An Introduction to Quantitative Easing:
With base rates set at a historical low, yet still failing to stimulate and reflate the economy, both the Bank of England and the Federal Reserve were forced to use the most unorthodox and unconventional monetary policy instrument in their armoury: quantitative easing. Quantitative Easing (QE) was defined by Bernanke as “a policy which expands the central bank’s balance sheet, in order to increase the level of central bank money in the economy.”
Spearheading the attack on slow growth in the UK and attempting to stimulate consumption in order to keep inflation on track to hit 2%, the initial asset purchasing programme, valued at £75 billion per month, was undertaken to cause a positive wealth effect on individuals and firms, cause a heightened liquidity and increase M4 lending. Figure 1.1 shows the effects of the asset purchasing programme on 15 year gilt yields between December 2010 and December 2012. Clearly, the major implication of the chart is that the QE programme has caused gilt yield to fall from 4.21% in January 2011, to a low of 2.04% in July 2012. Subsequently, demand for government securities has fallen over this time. Theoretically, in the medium-term this would cause a multiplier to spread across the credit markets, heightening corporate bond demand.
Obviously the main dependent on the increased liquidity would be the level of quantitative easing, according to classical economic principles. Being a relatively untried and untested method, setting the initial asset purchases was a conjecture for the monetary policy committee, who were now relying on this ‘neo-monetary transmission mechanism’ to support falling economic growth, and drive up consumption. Over time, the asset purchasing scheme has led to its current injection valuing at £375 billion per month today while the CPI inflation rate in the UK seems somewhat stable at 2.7%.
The relationship between Quantitative Easing and Inflation
Fig 2.1 – UK inflation rates (CPI and CPIH), 2006 to 2013
On the surface, Figure 1.2 (above) indicates that in the wake of the financial crisis and in ‘Hayek’s Hangover’ stage, the UK economy was in a clear state of disinflation, which would have possibly lead to a deflationary cycle had QE not been introduced at the end of Q1 in 2009. Therefore, the implication of this is that QE has caused an upward inflationary pressure, as stated in Friedman’s Liquidity Effect hypothesis. This trend continues, as both the CPI and CPIH rates have a tendency to drift upwards until Q4 of 2011, where the full extent of fiscal austerity imposed by chancellor George Osborne eventually damages consumer spending to a state of drawing the economy into a double-dip recession.
At a more detailed level, this relationship between QE and inflation cannot be wholly true, considering that bank lending (shown in Figure 1.3) has fallen in the period of 2009-2012, whereas Figure 1.2 suggests that inflation rose by 4%. This therefore invites several discussion points. First is the fact that there are other factors needing to be taken into account when judging the inflation rate. Short term factors caused by natural resource depletion drove up the prices of necessary commodities such as oil and natural gas during this period. Other temporary factors causing an upward pressure on inflation included the 20% depreciation of Sterling over the discussed period, causing imports to be more expensive, driving CPI inflation further. This is especially prevalent and unsurprising in the UK, where the substantial current account deficit is one of reasons for long-term structural failure. In the Bank of England’s May inflation report 2013, Mervyn King announced that a major reason for the rising inflation in Q4 of 2012 was due to administrative government decisions such as university tuition fees being raised, and regulations on energy prices causing a substantial upward pressure on the inflation rate. The sheer number of factors affecting, and pushing up inflation, may also attest to the simple fact that QE is not liquidating markets fast enough, or perhaps even more worryingly, is not supporting demand whatsoever. This can be evidenced by the lack of consumption and capital investment in the economy, causing an economic growth rate of 0.3%, just a quarter of the chancellor’s expectation.
Another noteworthy point is that of the creation of a Keynesian liquidity trap which has arguably ensued despite QE reaching the value of £375 billion in the UK, with financial institutions unwilling to lend, mainly due to retrospective recollections of the crisis, causing bearish animal spirits. Subsequently, QE may not presently be working. The reason that it has not ended in inflation up till now is because it is a ticking time bomb waiting to drive up inflation unsustainably when the pressure of QE finally explodes the money supply into the economy, thoroughly pushing up inflation.
