Monday, 7 September 2009

In August, QE hit the economy

What are UK banks up to? Last month, their cash deposits at the Bank of England fell by 6 percent. In crude cash terms, banks withdrew almost ₤10 billion.

In the previous six months, banks had accumulated huge deposits. This was due to quantitative easing. The BoE was buying up bank holdings of Treasury paper. In return, it paid for this paper by increasing bank deposits held at the Bank of England. This was how the BoE were "printing cash"; it was generating big increases in reserve balances.

In principle, UK banks could have withdrawn that cash and used it to create new credit. However, during the first half of this year, banks preferred to park the money in the vaults of the Bank of England. That all changed in August, when for the first time since QE began, deposits shrank.

There is, of course, no explanation from the BoE about this recent development. The most likely story is that banks are beginning to lend again. The question, however, who are their new customers?

The most recent lending data, which goes up to June, shows that banks have a strong preference for mortgage lending. On a net basis, mortgage lending is still growing, although not at the levels seen during the recent bubble. Corporate lending, on the other hand, was shrinking rapidly. Meanwhile, unsecured consumer credit was rather flat.

Has QE unleashed a new housing bubble? It is early days, but the signs are really bad. The pick up in house prices since QE began has been remarkable. It is likely that house prices will record positive growth this year.

Since QE began, the BoE has pumped in breathtaking amounts of liquidity into the banks. In six short months, the BoE has created around 15 percent of GDP in new cash. That is a lot of spending power to throw into an economy with declining output. So far, that money has been held in the BoE. Now, banks are starting to pump it into the economy. It is highly doubtful that the economy can absorb such a massive increase in liquidity without sparking off a further round of asset inflation and a rising price level.

Can the BoE quickly withdraw this liquidity, should things get out of control? It is going to be really hard. There is only one mechanism; sell the government paper that they have accumulated. If they start to unwind, they are likely to cause a run on UK gilts, and interest rates will spike. This could, of course, push the UK straight back into recession.

So, the UK economy seems to be heading towards one of two extreme outcomes; another bubble or a double dip recession. Moreover, this mess was caused by one bad policy mistake being followed with another.

There are days, when I really wonder if the BoE know what they are doing. Today was one of those days.

52 comments:

Mark Wadsworth said...

Hmm.

I'll have to think about that. I don't think that QE has had or ever can have much effect, and if your theory on the link between QE and house prices were true*, then your theory on the link between bank balances with BoE and house prices would be false**, and so on.

* The BoE was not printing cash; it was exchanging £x nominal of UK gilts for £x plus a bit nominal of BoE deposits.

** Or else prices would have plummeted between March and July and suddenly swung up again last month.

Alice Cook said...

Mark,

The BOE creates cash (reserve balances), which goes into bank balance sheets. If the money stays in reserve balances, nothing happens. If banks withdraw the cash, they use it to generate new credit.

Where will that new credit go? If it goes into the housing market, mortgage volumes will increase and house prices will rise.

Alice

Anonymous said...

Alice - there are plenty of ways the BoE can withdraw cash from the economy - they can raise the rates paid on reserves (so banks have less incentive to take risk when they can earn a better reward with the BoE), they can increase the reserve requirement (force banks to hold more cash with them) and they can take cash out from open market operations.

There are plenty of other ways they can have the same effect too - tweaking the SLS or withdrawing/scaling back some of the special schemes they have set up over the past 18 months.

You're a harbinger of doom without the knowledge to back up your inane predictions.

Anonymous said...

Maybe it's because we just massively increased our holdings in US treasuries.

http://www.treas.gov/tic/mfh.txt

Could it be that the uk and us are using some of the qe to buy each others bonds? Chris martenson did an article about it but i can't find it.

Anonymous said...

And (asking) prices are still falling in my area (way north of London). Four listings on my Rightmove feed this morning: two new listings and two updated. The updated listings had asking prices cut by £5,000 and £8,000, respectively. The increased supply will lead to further prices cuts in future. We're just biding our time.

Oh, and average rents in our area have fallen by about £25/month. Not much, but I'm sure £300/year will come in handy for someone. Our landlord is improving our property, so we're happy to stay a bit longer.

Anonymous said...

This sounds all very interesting but the simple facts are, If you face financial problems for living beyond your means, there is only one effective remedy - reduce spending. Is any of you buying HD flat screens?

We are all cutting back on consumption and no credit terms can make us buy anything other than bare necessities.

sobers said...

