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