Fig 1.4 – Markets and economy response to monetary stimulus, USA
Across the Atlantic, in the USA, as shown in Figure 1.4 (USA), each phase of quantitative easing led to a period of inflation, followed by a short period of disinflation before the next Federal Reserve stimulus, suggesting a direct correlation between the QE and inflation, especially in the short and medium terms. Another important factor to note is that of investor wealth. As shown by the rallying of the S&P 500 in times during each session of QE, the increased wealth of investors would be sure to drive up consumer expenditure and capital investment in the medium and long term, causing an inflationary spiral, when enhanced by Thomas Carver’s ‘Accelerator Theory’. With classical economic theory verifying the link between inflation and QE, it seems that inflation is the only eventual outcome for this type of programme, and it is important to note that this was indeed its actual design, to prevent a deflationary spiral while supporting growth. However, new research conducted by the IMF suggests that QE is unlikely to cause inflation to increase dramatically, as the chief of the IMF, Christina Lagarde stated that “that ongoing monetary accommodation is unlikely to have significant inflationary consequences, as long as inflation expectations remain anchored.” This research is based upon the muted relationship between unemployment and inflation (as observed by the IMF) as of late, especially in the rise of the technological generation, which sees inflation expectations at the pinnacle of inflationary risks causes. While this may be the case, the IMF recognises that some inflation will be the consequence of QE, albeit less that other financial institutions initially believed.
Operation Twist, an asset purchasing programme different from QE, (set between US QE2 and QE3), led the Federal Reserve to purchase $400 billion per month of mature bonds (6 to 30 years) while selling the same amount of credit of under 3 year maturity. This sterilisation function allowed the Federal Reserve to increase liquidity and boost spending without the inflationary risk which QE had. This can clearly be seen by the inflation composite not suddenly spiking due to this unusual monetary transaction. Hence, it can be understood that asset purchasing programmes do not have to lead to inflation.
In recent months, there has been much talk of Federal Reserve tapering and buying back their monetary stimulus to remove any negative effects of the QE now that the US economy is seen to be strong enough to support itself. Despite much effect on emerging markets, the Federal Reserve will delay the first reduction in its bond purchases until March after the government shutdown slowed Q4 growth. This simple conclusion highlights that there are definitely inflationary risks to QE, but these can be removed when the economy no longer requires the stimulus.
The HICP rate of inflation in the Eurozone (as shown in Figure 2.4) paints a similar picture to that of the UK. The financial crisis injured economies in the Euro-bloc, with Spain and Greece in a sovereign debt crisis, due to the crash of the outrageously hazardous and volatile sub-prime mortgage markets in both countries , decrementing the exports of the UK, USA and China and thus providing evidence that this really has been the most global and integrated financial crisis ever.
The ECB reacted swiftly to the downturn with a series of collateralised loans and repos focussing especially on the Spanish and Italian crises, however, over time the focus was switched to a higher rate sterilisation method whereby a combination of high value and low value assets were bought and sold to keep the money supply neutral. In reality this is not truly QE, but is a counter-deflationary measure, designed to boost the consumption in the EU according to Mario Draghi.
However with inflation fluctuating greatly within the EU and a recession entering a sixth consecutive quarter, with growth down by 0.2%, US economist James Bullard believes that the ECB would need a period of “aggressive Quantitative Easing” to create an upward inflationary pressure, before any a deflationary spiral reminiscent of Japan occurs. Justice must be given to the ECB for such creative inventions such as the Outright Monetary Transaction (OMT) system which has seen long term bond yields (above 10 years) lowered as to decrease borrowing costs for other credit-stifled economies, and with this create market confidence. Nevertheless, this type of system is unlikely to boost the inflation greatly, despite affecting medium to long term expectations, because it does not deal with a direct injection due to the sterile nature of the function. In accordance with many other economists however, the ECB clearly recognise that QE in its purest form (an asset purchasing programme similar to that of the UK and the USA) would lead to inflation, but the long term sustainability of it would be in question by the skeptics in the ECB such as Vitor Constâncios (the Vice-president of the ECB) and its past members such as Jean-Claude Trichet.
Is Quantitative Easing sustainable?
Austrian economists, von Mises or Hayek for example, would argue that QE is the simple, unnecessary creation of money in the economy, which by default will cause an upward inflationary pressure because the economy is in a state of (as another laissez-faire economist, Milton Friedman once stated) “too much money, chasing too few goods.” This economic theory would suggest that quantitative easing complicates the fine balancing act which is required of central banks. Since the new Bank of England’s new remit in the March Budget 2013, which clearly defines the flexible monetary powers to try and support growth in addition to its already complicated enough job of keeping the inflation rate on track to meet the 2% target. All central banks are faced with this type of challenge now.