@Anonymous 02:00

Look at Alice's post for Friday 4th Sept. That tells me that in the inflation/deflation race, inflation is the one to bet on. The BoE is betting on inflation - it has invested its pension fund in index linked gilts. Do think they are harbingers of doom as well?

Anonymous said...
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fajensen said...

They are probably lending it all to George Soros so he can take a huge, leveraged bet against the pound.

it has invested its pension fund in index linked gilts.

It is getting hard to decide what any market positioning means in these times where the largest profits can be made by failing!

Maybe the insiders holds CDSs against the pension fund so when Soros uses his leverage to blow up the pound (once again) they can retire in style to private islands in the Caribbean.

The pensioners can sell their organs ... or something ... for food.

Anonymous said...

A quote from a legitimate source about USA’s debt situation:
"...A look at
who are the most important creditors of America’s
highly indebted public finances reveals
something truly remarkable. It is the public authorities
themselves! A study by Sprott Asset
Management, a Canadian asset management firm
distinguished for its intelligent macroeconomic
analyses, showed that in 2008 over 4 trillion of the
total outstanding public debt of some 10 trillion,
or around 40 percent, was in the hands of socalled
“intragovernmental holdings”. These holdings
include social welfare institutions, whose
assets, accumulated in order to be (halfway) able
to meet future liabilities, are invested in special
Treasury debt instruments, known as “intragovernmental
bonds”. In other words, the paying
recipient of, say, Medicare, the American health
service, is an indirect source of finance for the
Treasury. Unusual, remarkable, or rather, alarming?
Debtors are now simultaneously creditors..."

http://www.wegelin.ch/medien/anlagekommentar.asp

Markbaldy said...

Double dip recession, with the second dip a lot deeper than the first.... after the general election... naturally !

Mark Wadsworth said...

Alice: "The BOE creates cash (reserve balances), which goes into bank balance sheets(1). If the money stays in reserve balances, nothing happens (2). If banks withdraw the cash, they use it to generate new credit(3)."

(1) That's not actually true. QE means that two different dept's in HM Treasury (Debt Mgt Office and Bank of England) buy back govt bonds and pay for these with deposits at BoE. So instead of bank having bit of paper saying "The Treasury owes you £1 million, due for repayment 2013, interest rate 3%" it has a bit of paper saying "You have £1 million on deposit with Bank of England, withdrawable on demand, interest rate 0.5%".

Either way, that is government debt. This does not increase commercial bank balance sheets by one penny (well it does, because BoE are overpaying ever so slightly, different topic).

IF banks were keen to lend (which they aren't) they could have sold the govt bonds in the open market and then lend the money to mortgage borrowers. But they aren't keen to lend, are they?

(2) Agreed. Aboslutely nothing has happened. The amount "spent" on QE has nearly all gone into deposits with BoE.

(3) Sure they could withdraw the cash. But they don't want to, do they? If you are a bank which owns govt bonds and you wanted to lend to mortgage borrowers, you'd just sell them in the open market and get lending. Whether you go the circuitous route and sell them to BoE first and then withdraw the cash or not makes little difference.

Plus, you have to look at the other side of the bookkeeping entry. If banks tell the BoE that they want hard cash, the BoE has to get that money from somewhere. It would raise the money by selling the government bonds. To whom would it sell them? I don't know, but it would suck a corresponding amount of cash out of the financial system somewhere else (i.e. it would sell them to the pople who would have bought them had the banks decided to go the direct route).

Of course, the BoE could at this stage just print new coins and notes and give them to the banks. But it could have done that anyway, governments have been doing this for centuries, even without this new fangled invention called QE.

Reino Ruusu said...

"In principle, UK banks could have withdrawn that cash and used it to create new credit. However, during the first half of this year, banks preferred to park the money in the vaults of the Bank of England. That all changed in August, when for the first time since QE began, deposits shrank."

Banks, in aggregate, do not lose any cash reserves when they are creating credit. Instead, the amount of cash that the bank is required to hold on reserve increases. The total balance is unchanged. Cash reserves only decrease when currency in circulation increases or when the central bank reduces the stock of cash.

Knowledge of reserve bank balances is quite useless without vault cash balances. These two balances are only important together.

The thing that limits credit creation is not the availability of cash, but the lack of credit-worthy debtors. Thus, if makes no difference at all whether the banks have £20 or £120 billion of reserves over their current needs.

Quantitative easing is mostly useless as a means of increasing credit creation. It is merely an attempt to move savings from government paper into more productive investments.

