By GRAHAM FROST 13/07/2009
Last week, the Monetary Policy Committee (MPC) decided not to increase the programme of quantitative easing (QE) from the current £125 billion to £150 billion, the maximum permitted. There was some speculation ahead of the announcement that the Committee would seek to increase the allowable limit beyond £150 billion because the perception has been QE has, so far, has had little effect in injecting liquidity into the UK economy. The MPC said it would complete the current programme and review the policy at its next meeting to be held in August.
Market’s reaction
Gilt markets reacted with disappointment and yields rose sharply on the absence of further aggressive buying by the Treasury. The market’s expectation had been based on the lack of evidence that UK lending is responding to the injection of liquidity via QE. We believe the failure is not because the QE programme is too small, but because the conduit for enabling the extra money supply to get into the economy is not working effectively.
The sellers of bonds have mostly been institutions (many overseas) and much of the extra liquidity has been spent on other asset classes, especially equities, contributing to the rally in those markets. The banks are still hoarding cash as reserves in an effort to strengthen their balance sheets and restore capital ratios to adequate levels following the credit crunch. In this respect the problem for the MPC and the Government is to get the banks lending again and a normal flow of credit circulating around the economy.
What is Quantitative easing?
Quantitative easing (QE) is the term applied to money creation. The purpose of QE is to buy shorter-dated gilts to encourage investors to move to long-dated gilts. The demand would force up the price and drop the yield, making borrowing money over the longer term cheaper. It would also make it easier for the Government to issue long-dated gilts at low coupons.
Our view
We think the MPC is right to hang fire. The jury is still out as to whether QE will succeed in meeting its desired objectives, but there is also a danger that by being too aggressive too soon it will result in raised inflationary expectations. If inflation takes off, once the economy starts recovering, it is a dragon that is very difficult to slay, as the UK economy learnt in the 1970s and 1980s. A balanced approach is correct for the time being and the MPC should concentrate on finding a way of persuading or coercing the banks to lend in the meantime.
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