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.