next time, perhaps we'll get a postcard: "Dear Chancellor ... having a wonderful time although weather cloudy ... have come across this thing called a printing press ... looks great, but must be used carefully ... love Merv xx."

Mervyn King's letter sent last week to the Chancellor argues in favour of boosting so-called "central bank money", a process which is typically described as "quantitative easing". Rather than acting on the short-term price of money (which, after last week's interest rate cut, is close enough to zero to render further cuts in short-term interest rates monetarily meaningless), the Bank of England intends to act on the quantity of money.

Arguably, the Bank has no choice. If short-term interest rates were the only tool available to the Bank, the members of the Monetary Policy Committee (MPC) would now be telling the nation that, despite the dangers of a long and lasting recession, the Bank of England could do nothing more. The move towards quantitative easing allows the Bank a role in managing the outlook for the UK economy.

From now on, the MPC will discuss not the level of interest rates but instead, how many assets, including gilts, to buy with central bank money. This money is simply created by the central bank and is the equivalent of turning on the printing press. The Governor's letter asks for "the MPC to be authorised ... to purchase eligible assets financed by central bank money up to a maximum of £150bn but that ... up to £50bn of that should be used to purchase private sector assets."

Alongside the reduction in bank rate to 0.5 per cent, the Bank announced last week that it would use half this facility with immediate effect. Some £75bn would be spent over roughly the next three months, with a heavy emphasis on the purchase of medium- and long-maturity conventional gilts.

The UK economy produces output worth around £1.4trn a year in current prices, so a £150bn facility amounts to roughly 10 per cent of nominal GDP. That is quite chunky. On the face of it, then, last week's announcement is an act of monetary aggression designed to stop the rot in the UK economy.

According to the Bank of England's inflation-targeting mandate, success will be measured through the Bank's ability to deliver on its 2 per cent inflation objective. We won't know the answer to that for a year or two. In the meantime considerable uncertainty will remain. The authorities need to find ways of overcoming this uncertainty otherwise the danger is that money created ends up being hoarded. The public is deeply uneasy about the prospects for jobs and businesses.

What then are the road signs which might indicate success with quantitative easing? If the idea is to boost the supply of money, money supply data suddenly become interesting again. However, bitter experience over the last 35 years has surely taught us that monetary data, on their own, are as difficult to read as the tea-leaves. Moreover, an increase in the supply of money may say very little in a world where there is simultaneously an increase in the demand for it to be stuffed under the mattress.

An alternative, then, is to think about the impact of the new policies on the whole range of interest rates on offer in capital markets. After all, with the plunge in 10-year gilt yields following the announcement, there is already evidence that the new policy is working in certain areas. Might it be, then, that the best measure of success will come not from the quantity of central bank money that is created but rather from the impact on yields which stems from the increase?

One way to consider this problem is to think about credit risk. Corporate bond yields are significantly higher than government bond yields, suggesting that investors are very nervous about the possibility of rising insolvencies. Given the depth of the downswing to date, and the absence of any meaningful "green shoots", this fear is not very surprising.

Narrowing credit spreads would, therefore, seem to be an encouraging sign. There are, though, two ways in which spreads can narrow. Either corporate bond yields fall, which would be good news. Or gilt yields rise, which in current circumstances would be very bad news, indicative of growing investor concerns about the implications for the public finances of huge bank bailouts. With the Bank of England stepping in to buy large quantities of gilts, the chances of gilt yields rising are now much lower and hence, if spreads narrow, they will do so favourably via a fall in corporate bond yields.

This, though, is not a watertight approach. The Bank of England and the Treasury make for awkward dance partners in this monetary experiment. As the Governor said in last week's letter, it is "important that the government's debt management policy remain[s] consistent with the aims of monetary policy. It should not alter its issuance strategy as a result of the transactions that are undertaken through the Asset Purchase Facility for monetary policy purposes."

In other words, the Bank is well aware that any operation designed to place a ceiling on gilt yields might allow the Government to increase its borrowing almost without limit. We will hear more about the amount of public borrowing when the Chancellor delivers the Budget on 22 April. The incentive to borrow, though, must surely have increased now that the printing press is humming in the background. Presumably, if the Bank thinks the Government is borrowing too much, it will allow gilt yields to rise. That, though, sounds like a recipe for a punch-up between Threadneedle Street and Whitehall.

Other problems need to be resolved. First, in a world of tremendous monetary uncertainty, the increase in gilt purchases by the central bank may simply lead to investors holding more gilts and less of anything else because the Bank's actions limit the risk of gilt prices falling very far. With equities and other assets tumbling in value, this makes gilts relatively attractive. Second, if the lack of demand in the economy leads to deflation, corporate bond spreads over gilts will narrow but only because the "real" inflation-adjusted yield on gilts will be rising. Corporate bond spreads were very narrow in Japan through much of its deflationary phase, but at no point did they signal a recovery in economic activity.

