UK’s quantitative easing keeps bond yields down but fails to stimulate lending
Guest Post by Oxford Analytica
The Bank of England’s Monetary Policy Committee (MPC) on November 5 decided to continue its unorthodox programme of asset purchases, known as quantitative easing (QE). This is the United Kingdom’s one remaining policy instrument for promoting recovery from the recession, which has reduced GDP by about 5%. Conventional interest rate policy is exhausted, with an interest rate of 0.5%. Further expansion of fiscal policy is virtually precluded by the size of the budget deficit, now 12% of GDP, and the sharp increase of the debt/GDP ratio.
Prior to the crisis, the MPC failed to take account of asset prices and took no action to curb the upsurge in real estate prices. However, such action was not within its present remit, which limited to achieving a predetermined target rate for inflation, with some concern for growth and stability. If asset price bubbles are to be addressed by the MPC, its terms of reference must be redefined:
- Financial crisis. The MPC’s minutes reveal that it was mainly concerned with the risk of inflation until well into the crisis. It concluded that there was a risk, because of the strong increase in oil and commodity prices, as late as September 2008. It feared that these increases would create expectations of inflation with knock-on effects on wages. This was the view of the MPC, with the exception of independent committee member David Blanchflower, who disputed this reasoning. He was concerned that the United Kingdom would follow the United States into a severe recession; fears about inflation were misplaced, as rising excess capacity would curb price increases. This view was not adopted by the MPC before end-2008.
- Economic stability. The MPC’s discussions of the crisis do not reveal much insight into the problems affecting the financial system. This was partly the fault of the separation of the FSA from the Bank and the FSA’s own failings. However, the MPC also failed to appreciate the banking system’s difficulties. Moreover, there has been a failure to take account of the Bank’s report on economic stability, giving warnings at an early stage of a possible crisis.
Once the MPC grasped the seriousness of the crisis, it reduced the bank rate dramatically by 300 basis points, from 5% in September 2008 to 2% in December. This was followed by further reductions to an unprecedented low of 0.5% in April 2009. These reductions were justified within the inflation-targeting framework; without them the target would have been undershot.
After interest rates were reduced to a minimum, further relaxation required the central bank to buy assets through expansionary open market operations. This purchase programme has now reached its limit of 175 billion pounds (289 billion dollars) and a decision had to be taken whether to expand quantitative easing (QE) by up to 50 billion pounds. Given the views on inflation of some MPC members, it is not surprising that it has now opted for an expansion of only 25 billion pounds.
Outlook. The scheme has had some success in keeping down bond yields at a time of heavy government borrowing to finance its budget deficit. It has been less successful in stimulating the growth of broad money, measured as adjusted M4. Asset purchases should have been directed more towards corporate than government bonds.
The MPC has done little to bring pressure on the banks to make credit more available to smaller companies and has not discouraged the hoarding of reserves.
However, the policy response of the MPC has been valuable in maintaining the pound at a highly competitive level. When recovery comes, the MPC will have to consider how best to reverse QE and resolve the fears of some of its members about the medium-term prospect for inflation.
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