Shadow MPC - February

6 February 2012

With the stage set for a further round of quantitative easing Mortgage Strategy’s shadow Monetary Policy Committee sticks with its vote to hold. But if it is to avoid inflation problems later the government must time its ending of QE carefully

THIS MONTH’S DECISION: HOLD

Persistent weak demand and easing headline inflation open the way for a further bout of quantitative easing by the Bank of England this month.

By February, when the existing £75bn QE programme announced in October 2011 comes to a close, the Bank will have injected a total of £275bn into the economy by buying government bonds. This is equivalent to more than half of all new gilt issuance in the period since QE began in early 2009. Blaming weak economic outlook at home and abroad, the Bank claims more QE will support activity and stop inflationundershooting its target.

Evidence about the effectiveness of QE is mixed. By supporting asset prices during financial market stress in 2009, QE stabilised investor sentiment and lowered the government’s and large firms’ borrowing costs. The Bank’s readiness to engage in QE is a major reason why the government is able to borrow so cheaply. But funds were largely redistributed in the financial sector, including commodity speculation, which indirectly boosted inflation and weighed on domestic demand through higher import prices.

Most experts are sceptical that QE benefits the real economy given a perceived dearth of business investment opportunities. Long-term borrowing costs for larger corporates and the state are now low, credit demand from overleveraged and risk-averse borrowers is weak, and continued artificial support of asset prices will do little to support the coalition’s aim of economic rebalancing. It is evident that businesses prefer to hold cash because they are sceptical of returns on spending or investment. The danger is that sellers of gilts will continue to sit on the cash rather than buy the riskier assets that the Bank believes will support higher spending.

The Bank has acknowledged that QE will not directly improve credit flows to small and medium-sized firms, arguing that the state should bear any credit risk from efforts to boost loans to such firms. Nevertheless, with the government set firm on fiscal consolidation, the scope for providing any stimulus for the economy is largely in the hands of the Bank.

Given the gloomy outlook, I expect the Monetary Policy Committee to announce a £75bn expansion of QE this week. This would see the Bank holding around 25% of the outstanding stock of gilts by mid-2012. Despite the scale intervention, even the programme’s critics struggle to identify major near-term risks, with inflation expectations fairly stable and no sign of rampant asset price inflation. Nevertheless, given the huge increase in the monetary base in recent years and large liquidity injections by the US and eurozone central banks, policymakers are in uncharted territory.

Central bank studies imply a close correlation between earlier periods of monetary base expansion and inflation over the medium term, periods of five to 10 years. So the timing and pace of any eventual reversal of the Bank’s money-printing programme could be crucial if we are to avoid a serious inflation problem.

Mehrdad