The Bank of England’s Monetary Policy Committee today voted to maintain the official Bank Rate paid on commercial bank reserves at 0.5%. The Committee also voted to continue with its programme of asset purchases financed by the issuance of central bank reserves and to increase its size by £50 billion to £175 billion.
So far, quantitative easing has done little to revive the economy. Corporate sector lending is falling, with many firms paying back loans on a net basis. Consumer lending is also weak. Government bond yields remain stubbornly high. The mortgage market is the only sector where the architects of QE can claim any degree of success. Approvals are up and house prices have stabilized.
The initial results have been disappointing, and so the Bank of England have decided to pour in another £50 billion, bring the total amount of new money up to £175 billion. In terms of GDP, that amounts to about 12.5 percent of GDP.
Think about that for a moment. Since February, the Bank of England has printed a pile of cash that is equivalent to one eighth of the entire output of the economy. Imagine, if each one of those pounds was spend just once. Could the UK economy immediately increase output by 12.5 percent to meet this new demand? Or would it be the case that firms would simply raise prices, leading to a sudden surge in inflation?
So why haven't we had any inflation. So far, quantitative easing has not led to an increase in aggregate demand. Banks have sold their assets to the Bank of England, and deposited the cash back into the central bank. As of now, there the cash idly sits.
However, here is the killer question - will it sit there forever? Or will the banks start to use this cash and begin to extend credit? My feeling is that one bright day, the banks will wake up and realise that they excessively liquid, start lending and the economy will take off like a rocket.
But isn't this what the Bank of England wants? Yes, but don't think for a second that they know what they are doing. Outside of hyper inflating economies, no central bank has ever tried this trick before. Perhaps the kindest description of quantitative easing is to say that it is an experiment.
If lending does start to increase rapidly, the only thing the Bank can do is unwind their huge holdings of government debt. In other words, it needs to reverse quantitative easing.
When it begins this huge roll back of liquidity, the Bank of England may find that interest rates become extremely volatile as it unloads this debt in a desperate attempt curb lending. Unwind too much, and they could push the economy back into a recession, unwind too little, the banks could keep lending, and inflation could pick up.
However, this could be someway into the future. It could be a year or two before the banks start to change their credit crunching ways. The MPC aren't thinking that far ahead. Nor is the government for that matter. The future belongs to someone else. Today is what matters. If QE boosts GDP by the end of the year, paving the way for a half hearted New Labour election boost, then the policy will be a raging success.