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

Start your day with The Independent, sign up for daily news emails
ebooks
ebooksAn introduction to the ground rules of British democracy
Latest stories from i100
Have you tried new the Independent Digital Edition apps?
SPONSORED FEATURES
Independent Dating
and  

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

iJobs Job Widget
iJobs Money & Business

SThree: Experienced Recruitment Consultant

£20000 - £40000 per annum + OTE + Incentives + Benefits: SThree: Established f...

SThree: Trainee Recruitment Consultant

£20000 - £25000 per annum + OTE 40/45k + INCENTIVES + BENEFITS: SThree: The su...

Recruitment Genius: Collections Agent

£14000 - £16000 per annum: Recruitment Genius: This company was established in...

SThree: Trainee Recruitment Consultant

£20000 - £25000 per annum + OTE 40k: SThree: SThree are a global FTSE 250 busi...

Day In a Page

Refugee crisis: David Cameron lowered the flag for the dead king of Saudi Arabia - will he do the same honour for little Aylan Kurdi?

Cameron lowered the flag for the dead king of Saudi Arabia...

But will he do the same honour for little Aylan Kurdi, asks Robert Fisk
Our leaders lack courage in this refugee crisis. We are shamed by our European neighbours

Our leaders lack courage in this refugee crisis. We are shamed by our European neighbours

Humanity must be at the heart of politics, says Jeremy Corbyn
Joe Biden's 'tease tour': Could the US Vice-President be testing the water for a presidential run?

Joe Biden's 'tease tour'

Could the US Vice-President be testing the water for a presidential run?
Britain's 24-hour culture: With the 'leisured society' a distant dream we're working longer and less regular hours than ever

Britain's 24-hour culture

With the 'leisured society' a distant dream we're working longer and less regular hours than ever
Diplomacy board game: Treachery is the way to win - which makes it just like the real thing

The addictive nature of Diplomacy

Bullying, betrayal, aggression – it may be just a board game, but the family that plays Diplomacy may never look at each other in the same way again
Lady Chatterley's Lover: Racy underwear for fans of DH Lawrence's equally racy tome

Fashion: Ooh, Lady Chatterley!

Take inspiration from DH Lawrence's racy tome with equally racy underwear
8 best children's clocks

Tick-tock: 8 best children's clocks

Whether you’re teaching them to tell the time or putting the finishing touches to a nursery, there’s a ticker for that
Charlie Austin: Queens Park Rangers striker says ‘If the move is not right, I’m not going’

Charlie Austin: ‘If the move is not right, I’m not going’

After hitting 18 goals in the Premier League last season, the QPR striker was the great non-deal of transfer deadline day. But he says he'd preferred another shot at promotion
Isis profits from destruction of antiquities by selling relics to dealers - and then blowing up the buildings they come from to conceal the evidence of looting

How Isis profits from destruction of antiquities

Robert Fisk on the terrorist group's manipulation of the market to increase the price of artefacts
Labour leadership: Andy Burnham urges Jeremy Corbyn voters to think again in last-minute plea

'If we lose touch we’ll end up with two decades of the Tories'

In an exclusive interview, Andy Burnham urges Jeremy Corbyn voters to think again in last-minute plea
Tunisia fears its Arab Spring could be reversed as the new regime becomes as intolerant of dissent as its predecessor

The Arab Spring reversed

Tunisian protesters fear that a new law will whitewash corrupt businessmen and officials, but they are finding that the new regime is becoming as intolerant of dissent as its predecessor
King Arthur: Legendary figure was real and lived most of his life in Strathclyde, academic claims

Academic claims King Arthur was real - and reveals where he lived

Dr Andrew Breeze says the legendary figure did exist – but was a general, not a king
Who is Oliver Bonas and how has he captured middle-class hearts?

Who is Oliver Bonas?

It's the first high-street store to pay its staff the living wage, and it saw out the recession in style
Earth has 'lost more than half its trees' since humans first started cutting them down

Axe-wielding Man fells half the world’s trees – leaving us just 422 each

However, the number of trees may be eight times higher than previously thought
60 years of Scalextric: Model cars are now stuffed with as much tech as real ones

60 years of Scalextric

Model cars are now stuffed with as much tech as real ones