By Andrew Smith, Chief Economist, KPMG in the UK
Almost two years ago, the Monetary Policy Committee took an unprecedented step and cut interest rates to 0.5%, at the same time unleashing a multi-billion pound programme of asset purchases – known (simply!) as quantitative easing (QE) – to support the economy. Since then, GDP growth and inflation have moved erratically and output remains 4% below its pre-recession peak. This week, I was struck by how calmly the announcement of a further round of QE and continuing ultra-low rates was reported. It’s almost like this is the norm – but it’s not normal. These are desperate measures in extraordinary times. It is worth considering how we got here, and does QE really help?
The financial crisis of late 2008 and subsequent recession destroyed confidence and damaged the balance sheets of households, banks and governments. Central banks attempted to ease these pressures and avert a global depression by slashing interest rates. But, even as rates fell, households and banks were still not prepared to spend – instead they saved in an attempt to repair battered finances and deleverage. And at near zero, there was nowhere left for rates to go. Fearing deflation and depression, the authorities took a leap into the unknown and embarked on QE.
QE is intended to be inflationary. Buying up gilts with newly created money injects cash into the economy, and should ordinarily boost nominal spending. The Bank of England identified many channels through which QE may work – too many to list here. But it’s fair to say that even the MPC wasn’t sure what the exact effect of the policy would be.
So, when the Bank released an estimate of the impact of the first tranche of QE – (they speculated it raised GDP by between 1.5 and 2% and increased inflation by 0.75 to 1.5%) – it was met with a combination of relief and concern. Relief that the policy had a positive impact, and yet concern because, without it, there would have been no growth at all.
Given the apparent success of the first round (2009), it is surprising the MPC did not do more, sooner. Natural caution is one reason, while at the start of 2011 things were beginning to look brighter and inflation was taking off, removing the pressing need for further easing. Also, like most things in life, QE is probably subject to the law of diminishing returns.
But a year is a long time in economics – inflation, although still high, looks likely to fall fast this year and the outlook for growth appears bleak. It was therefore no surprise that a further £50 billion of asset purchases was announced this month, complementing the £75 billion launched last October, and taking the total programme to £325 billion. I suspect more is likely too, not because it is some sort of silver bullet – it may not even work this time. But with no sign of any imminent stimulus from fiscal policy and interest rates already at their lowest bound, there are very few other options left.
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Interesting article Andrew. One question that I have not seen satisfactorily answered anywhere is why there has been little if any discussion of interest rates falling further if deflation is a serious concern?
I realise that at 0.5%, interest rates could only move 0.5% lower, but this isn’t quite the “nowhere left for rates to go” stated. Is this simply the lowest that the Bank of England considers it can lower interest rates to without attracting the deep ire of savers; if so, this is not within its stated objectives “to deliver price stability – low inflation – and, subject to that, to support the Government’s economic objectives including those for growth and employment”
It appears to me that, for the Bank of England, Keynesian thought holds sway with regards to interest rates, whilst more contemporary literature is the strongest influence over the Bank’s decision to implement QE. What I mean by this is that the Bank of England seems to held Keynesian concerns over the liquidity trap in high esteem with regards to interest rates. It must consider that increasing money supply (i.e. lowering interest rates) would have no discernable effect on output or prices, or else why the lack of consideration for such a move? Thus it would appear that the Bank of England views the short-term interest rate as (effectively) zero and, in original Keynesian thought, no increase in money supply in such a circumstance can raise output or prices. This contrasts with more modern literature viewing current interest rates within the intertemporal stochastic general equilibrium model whereby lowering interest rates, whilst perhaps not influencing the current short-term interest rate, could influence expectations of future interest rates. Within the intertemporal stochastic general equilibrium model, such expectations would increase output and prices in the here and now.
If this is the case however, why does it consider QE to be worth undertaking? Viewed objectively, the effect of QE should be the same as that of lowering interest rates: both should lower longer-term interest rates. Whilst the lowering of nominal interest rates appears more immediate, such a move is only considered to have a significant effect on prices and output after 12 to 24 months of the decision. Clearly, the decision must be made with (at least partial) emphasis of thinking on the intertemporal stochastic general equilibrium model: why else the lack of consideration of a move to lower interest rates?
We appear thus to be left with a paradox. If the Bank of England is following Keynesian thought, why follow QE at all if the short-term interest rate is considered to be zero (save perhaps for the Bank of England to avoid comparisons to Nero) as neither move would be expected to influence prices or output; and if the Bank of England is following more modern thinking, why follow QE before/without lowering the nominal interest rate, as this should objectively have the same effect on expectations of future real interest rates?
I would appreciate your thoughts with regards to this. It would appear from your final paragraph you lean towards the Bank of England thinking along a Keynesian line, and this would tie with the experience of the Bank of Japan policy of ‘quantitative easing’ from 2001 to 2006 where the monetary base was increased by over 70 per cent in that period by QE (by most accounts, however, the effect on prices was sluggish at best). Nevertheless, if the Bank is proceeding with quantitative easing, is lowering interest rates to 0.25% or even 0% so inconceivable?
Thomas
Thomas Cullis raises interesting theoretical, and practical, questions about monetary policy under current conditions.
To take the practical question first, can the BoE policy rate be reduced below 0.5% and if so why hasn’t it been?
The Monetary Policy Committee has in the past considered lowering its rate further but not done so due to concerns over the potential for an adverse impact on the functioning of the money markets and on bank lending and profits. These worries might be overdone – other countries have rates closer to zero – but a further 25-50 bp cut might not be thought to have much impact anyway. Indeed, the bank estimated the economic impact of the first QE tranche of £200bn to be the equivalent of a 150-300 bp cut in interest rates.
This takes us on to schools of thought on QE and how it works. I think that, writing in the 1930s, Keynes himself probably thought that in a liquidity trap (where desired savings remain above demand for investment funds even at zero interest rates so there is a shortfall in aggregate demand) printing money will have no traction which is why he argued for active fiscal policy.
Obviously that is not the position taken by the MPC which has just announced a further £50bn of QE. It believes that QE feeds into demand by lowering gilt yields and hence general longer-term borrowing costs, depressing the pound and raising other asset prices.
Quite what school of thought this fits into is debateable but there is a “rational expectations” argument that what QE really needs to do is to raise expectations that inflation and demand are being stoked and, crucially, that the central bank will not clamp down at the first signs of revival. Hence pledges by the US Fed to keep short rates on hold for a defined period.