Quantitative easing: risks vs benefits

definition-quantitative easing

Readers Question: Could you comment on This BBC programme on Q.E.

The programme highlights several criticisms of Quantitative Easing, especially the Q.E. adopted by the Bank of England.

Since 2009, the Bank of England’s balance sheet has quadrupled, and now a third of all government bonds are now held by Bank of England. The programme fears this is storing up future inflation and a possible loss of confidence in the bond market.

Firstly, just to recap:

Quantitative easing involves

  1. Central Bank creating money electronically
  2. Using this electronic money to purchase bonds (mostly government bonds)

The effect of quantitative easing has been

  • To reduce bond yields on government debt.
  • Increase money supply and bank reserves of commercial banks.

Drawbacks of quantitative easing

  • The new inflow of money into commercial banks from quantitative easing has encouraged banks to use this extra money through greater risk-taking. Some argue that Q.E. has increased the risk-taking nature of banks (a problem behind 2008 crisis)
  • Bond traders have benefited from making large profits out of the Bank of England by manipulating the bond market.
  • Because government debt is being financed by quantitative easing, the government has less market discipline to think about reducing fiscal deficits and tackle the underlying problem of UK public sector debt rising to 100% of GDP by 2016.
  • Quantitative easing has been a stealth method of reducing the value of the Pound and Dollar – and therefore making UK exports cheaper. Some commentators call this currency manipulation (or currency wars). They argue this is unfair on emerging markets who are seeing their exports become less competitive.
  • The increase in money supply has led to an unexpected rise in commodity prices, such as oil. This is unusual when the Western economies are in recession; rising oil prices have led to cost-push inflation.
  • By depressing interest rates, quantitative easing has wiped out people’s return on savings (though share price rises have compensated to a certain extent.)
  • Quantitative easing is causing inflation in the UK. (Inflation has frequently been above the government’s target of 2%, and when the velocity of circulation rises, these extra bank balances will be lent – causing a possible inflationary surge.
  • The scale of quantitative easing could make it impossible to sell bonds back to the market and this will damage the UK’s ability to borrow in the future. If the UK’s ability to borrow is constrained, this will lead to higher interest rates and reduce economic growth.
  • Evidence in the US suggests even raising the possibility of tapering could cause damage to the bond market, and higher interest rates. These higher interest rates could reduce economic growth.

Potential benefits of Q.E.

  • Low bank lending. There is no real evidence that there has been a surge in risky bank lending. In fact, the opposite has been the main concern over the past few years. – A more potent criticism of Q.E. is perhaps that it did so little to increase commercial bank lending. Bank lending is still very low compared to pre-crisis trends.
  • We need fiscal expansion, not austerity. It is a very good thing if Quantitative easing has reduced the need for austerity and immediate measures to cut budget deficits. If the UK has pursued Greek or Spanish style austerity, the UK recovery would have been much weaker or non-existent. A recession is not the time to tackle the public sector debt. The important thing is to promote economic growth; this will enable debt to be tackled in the long term when the economy can better absorb spending cuts and tax rises.

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The natural rate of interest

natural interest rate

The natural rate of interest is the interest rate consistent with maintaining economic growth at its trend rate and stable inflation. Another definition of the natural rate of interest is: “the real interest rate consistent with real GDP equalling its potential level (potential GDP) in the absence of transitory shocks to demand. (FR) In other …

Read moreThe natural rate of interest

Base rates and bank interest rates

lending-rates-base-rates

The Bank of England set the base rate. The base rate is the rate at which they charge commercial banks to borrow from the Bank of England. In normal economic circumstances, this base rate will influence all the interest rates set by other banks and financial institutions. If the Bank of England cut the base …

Read moreBase rates and bank interest rates

UK Unemployment Target

The new Bank of England governor, Mark Carney, has implemented a type of unemployment target.

As part of forward guidance, the Bank of England state that:

Interest rates won’t rise from 0.5% until unemployment falls below at least 7%.

Essentially, the bank are committing to expansionary (loose) monetary policy until there is a stronger economic recovery and unemployment has fallen. The hope is that the commitment to low interest rates will encourage firms to invest and consumers to spend.

However, this unemployment target of 7% has a few caveats.  The unemployment target and forward guidance on interest rates can be ignored if:

  • Inflation is forecast to breach a 2.5% target over a 24 month horizon.
  • If there is a sharp rise in the public’s expectations of inflation
  • If low interests are likely to imperil the stability of the financial system, e.g. low interest rates could fuel an asset bubble.

UK unemployment-past-5-years-percent

Under the Bank of England’s latest targets, it does not expect unemployment to fall below 7% until 2016. According to the ONS, unemployment is currently 7.8%. It would require the creation of nearly 750,000 new jobs for the rate to fall below 7%

Equilibrium Unemployment

The Bank of England also mentioned the term ‘equilibrium unemployment’. They believe the equilibrium unemployment rate is around 6.5%. The equilibrium rate means that if unemployment falls below 6.5% it might start causing inflation (e.g. competition for employers pushes up wages). If unemployment is above the equilibrium rate of 6.5% then there is slack in the economy (demand deficient unemployment) and this will keep inflation low.