In the UK, the asset purchasing programme in conglomeration with the Funding for Lending scheme is slowly starting to erode the liquidity trap, as effective supply, aided by effective demand look to pick up gradually, as shown by the expected growth rate in the UK being estimated at 1-2.5% between 2014 and 2015. While still fragile, the economy can rely on its current spare capacity to help improve economic growth. Lowering unemployment and raising productivity will most certainly be the most important function for navigating the delicate and all too frail present market system. With this in mind, and growth the most important in the short to medium term target, the bank should not be overly concerned about the inflation being caused by QE at present, because of the considerable amount of spare capacity currently present in the economy. Economist Andrew Goodwin (from the IFS) estimated the output gap at 5% of potential output in 2012, suggesting that any leaks from the overblown liquidity trap to consumers will lead to higher production, thus nullifying much of the risk of inflation, as growth occurs. This effect is of course is subject to the QE slowly trickling into the economy.
Evidently, a reason for this lack of demand is the fiscal austerity which this government has continued to follow since the 2010 general election, providing all too many easy criticisms for Ed Milliband’s Labour to attack. However it is not just the Labour party calling for a fiscal stimulus to boost growth and lift inflation. Both the IMF (International Monetary Fund) and the IFS (Institution for Fiscal Studies) have called for some of the yoke to be relieved from QE and the monetary transmission mechanism, and the lion’s share of the burden to be taken up by fiscal stimulus, which would perhaps see Britain regain its AAA credit rating again, as growth and liquidity both pick up. As animal spirits change from bearish to bullish, it is extremely probable that lending would increase, meaning that the QE procedure could be ended. It is this which has been shown by strong recent economic growth figures of 0.8%, with an increase in manufacturing, construction (thanks to the help to buy scheme) and consumption. However, now is not the time to stop fiscal expansion, new overheating buffers will tackle any such problems in the near future.
The question here however is not when would this occur, but instead what the actual procedure for this would be. It would not be unsustainable to stop and leave the newly created money in the UK economy, not to mention the $ 2.9 trillion from the US portfolio which enters the British economy through the international trading system, and global financial markets. Eventually, this money will need to be removed from the system using a tapering plan, however, this looks perhaps 7-10 years into the future where there is an evident boom underway, and central banks are looking to cause stability, rather than preposterously unsustainable growth. The first stage of this plan is to slow the function of QE in its purest form, and switch instead to a sterilisation method, similar to the Outright Monetary Transaction, or perhaps more realistically, the Operation Twist which significantly helped to rally the S&P 500 (as seen in Figure 2.3).
In conclusion with regards to inflation, it seems that QE does in fact have a positive correlation with a rise in the general price level, but this is essentially the nature and design of it as a counter-deflationary measure, similar to any other monetary policy intended to drive up spending, Helicopter Money (-a quip by Milton Friedman suggesting that deflation could be countered by dropping money from a helicopter) for example. Evidence which may suggest a weaker correlation, still makes it a point of understanding that with QE there will always be some kind of inflationary pressure, but the time it takes to come through will be dependent on the size of liquidity trap caused by bearish animal spirits, or alternatively, until mal-investment has been played out, and the right time comes for sizeable commercial loans.
With regards to QE supporting economic growth, it seems obvious that QE is not a magical tool to fixing a slowed down economy. The need for fiscal stimulus has never seemed more apparent in a time to kick-start the economy, just as a stalled engine needs a spark. In an age of apparent austerity, it is the rising spending of the current UK government which is producing long overdue growth figures. In final remarks, as concluded in the G7 conference, May 2013, no economy can find a solution on its own, instead the world economy must find a healthy trading equilibrium between all economies, whereby the sustainability of an international recovery is based on the rallying of global issues.
References and Bibliography
Davidson Alexander, 2009. How the Global Financial Markets Really Work: The Definitive Guide to Understanding the Dynamics of the International Money Markets. (Times (Kogan Page))
Joseph A. Schumpeter, 1997. Ten Great Economists.
John Maynard Keynes, 1965. General Theory of Employment, Interest and Money.
Paul Krugman, 2012. End This Depression Now!
Thomas Nixon Carver, 2011. Principles of rural economics.
Milton Friedman, 1993. Capitalism and Freedom.
Figures 2.1 and 2.2 http://www.bankofengland.co.uk/publications/Pages/inflationreport/2013/ir1302.aspx.