The Bank of England has tacitly admitted that its past strategies of aggressively cutting interest rates and recapitalising the banks have failed to lift the economy out of recession.
Alongside a cut in Bank Rate of 0.5 per cent, to 0.5 per cent – widely regarded as being the final throw of that dice – the Bank's Monetary Policy Committee yesterday announced an unprecedented £150bn programme of "quantitative easing" – a direct increase in the quantity of money circulating in the economy.
Political reaction to the Bank's radical move was lukewarm. George Osborne, the shadow Chancellor, described the policy as "a leap in the dark". The Liberal Democrat Treasury spokesman, Vince Cable, agreed that increasing the amount of money flowing into the economy was now the "only clear option", but warned: "The Government must be careful that this kind of radical action doesn't quickly turn deflation into high inflation."
The policy, colloquially termed "printing money", has never been tried in the current conditions of deflation – falling prices in the shops, and in property and stock markets – and a dysfunctional banking system.
An exchange of letters between the Chancellor, Alistair Darling, and the Governor of the Bank, Mervyn King, sets out the MPC's remit – to create up to £150bn of new money through purchases of government securities (gilts), with £50bn of the total earmarked to buy debt issued by companies, such as bonds and commercial paper. Some £75bn will be disbursed over the next three months.
Mr King commented: "Nothing in life is ever certain. Changing interest rates is not certain. These measures, we think, will work in the long run. I can't be sure how long it will take." In his letter to the Governor, Mr Darling said that the policy would be "kept under review".
The Bank's aim is to increase spending in the economy, ease the supply of credit to households and companies and reverse the current trend of falling prices. However, there are doubts that the banks will use the extra cash to boost lending to hard-pressed companies and homebuyers. According to Roger Bootle, the economic adviser to Deloitte in the UK, "the uncertainties surrounding how much, and what type, of quantitative easing is required are huge. Banks might just sit on the increase in their reserves, rather than using them to lend more."
The Bank will move rapidly to inject the cash into the system. The first of a series of twice-weekly gilt auctions will start next Wednesday. The Bank says that it will focus on purchasing conventional gilts with maturities of five to 25 years. The increase in demand from the Bank for gilts should drive their prices up and their yields down, while the demand for corporate bonds will make it easier for firms to raise money for investment through this route. Teams of economists at the Bank and the Treasury have been working on the proposals since before Christmas.
This £75bn figure is a very large increase in the money supply – defined as notes and coins in circulation plus a much larger volume of bank and building society accounts. At about £1.2 trillion, the £75bn represents about six per cent of this "broad money" base held by UK individuals and companies. However it is a much bigger proportion of the money immediately available to people and the banks – so called "narrow" or "base" money and the type of cash most likely to be spent. Base money will thus increase from £93bn to £168bn before the summer – up more than 80 per cent. Karen Ward, the UK economist at HSBC, said: "This is an aggressive starting point, and suggests they don't have much faith in the money being passed on."
While not returning to the "monetarist" approach of targeting increases in the money supply that was tried in the early 1980s, the Bank of England will keep a keen eye on the growth of money in the economy and the volume of spending feeding into the shops as it seeks to edge inflation back to the two per cent target.
All agree that the bank is moving into uncharted territory and the speed and effectiveness of the policy is uncertain. Missing from yesterday's announcements was any direct assistance to the property market. The Government and the bank have, for now, apparently ruled out purchasing mortgage-backed securities, as was recently discussed in the Government-sponsored Crosby Report into mortgage finance. Some expressed disappointment. Nicholas Leeming, the director of propertyfinder.com, remarked: "There is huge pent up demand for homes, with first-time buyers champing at the bit to take advantage of lower prices. Quantitative easing may turn on the taps, but the bankers have to take the plug out to let the money flow into the economy."
Q&A: What is quantitative easing and will it fuel inflation?
What is Quantitative Easing?
Put simply, it is what we used to call "printing money". These days the money is created by the Bank of England by changing an entry in a spreadsheet say, to credit a commercial bank with more money in its account at the Bank. Simple as that.
How will the Bank create the new money?
Imagine that you are rich enough to have a few British government securities – gilts. You will soon be able to go along to the Bank of England and offer them in an auction. If the price you ask is not too exorbitant then the Bank will buy them and credit your bank account. What's new is that the Bank will not in this case borrow money in the market – issuing a roughly equivalent quantity of new securities to neutralise or "sterilise" that purchase – but will simply pay for it by creating money. The beauty of it is that the Bank can create as much money as it wants.
What happens then?
You then receive the money and spend it or put it on deposit at a bank. The idea is that the banks, flush with these new funds, will start lending to businesses and households, lifting demand and confidence and inducing a little bit of inflation into a world of falling prices. In reality, many of the purchases of gilts will be from pension funds, insurers and other institutions, but the net effect should be similar: the money should find its way into shops and businesses.
Will the policy work?
Not necessarily. The banks might well "hoard" the new cash because their own financial opposition is so fragile. But that would be disastrous for the wider economy. It is a moot point as to how much of the new money will get spent, how quickly and whether some might "leak" abroad. The Bank and the Government may well need to look at forcing the banks – nationalised or not – to lend more.
Won't we get inflation, like in Zimbabwe and Weimar Germany?
Not really. The scale of these operations is modest compared to those two examples of hyperinflation. Besides, the danger to Britain is deflation – falling prices in the shops, of assets such as shares, houses and commodities. That is what happened in Japan after its "bubble economy" collapsed in 1990, and in the UK and US during the Great Depression. Fear of those scenarios is driving the authorities to take these unprecedented steps.
What about a bit of inflation?
More realistic. The "lags" in monetary policy are long and variable: a given change in interest rates or in the quantity of money can take many months, even years, to work through fully, and the impact is impossible to predict. Changing the money supply in a credit crunch and in a globalised, open economy such as the UK prone to "shocks" like oil price hikes is a new exercise. It is possible that the Bank will "overcook" things and we'll end up with a bout of inflation a year or two down the line. There are risks on both sides; too much deflation or too much inflation.