This equilibrium rate of 6.5% is therefore composed of structural factors / supply side factors (the natural rate of unemployment)

Read moreUK Unemployment Target

Forward guidance in monetary policy

Forward guidance is when the Central Bank announces to markets that it intends to keep interest rates at a certain level until a fixed point in the future.

The aim of forward guidance is to influence long term interest rates and market expectations. For example, the Central Bank might want to boost economic activity by convincing markets that interest rates will stay low for the foreseeable future.

It means that Central Banks are pledging to keep interest rates low, even if inflation starts to creep above its target. It can be seen as an indirect way of placing less emphasis on low inflation and more emphasis on economic recovery.

The Central Bank could say it intends to keep interest rates at 0.5% for a certain time period (until 2015) or
it could say it intends to keep interest rates at 0.5% until certain economic criteria are met (e.g. interest rates will stay at a certain level until unemployment falls below 6%).

What are the benefits of forward guidance?

It helps the Central Bank to influence long term interest rates. The Central bank can only directly control short term rates – Base rates. In normal economic circumstances, a change in base rates usually leads to an equivalent change in commercial bank rates (the long term lending rates which are important in an economy) However, in the credit crunch / great recession there was a divergence between base rates and commercial bank rates. Lower base rates were not passed onto consumers.

base-rates-bank-rates-mortgage-rates

mortgage rates and bank lending rates didn’t fall as much as base rates

If commercial banks feel the cut in base rates is temporary, they may not want to cut their long term rates. But, if the Central Bank confirms that it will keep base rates at 0.5% for a considerable time, then commercial banks may be more willing to reduce their long term rates (e.g. mortgage and lending rates) because they know they will be able to borrow from the Central Bank at 0.5%. The hope is that this will encourage banks to cut rates, and increase overall lending in the economy. This increase in lending should boost investment and economic growth.

Inflation / deflation expectations. Another feature of forward guidance is that it might influence inflation expectations. If the Central Bank states that interest rates will stay at zero until unemployment falls below 6%, markets, firms and consumers may be more liable to expect higher inflation than previously. Some economists argue that, if there is currently a risk of deflation, higher inflation expectations can help boost spending and economic growth. This is particularly beneficial in a liquidity trap.

How credible is forward guidance?

There is nothing to stop the Central Bank ignoring its own pledge. The Bank of England could  pledge to keep interest rates at 0% until 2015, but if circumstances change – they could raise interest rates. Markets and banks know this and this could reduce the usefulness of the commitment, but it can still give an indication of how monetary policy will operate. Markets do tend to place a lot of weight on Central Bank pronouncements. 

Read moreForward guidance in monetary policy

Credit Policy

Credit policy / financial policy is the use of the financial system to influence aggregate demand (AD). Monetary policy affects AD through the Central bank controlling interest rates and the money supply. Fiscal policy affects AD through the use of government spending and taxation.

Credit policy looks at factors such as:

  • Bank lending rates to firms and households in the economy.
  • The supply of credit and availability of loans from banks to firms and households.

In normal economic circumstances, it was felt the Central Bank could adequately control the economy through changing base rates.

When the Central Bank (e.g. ECB, Bank of England) changed interest rates, it had a strong influence on bank lending rates. When the ECB cut rates in 2001-03, bank lending rates fell, when the ECB raised rates in 2006-07, bank lending rates rose. Bank lending rates closely mirrored the Central Bank. Therefore, there was little attention paid to bank lending rates – there was no need.

However, since the credit crunch, the normal relationship between Central bank base rates has broken down. In particular, when the main base interest rate was cut, firms – especially small and medium sized firms (SME) didn’t see the actual interest rate they paid cut.

base-rates-bank-rates

See also bank and base rates in the UK

Implications of divergence between base rates and bank rates

This is very important for the effectiveness or not of monetary policy. Usually, if interest rates are cut from 5% to 0.5%, we would expect the loosening of monetary policy to boost lending, consumption and aggregate demand. But, that hasn’t been happening. Lending rates are still high, and credit tight. The base rate of 0.5% has become misleading to the actual reality of firms who face high borrowing costs.

Problems in the Eurozone

bank costs

Source: Economists – Central bank has lost control over interest rates

This problem of bank lending rates is most noticeable in the peripheral Eurozone countries. Since the crisis, small and medium sized firms have actually seen an increase in borrowing costs. Bank rates have increased, making the 0.5% ECB rate meaningless. The Economist reports

‘SMEs in Spain and Italy must pay over 6% to borrow; money is tighter there than it was in 2005, even though the ECB’s rate is far lower.’ (Woes for small business in Europe)

The problem for SME (small and medium enterprise firms) is that they are too small to sell their own bonds. They are reliant on bank lending. But, because of the credit crunch and fears over bank stability, they are finding their borrowing costs increase.

Read moreCredit Policy

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