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

Guru Careers: Tax Manager / Accountant

£35 - £50k DOE: Guru Careers: A Tax Manager / Accountant (ACA / CA / CTA) is n...

Ashdown Group: Contracts Executive - City of London

£35000 - £37000 per annum + benefits: Ashdown Group: Contracts Executive - Cit...

SThree: Trainee Recruitment Consultant

£20000 - £25000 per annum + OTE £45K: SThree: SThree Group have been well esta...

Recruitment Genius: Call Centre Debt Collector - Multiple Roles

£21000 per annum: Recruitment Genius: This is an exciting opportunity to join ...

Day In a Page

Giants Club: After wholesale butchery of Idi Amin's regime, Uganda’s giants flourish once again

Uganda's giants are flourishing once again

After the wholesale butchery of Idi Amin's regime, elephant populations are finally recovering
The London: After 350 years, the riddle of Britain's exploding fleet is finally solved

After 350 years, the riddle of Britain's exploding fleet is finally solved

Archaeologists will recover a crucial item from the wreck of the London which could help shed more light on what happened in the vessel's final seconds
Airbus has patented a jet that could fly from London to New York in one hour

Airbus has patented a jet that could fly from London to New York in one hour

The invention involves turbojets and ramjets - a type of jet engine - and a rocket motor
Tate Sensorium: New exhibition at Tate Britain invites art lovers to taste, smell and hear art

Tate Sensorium

New exhibition at Tate Britain invites art lovers to taste, smell and hear art
10 best sun creams for kids

10 best sun creams for kids

Protect delicate and sensitive skin with products specially formulated for little ones
Ashes 2015: Nice guy Steven Finn is making up for lost time – and quickly

Nice guy Finn is making up for lost time – and quickly

He was man-of-the-match in the third Test following his recall to the England side
Ashes 2015: Remember Ashton Agar? The No 11 that nearly toppled England

Remember Ashton Agar?

The No 11 that nearly toppled England
Turkey-Kurdish conflict: Obama's deal with Ankara is a betrayal of Syrian Kurds and may not even weaken Isis

US betrayal of old ally brings limited reward

Since the accord, the Turks have only waged war on Kurds while no US bomber has used Incirlik airbase, says Patrick Cockburn
VIPs gather for opening of second Suez Canal - but doubts linger over security

'A gift from Egypt to the rest of the world'

VIPs gather for opening of second Suez Canal - but is it really needed?
Jeremy Corbyn dresses abysmally. That's a great thing because it's genuine

Jeremy Corbyn dresses abysmally. That's a great thing because it's genuine

Fashion editor, Alexander Fury, applauds a man who clearly has more important things on his mind
The male menopause and intimations of mortality

Aches, pains and an inkling of mortality

So the male menopause is real, they say, but what would the Victorians, 'old' at 30, think of that, asks DJ Taylor
Man Booker Prize 2015: Anna Smaill - How can I possibly be on the list with these writers I have idolised?

'How can I possibly be on the list with these writers I have idolised?'

Man Booker Prize nominee Anna Smaill on the rise of Kiwi lit
Bettany Hughes interview: The historian on how Socrates would have solved Greece's problems

Bettany Hughes interview

The historian on how Socrates would have solved Greece's problems
Art of the state: Pyongyang propaganda posters to be exhibited in China

Art of the state

Pyongyang propaganda posters to be exhibited in China
Mildreds and Vanilla Black have given vegetarian food a makeover in new cookbooks

Vegetarian food gets a makeover

Long-time vegetarian Holly Williams tries to recreate some of the inventive recipes in Mildreds and Vanilla Black's new cookbooks