Anonymous said...

Reino Ruusu: "The thing that limits credit creation is not the availability of cash, but the lack of credit-worthy debtors."

Exactly.

In current circumstances, those who are good risks probably don't want to take on any (more) debt. The banks don't want to take on any more bad risks.

Quite a few banks in the UK might be out of business if they wrote their assets to current market value too.

Anonymous said...

Which banks?

Are they all parking the balances in the BofE? Or is it mostly those nationalised ones?

bnfox1957 said...

And why would anyone be surprised that what is happening in the UK would be a carbon copy of what is going on in the US???

ndk said...

"Banks, in aggregate, do not lose any cash reserves when they are creating credit. Instead, the amount of cash that the bank is required to hold on reserve increases. The total balance is unchanged."

Yes, exactly right. This post is inaccurate.

Anonymous said...

Learn the difference between Solvency and Liquidity. If you have commercial banks with a lot of toxic assets that are currently worth pennies in the pound, you need to balance those out with QE cash held at the BoE and not in circulation. Other central bank mechanisms are letting them move toxics off their balance sheets. See following.

http://marketplace.publicradio.org/display/web/2009/07/13/whiteboard_wheres_the_toxic_waste/

Anonymous said...
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Anonymous said...

Housing uber alles: its the coin-shitting machine of all time, the UK housing market. Who thought it would ever stop? The government was going to do everything on earth to make it work again. At a minimum it is because all the MPs, the PM, the ex-PM, and all of the UK's elite are heavily invested in housing. It is natural they will bail it out.

electro-kevin said...

And Ajay Ahuja predicted the way the media would turn positive on the housing market almost to the minute.

I was hoping that the state of the economy would bring other, more important, political issues to the fore. A good outcome from all of this at least is that the major parties seem to agree that public spending needs to be reigned in. Perhaps these are just the right noises to keep our AAA rating.

But where is our referendum on the EU ? Who is going to confront Islamo-fascism, welfare dependency, immigration, crime ... ???

The politicians are getting through this by the skin of their teeth - rest assured that if housing slumps a very large broom would be sweeping through Parliament.

That it hasn't happened is a golden opportunity missed. I'd give up all of my equity (and some) to be given the choice of truly representative parties and a vote on the continuation of EU membership.

Mark Wadsworth said...

RR "Knowledge of reserve bank balances is quite useless without vault cash balances"

In theory yes, but physical vault cash balances are bugger all divided by six.

The use of the words "reserves" in this context is very unhelpful, as it can mean two completely different things - it can mean retained profits (a credit balance, i.e. money morally owed to shareholders) or "stuff you've got kicking around ready to be used" (as in "reserves of ammunition") which is a debit balance, i.e. an asset.

Mark Wadsworth said...

@ E-K, try UKIP, they tick most of your boxes.

McRealton said...

Very interesting article to read! It is good news to hear that the prices in the UK are shooting after financial crisis! I know of a wonderful website which promotes real estate business. This business is about buying and selling of US property. People can purchase property at a discount of 60-80%. Lots of foreclosure properties are available. In this business people can invest and earn profits!

Wat Tyler said...

Whatever the precise explanation for the August reserve figures, Alice is most certainly on the right side of the argument here.

Sooner or later this massive creation of liquidity will feed through into more lending - indeed, that's the Bank's supposed purpose. And one of the key mechanisms by which that will feed through to the real economy is via the property market.

The only question is whether the Bank can pull the chips off the table quickly enough to avert the inflationary consequences. Oh, and whether pigs might take flight.

(for those with an hour to spare, here's an excellent podcast by legendary US economist Alan Meltzer, explaining how QE works its way through the banking system, and the huge inflationary risks - http://www.econtalk.org/archives/2009/02/meltzer_on_infl.html )

Anonymous said...

It is engineered inflation to get things back on track. The simple fact is this: nobody gets up in the morning, screws over the other guy, cheats on his wife, lies, steals and cheats if prices were going down. It just wouldn't be capitalism. We need prices going up to lodge a giant chilli pepper up everyone's arse to get them hustling again.

Acorn said...

Alice, is there a trick to posting links on your site that will turn blue and be clickable? I see above that www seems to work but not http doesn't.

Anonymous said...

Just in case you have not seen it, I sent an email to the address given in your profile, making the same point as Reino Ruusu and ndk have since made - bank lending does not reduce reserves.

dearieme said...