While I think the Bank is doing the right thing by moving towards quantitative easing, it needs to offer more details of how the policy is meant to work. Those details should include clear intermediate objectives to indicate whether the inflation target is within reach (involving spreads and the pace of monetary expansion) and say more about how quantitative policy is deemed to operate in a world of deflation. There is still work to be done.



Stephen King is managing director of economics at HSBC

News
people'It can last and it's terrifying'
Sport
Radamel Falcao
footballManchester United agree loan deal for Monaco striker Falcao
Sport
Louis van Gaal, Radamel Falcao, Arturo Vidal, Mats Hummels and Javier Hernandez
footballFalcao, Hernandez, Welbeck and every deal live as it happens
Sport
footballFeaturing Bart Simpson
PROMOTED VIDEO
News
Kelly Brook
peopleA spokesperson said the support group was 'extremely disappointed'
News
i100
Life and Style
techIf those brochure kitchens look a little too perfect to be true, well, that’s probably because they are
Arts and Entertainment
Alex Kapranos of Franz Ferdinand performs live
music Pro-independence show to take place four days before vote
News
news Video - hailed as 'most original' since Benedict Cumberbatch's
Arts and Entertainment
booksNovelist takes aim at Orwell's rules for writing plain English
News
ebooksAn unforgettable anthology of contemporary reportage
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

Head of IT (Windows, Server, VMware, SAN, Fidessa, Equities)

£85000 per annum: Harrington Starr: Head of IT (Windows, Server, VMware, SAN, ...

Technical Software Consultant (Excel, VBA, SQL, JAVA, Oracle)

£40000 - £50000 per annum: Harrington Starr: You will not be expected to hav...

SQL DBA/Developer

£500 per day: Harrington Starr: SQL DBA/Developer SQL, C#, VBA, Data Warehousi...

.NET Developer

£650 per day: Harrington Starr: .NET Developer C#, Win Forms, WPF, WCF, MVVM,...

Day In a Page

Alexander Fury: The designer names to look for at fashion week this season

The big names to look for this fashion week

This week, designers begin to show their spring 2015 collections in New York
Will Self: 'I like Orwell's writing as much as the next talented mediocrity'

'I like Orwell's writing as much as the next talented mediocrity'

Will Self takes aim at Orwell's rules for writing plain English
Meet Afghanistan's middle-class paint-ballers

Meet Afghanistan's middle-class paint-ballers

Toy guns proving a popular diversion in a country flooded with the real thing
Al Pacino wows Venice

Al Pacino wows Venice

Ham among the brilliance as actor premieres two films at festival
Neil Lawson Baker interview: ‘I’ve gained so much from art. It’s only right to give something back’.

Neil Lawson Baker interview

‘I’ve gained so much from art. It’s only right to give something back’.
The other Mugabe who is lining up for the Zimbabwean presidency

The other Mugabe who is lining up for the Zimbabwean presidency

Wife of President Robert Mugabe appears to have her sights set on succeeding her husband
The model of a gadget launch: Cultivate an atmosphere of mystery and excitement to sell stuff people didn't realise they needed

The model for a gadget launch

Cultivate an atmosphere of mystery and excitement to sell stuff people didn't realise they needed
Alice Roberts: She's done pretty well, for a boffin without a beard

She's done pretty well, for a boffin without a beard

Alice Roberts talks about her new book on evolution - and why her early TV work drew flak from (mostly male) colleagues
Get well soon, Joan Rivers - an inspiration, whether she likes it or not

Get well soon, Joan Rivers

She is awful. But she's also wonderful, not in spite of but because of the fact she's forever saying appalling things, argues Ellen E Jones
Doctor Who Into the Dalek review: A classic sci-fi adventure with all the spectacle of a blockbuster

A fresh take on an old foe

Doctor Who Into the Dalek more than compensated for last week's nonsensical offering
Fashion walks away from the celebrity runway show

Fashion walks away from the celebrity runway show

As the collections start, fashion editor Alexander Fury finds video and the internet are proving more attractive
Meet the stars of TV's Wolf Hall... and it's not the cast of the Tudor trilogy

Meet the stars of TV's Wolf Hall...

... and it's not the cast of the Tudor trilogy
Weekend at the Asylum: Europe's biggest steampunk convention heads to Lincoln

Europe's biggest steampunk convention

Jake Wallis Simons discovers how Victorian ray guns and the martial art of biscuit dunking are precisely what the 21st century needs
Don't swallow the tripe – a user's guide to weasel words

Don't swallow the tripe – a user's guide to weasel words

Lying is dangerous and unnecessary. A new book explains the strategies needed to avoid it. John Rentoul on the art of 'uncommunication'
Daddy, who was Richard Attenborough? Was the beloved thespian the last of the cross-generation stars?

Daddy, who was Richard Attenborough?

The atomisation of culture means that few of those we regard as stars are universally loved any more, says DJ Taylor