Can Bank pull off quantitative easing without inflation crisis?

Hugo Duncan
8 Jul 2009

The Bank of England “printing presses” are rolling, and more than £100 billion of new money has been pumped into the economy in the last four months through the controversial programme of quantitative easing.

Billions more will be provided this month to take the total up to the current limit of £125 billion, and the monetary policy committee meets this week to debate what to do next.

The Bank has permission from the Government to spend £150 billion on quantitative easing but this number can be extended if the MPC gets the approval of the Chancellor. Relations between the Treasury and Threadneedle Street may have soured recently, but there is little chance Alistair Darling would defy Bank Governor Mervyn King should such a request be made.

So all eyes will be on the Bank to see what it does when the monthly two-day meeting of the MPC ends at noon on Thursday. With the UK still deep in recession, the Bank must decide if it has done enough to ensure it has prevented a dangerous bout of low inflation or even deflation.

If not, the big question facing the MPC is how much more money it should print and when should it stop.

Here the Evening Standard looks at the quantitative easing programme so far and what comes next.

What is quantitative easing?

It is a modern form of printing money, although it does not actually involve printing more banknotes. The Bank buys assets such as Government gilts and corporate bonds from the likes of pension funds and life assurance companies to flood the economy with cash.

It pays for the assets by creating money electronically and crediting the accounts of the companies it bought the assets from, leaving them free to spend the money and boost the economy. The Bank has been buying the assets at a rate of about £25 billion a month since March.

Why was it introduced?

The MPC's job is to keep inflation at 2% to support economic growth and employment, so with inflation falling fast and the UK deep in recession it was forced to act. Having cut interest rates to an all-time low of 0.5% in March, the Bank needed a new tool to reverse the slide in the economy and stave off a period of dangerously low inflation or even deflation.

The Bank hopes that by pumping new money directly into the economy it will achieve just that. It also hopes that buying assets will restore confidence in the markets and increase trading activity.

Has it worked?

The City is far from sure, as indeed is the Bank, and the overriding view is that it is too early to tell.

Lending to households and businesses remains subdued — something the Bank and the Government see as a serious threat to economic recovery — and there is little sign that the money used to buy assets has been passed on to the wider economy.

Inflation also remains on a downward path and looks all but certain to undershoot the 2% target for much of the second half of the year. The threat of deflation has eased but not disappeared.

There has, however, been some impact on the corporate bond markets where confidence is slowly returning and liquidity improving. Although not the main objective of quantitative easing, a welcome development.

But the most telling assessments come from the Bank itself — and they suggest more needs to be done despite hopes that “green shoots” are emerging.

Paul Tucker, Deputy Governor for financial stability, said last month: “A sense of perspective is needed if those apparently small steps forward are not to be frittered away. That path back to anything like normal can only be gradual.”

King said he is “more uncertain now than ever” about the state of the economy and warned the recovery will be “a long hard slog”. And Tim Besley admitted last week: “We will not know for sure whether quantitative easing has been directly effective in supporting demand growth for some time and a definitive assessment right now would certainly be premature.”

What next?

It looks highly likely the Bank will use the last £25 billion of the original £150 billion sanctioned by the Chancellor. It could also ask the Government for more headroom — even if it does not wish to spend the extra cash now, at least the groundwork will have been laid for when and if it does.

Indeed, economists reckon the Bank could end up spending anything between £150 billion and £350 billion before it pulls the plug on quantitative easing. However, it is far from certain whether the MPC will act this month or next, or even wait until later in the year. At the current rate of asset purchase, the Bank will have spent the planned £125 billion within the next two or three weeks, so there is every reason to expect it to raise its target to £150 billion on Thursday.

The markets have certainly got used to the weekly £6.25 billion auctions held by the Bank, and will expect them to continue at least until the full £150 billion is spent.

But the MPC could hold off to next month to coincide its decision with the quarterly inflation report, when it publishes its projections for growth and inflation.

This would provide the Bank with the perfect opportunity to assess the impact quantitative easing has had so far, and explain what it intends to do next.

As King explains, it is a fine balancing act: “If you withdraw stimulus too quickly, you run the risk that the downturn will resume. Equally of course, we need to be very careful not to allow the stimulus to reach the point at which inflation takes off.”

To avoid spooking the markets, a sensible solution would be to extend quantitative easing to £150 billion this month and outline the next phase of the programme — whether it be further expansion, a pause for breath, or the start of the exit strategy — next month to coincide with the inflation report.