This is the most interesting commentary on inflation that I've seen in a while - though it's about the US.
http://www.financialsense.com/fsu/editorials/iacono/2009/0909.html

John East said...

What is the BOE doing?

It's clear to me that with a general election early next year that the BOE is acting perfectly logically. Plan A appears to be to delay the next leg down by 6-9 months, get New Labour re-elected, then allow the crash with 4-5 years left before the next general election to give them time to pick up the pieces.

Fallback plan B follows the same path, but assumes New Labour losing the general election next year. Then, by delaying the crash, they will still gain in two ways. Firstly by avoiding a wipe out at the polls, and secondly by handing over the coming disaster to that nice Mr. Cameron.

Of course, whilst these are the only sensible options they have, a lot can happen in the medium term to derail this fiendish plan.

I hope.

Anonymous said...
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Anonymous said...

The *BBC*, yes, THE BBC reporting today that the two flavors of inflation metric are on the one measure below target and on the other NEGATIVE.

No, no deflation in the UK. QE has worked.

And good 'ol Georgie is saying the UK economy will be in growth ... uh, soon.

Yea, really.

Then the BBC, yes, THE BBC, reporting that GORDON BROWN is talking about cuts. Nah! Gordon the moron talking about cuts? He must mean TORY cuts, 'uknow, the sort of CUTS the TORY party has been saying will be necessary for, well three months now.

Anonymous said...

When Bernanke was talking I didn’t witnessed any movements of the greenback…
Did any body trade this or what?

A pre-speech sum up, courtesy of Ac-markets:
http://www.ac-markets.com/forex-news/forex-alerts-2009-9-15-15-30-CET-Pay-attention-to-Bernanke-s-speech.aspx

John said...

Alice, Alice, wherefore art thou? We're missing your insights!

Anonymous said...

==>
The thing that limits credit creation is not the availability of cash, but the lack of credit-worthy debtors. Thus, if makes no difference at all whether the banks have £20 or £120 billion of reserves over their current needs.

<===

This is clearly wrong. The bubble was caused by banks creating credit and making loans to creditors who they knew had no hope of paying them back, getting their friends in the ratings agencies to say they were AAA, and then palming them off this "toxic waste" on unsuspecting pension funds.

==>
"Banks, in aggregate, do not lose any cash reserves when they are creating credit. Instead, the amount of cash that the bank is required to hold on reserve increases. The total balance is unchanged."

Yes, exactly right. This post is inaccurate.

<==

Well I have not yet fully got my head round this, but from my reading so far I am with Alice on this one.

All British money is denominated in pounds, but it is not all born equal. There are different rules that apply to cash, BoE money and bank credit.

My understanding is that in this case we have to distingish money created by the BoE, which forms the basis of fractional reserve lending, and money created by commercial banks, which multiplies this reserve by the fractional reserve ratio.

At least in principle. In practice, banks create the money first, and worry about their reserves later. And Many banks had reserve ratios of over 100% which means they can create an unlimited amount of credit on a single penny in reserves.


Tim.

TheBinMan said...

Anon

No it's not deflation ,just under performing hyper-inflation.

Anonymous said...

fuck you and your QE. Write a new post already i'm sick of looking at it.

mike said...

Please come back Alice. Perhaps you have been whisked away to Paris, but we all miss you.

Stevie b. said...

C'mon Alice - stop messing about leaving us with nothing new to read and at least let us know you're ok.

Anonymous said...
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Andrew said...

As others have commented Alice, miss your observant blogging and hope your absence is Paris reprise.

TheBinMan said...

She must have bought a house and started doing it up.

Chief of men said...

where did you go

Chief of men said...

where did you go

Anonymous said...

Its been a year, no more bubbles?

Stevie b. said...

still visit cos i like The Daily Read - and still hope for Alice's return....

Half The Story said...

Its been a year, its a shame as this was a top site.

dca said...

This was a great blog. I hope everything worked out for the best Alice

Mellisa said...

Maybe Alice got something going on, let's hope for a comeback! It's only sad, she didn't post anything about a hiatus.

Jim in San Marcos said...

Ever thought of getting it together and writing again?

So many bloggers burn out after a year, you had good content, why not try again?

Anonymous said...
This comment has been removed by a blog administrator.
Anonymous said...

Hey,

Thanks for sharing this link - but unfortunately it seems to be not working? Does anybody here at ukhousebubble.blogspot.com have a mirror or another source?


Cheers,
William