January 9, 2012 / 9:29 AM / 8 years ago

As euro crisis drags on, Bank to rely on QE - or prayer

LONDON (Reuters) - “Prayer!” That is what the Bank of England will need in 2012, said former Bank policymaker Charles Goodhart, only half in jest.

A double decker bus is reflected in a puddle after a rain shower outside the Bank of England in the City of London August 4, 2011. REUTERS/Stefan Wermuth

The Bank will undoubtedly need luck on its side this year as it tries to ride out the euro zone debt crisis by continuing its ‘quantitative easing’ policy of buying billions of pounds worth of government bonds with newly created money.

Indeed, as a relatively novel policy, QE hinges more on faith than some at the Bank might like to admit. Economists disagree over whether QE does much to support growth and jobs, and see no resolution to the debate for years to come.

But Goodhart, now a professor at the London School of Economics, and most other economists think the bank will stick to its policy of record-low interest rates and more gilt purchases for the first half of the year at least.

A Reuters poll last week showed that economists believe on average that gilt purchases will add up to 350 billion pounds versus the 275 billion committed to so far.

“The Bank’s line is that if QE’s not working sufficiently, it will do more of it. It thinks there is some benefit and not much downside, so if the effectiveness is less than in the past, they should just up the ante,” Goodhart told Reuters.

Britain’s economy could certainly do with a boost. The Bank forecasts it will grow at an annual rate of just 0.8 percent through most of 2012, and others think it may dip into recession.

However, evidence on QE’s effectiveness is mixed. The Bank conducted its first round of QE from March 2009 to February 2010, buying 200 billion pounds of gilts, before it launched a new four-month, 75 billion pound programme in October last year.

The Bank estimated in a report last September that the first round of QE added 1.5-2.0 percent to GDP, though policymakers accept this is only a provisional estimate.

The Swiss-based Bank for International Settlements, which acts as a forum for central bankers, was more cautious. Last month it ascribed an impact on government bond yields, and implicitly growth, of less than a third that in the Bank study.


Most economists accept the latest round of QE has helped push British government bond yields to their lowest on record, even at a time of heavy borrowing, though safe-haven flows from investors fleeing the euro zone may be a bigger factor.

Where there is greater dispute is how much lower government bond yields reduce borrowing costs in the rest of the economy.

The Bank believes that QE has a ‘portfolio effect’. By depressing the returns on low-risk government debt, it impels investors to put their money in higher return assets like shares and corporate bonds, driving investment in the real economy.

Analysts at research company 4CAST claimed to see some evidence of this earlier this week. Bank data showed 38 billion pounds of net foreign purchases of gilts in the three months to November. The flip side was 40 billion pounds of sales by British investors - more than in the entire first round of QE.

“(This) suggests that the Bank’s ‘portfolio substitution effect’ ... is working much better this time,” 4CAST said.

Other economists doubt this trend will persist. Goodhart warned that risk-averse investors may favour cash. And others said the second round of QE lacked the novelty and matching action from the U.S. Federal Reserve that the first had.

There is also the concern that QE primarily boosts inflation rather than growth. Sometimes this is not such a problem, like in 2009, when there were genuine fears of a global deflation.

The situation is more nuanced now.

British inflation is only just off a three-year high of 5.2 percent. The Bank’s forecast is for it to fall below 2 percent by this time next year as the effects of 2011’s jump in UK sales tax and energy prices fade and weak growth takes its toll. But this is not certain.

Bank chief economist Spencer Dale, one of the more hawkish members of the MPC, has said he might be uncomfortable extending QE without clear signs that economic slack was lowering prices.


The Bank resisted tacit invitations from Chancellor George Osborne to provide financial firepower to back up the ‘credit easing’ policies he announced on November 29.

Bank Governor Mervyn King opposes taking private-sector risk on to his own balance sheet, and effectively said that if the government wishes to do so, it should issue more gilts to fund its plans, which the Bank in turn might indirectly buy via QE.

“They’ve painted themselves into a corner where there’s not much else they can do,” said Goodhart, though he added it was hard to identify suitable private sector assets for the Bank to buy in sufficient quantities.

This could prove a problem if the Bank needed to suddenly step up QE purchases - for example to bolster market confidence in the event of a worst-case outcome to the euro zone crisis - something policymakers acknowledged at their December meeting.

Britain plans to issue 178.9 billion pounds of gilts over the fiscal year starting in April. So purchases of 75 billion pounds of gilts a quarter could rapidly lead to the Bank finding investors unwilling to sell, said Nomura economist Philip Rush.

“If things were to properly blow up in the euro area, then I think we would find that the MPC would need to look for other assets to purchase,” he said, suggesting index-linked gilts, currently off the Bank’s menu, as a first option.

“Their preference from there would be to goad the government into providing some additional (fiscal) stimulus that the Bank could then purchase the extra gilts from,” he added.

Reporting by David Milliken; Editing by Hugh Lawson

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