With inflation rising to 4.5% in April, there is plenty for the Monetary Policy Committee to worry about. The base rate is the most headline-grabbing part of the Bank of England’s arsenal but quantitative easing could be a bigger threat to economic stability than the over-extension of the low rate policy.
At the heart of the problem is the question of what will happen when the quantitative easing money dries up. To answer this, it is useful to consider the impact of quantitative easing in the US. The Federal Reserve has, like the MPC, launched two bouts of quantitative easing with the intention of redeploying capital into the financial system, raising asset values and generating increased consumer spending.
In both the UK and US the quantitative easing programmes seem to have worked. Since they began and prior to the development of concerns about a downgrade, the US stock market had risen by 61%, with more than 90% of the increase taking place while the Fed was using active quantitative easing.
It could be a coincidence but the correlation is remarkable. If quantitative easing has been the primary reason for this growth, we could find ourselves facing a major adjustment once the tap is turned off.
In the UK, the second round of quantitative easing has coincided with a price spiral. In February, Retail Prices Index inflation rose to its highest level since 1991, despite the economy entering negative growth in Q4 2010. It is possible that pulling the plug on quantitative easing will not only put the brakes on lending but also damage growth and household finances. When we consider the latest abysmal sales figures from the British Retail Consortium, it’s hard to sustain a bullish argument that consumer demand is sufficient to sustain growth.
Household finances are feeling the squeeze as spending power is eroded by the price spiral and rising taxes. When you factor in a growing sense that tracker mortgage repayment rates are set to rise, consumer spending power looks like it might be built on shaky foundations.
In this context, even the Treasury’s downgraded forecast to 1.7% growth looks optimistic. If the MPC was to step away from asset purchase activities, the recovery could be at risk. Equally, if monetary policy continues to be determined on a growth-first basis, its ability to affect inflation will be compromised.
The fundamental problem with interventions such as quantitative easing is that bringing them to a halt has the potential to send the economy into cold turkey. In truth, nobody knows how significant quantitative easing has been and how big a hole it will leave when it ends, but end it must. Any further monetary easing would serve only to delay the inevitable.
All we can say for sure is that we’ll find out the truth eventually but doing so could be a painful experience.