George Kerevan: Unconventional measures fuelling greatest interest

Published on Tuesday 5 May 2009 22:19

IT'S that time of the month when central banks decide on interest rates. At first reckoning, not much is likely to change. The Bank of England has no place to go as it has already slashed rates to 0.5 per cent – the lowest nominal figure since it was founded.

The more conservative European Central Bank (ECB) has more room for manoeuvre. The betting is on Frankfurt slicing a quarter point off eurozone interest rates, bringing them down to one per cent tomorrow.

However, central bank interest rates are not where the action is, largely because they have ceased to be effective in stimulating credit flows during the current recession. The crucial decisions to be made this week by the Bank of England and the ECB concern our new friend, quantitative easing (QE) – coyly referred to in European circles as "unconventional measures".

QE is where a central bank deliberately creates money and uses it to purchase existing government debt and commercial paper held by the market. Theoretically, this has two effects on the real economy.

First, by purchasing government and commercial bonds at a higher-than-market price, the central bank depresses the yield on these securities. This acts to lower overall business borrowing costs and so stimulates capital investment.

Second, by pumping vast new cash reserves into the financial system, the central bank hopes to persuade commercial banks to start lending again.

The Bank of England is now two-thirds of the way through spending the 75 billion in new money which it "invented" to fund the first stage of its QE programme. (By comparison, one year's entire output by the Scottish economy is worth roughly 100bn.) The Bank has to decide if QE is having a positive effect on the UK economy and if so, whether to authorise a second 75 billion tranche of QE.

There's a simple way of finding out if QE is working: look at the direction taken by government bond yields. They should be going down. Unfortunately, and paradoxically, they are going up. The yield on 10-year gilts (the name for British government bonds) is around 0.33 percentage points higher than it was on March 11 when the first QE purchases began.

Part of the explanation for this perverse result is that when the Bank of England first announced it was planning QE, market confidence soared. This led to gilt prices rising (and yields falling) even before QE had commenced. So when the Bank eventually started its massive gilt purchases, some of the job had already been done. However, the underlying reality is that market confidence is extremely volatile and that it has taken a massive injection of new money to depress yields even by a fraction. Will another 75 billion – with its long-run danger of inciting inflation – make any appreciable difference?

There is a similar paradox with corporate bond yields. Bank of England purchases seem to have been directed at the paper of solid commercial companies that had no difficulty borrowing in the first place. This may have weakened the market for company bonds being offered by more marginal businesses, actually raising the cost of their borrowing rather than lowering it. Such is the law of unintended consequences.

As to QE boosting bank lending, there seems no great evidence it has done so. Credit growth is still increasing at barely three per cent per annum, which is less than the economy is contracting. Banks are just hoarding their reserves.

What should the Bank of England do about future QE? If it does nothing, market confidence might snap and yields soar. Remember that Alistair Darling announced in his budget that he needs to sell 220bn of new gilts. That alone will tend to depress bond prices and jack up yields. This suggests the Bank is boxed in to announcing the second 75 billion of QE, though the Governor, Mervyn King, has been suitably equivocal on the subject.

It is also being mooted that the Bank should announce it is going to keep interest rates low for a considerable time. This would encourage consumers to start borrowing again, and tempt commercial banks to use their inflated reserves to expand lending. However, permanently low interest rates, combined with more QE, look like a recipe for serious inflation.

Unless, of course, that is what certain politicians want in order to diminish the national debt mountain?

Meanwhile, in Frankfurt, the ECB is under pressure to start its own QE programme following a catastrophic 2.5 per cent contraction of the 16-country eurozone economy in the first quarter of 2009. But the ECB's Governing Council is said to be split over what new measures to take.

The inflation-conscious Germans are against buying bonds, preferring to work directly on commercial banks to lend to each other.

One compromise is that the ECB could start a form of QE by buying bank bonds to unblock private lending. We'll find out tomorrow.