Bill Jamieson: Get ready for the QE slammer

ONCE more into the Quantitative Easing breach – sooner than most expect, and set to be much bigger. The first charge could come with the Bank of England’s Monetary Policy committee meeting this Thursday. There is growing speculation of an initial £50 billion to £100bn burst, rising in time to as much as £300bn.

How does QE work exactly? Why might we need so much of it? And is there any guarantee that more – much more than the £200 billion already expended – will help to avoid a double dip recession and kick-start a recovery, and this time, hopefully, a sustained one?

The speed of the downturn as much as the extent in almost all indicators of the economy tells us everything we need to know as to why a return to monetary easing is now imminent.

Certainly the turnaround in MPC thinking has been dramatic. Last month, none of the other eight MPC members joined Adam Posen in voting for more QE. Deputy BoE governor Charlie Bean, opposed in August, is now more open-minded. And in a newspaper article last week the Bank’s chief economist Spencer Dale said he would back further QE if the outlook remained gloomy. Dale had been voting for interest rate rises up until July.

But the UK is now on the brink of recession. Claimant count unemployment rose by 20,300 in August, the sixth successive monthly rise, taking the total to a 19 month high of 1.8 million.

Unemployment on the broader ILO measure spiked up by 80,000 UK-wide in the three months to July to reach 2.51 million.

Key measures on construction output and consumer confidence have fallen sharply. The OECD’s leading indicator for the UK has fallen for the sixth successive month. GDP growth forecasts have been cut, with Citigroup forecasting one per cent growth this year and – depressingly – just 0.7 per cent in 2012. Compare this to the Office of Budget Responsibility forecast of 2.5 per cent growth for next year – a prediction on which the coalition’s deficit reduction forecast now shakily rests.

If all this is not worrying enough, both the manufacturing and service sector Purchasing Managers Index (PMI) surveys due out on Monday and Tuesday of this week are expected to show further declines. Indeed, the services PMI is set to fall below 50. It will be the first time since the dark days of April 2009 that it has done so. And it is this that is likely to prove the decisive trigger for an announcement on Thursday.

The aim of QE is to support nominal GDP growth through buying government debt, most of it long-dated. This has the effect of putting more money into bank balance sheets, thus encouraging banks to lend more to businesses and individuals. The risk is that it by boosting the money supply, QE encourages inflation. But currently this would not necessarily be a bad thing from the Bank’s viewpoint. Even though inflation on the CPI measure is running at 4.5 per cent, it is set to fall sharply early next year as comparison with the pre-VAT rise period falls out of the 12-month comparison. The MPC does not wish to see inflation fall much below two per cent any more than a significant rise above it.

QE appeared to work in 2009. The economy and GDP growth recovered markedly. The mechanical effect of QE is to raise bank reserves, cut private sector holdings of gilts and expand private sector holdings of bank deposits. The hoped-for effects are lower yields on government gilt edged stock, higher asset prices and a boost to broad money. Overall, it makes it easier for companies and banks to issue debt, keep sterling low (helping exporters) and encouraging banks to lend more.

So much for the theory. The fact that the US Federal Reserve opted for “Operation Twist” rather than straightforward QE to address the US slowdown suggests some doubt as to how confident the world’s biggest central bank feels about the effectiveness of QE.

This may give a clue as to why expectations are rising of a turbo sized QE boost. Remember that at the time of the last resort to QE in the spring of 2009, the economy also benefited from fiscal stimulus, recently lowered interest rates and global economic growth. This time there is no fiscal stimulus contribution, interest rates are already at ultra-low levels and world growth is slowing. So, to make an impression, the QE charge has to be that much more powerful.

Will it work? On its own it may have a marginal effect. Certainly the UK stock market does not at present see it as a game-changer. The raging thunderstorm over the Eurozone continues to bear down on business and consumer confidence. No-one wants to be making big spending and investment decisions when huge uncertainties over the Greek crisis are still unresolved and when a Greek government default is still widely expected. This could have catastrophic effects if it triggers similar write-downs of Portuguese, Spanish and Italian bonds.

And the effect of QE on bank lending is tenuous. The Bank of England’s latest Credit Conditions survey clearly illustrates the problem. Demand for unsecured lending was broadly unchanged in the three months to early September. Lenders also reported a fall in demand for credit from small businesses and large companies. “Demand for credit from the corporate sector,” it added, “is expected to fall across companies of all sizes in Q4.”

So the immediate problem is less the supply or availability of credit but depressed demand for credit across business. Investment has been put on the sidelines because businesses cannot see any immediate way through the current crises in financial markets or any spark that would ignite an upturn on consumer demand. In fact, all the evidence points to households preferring to pay down debt at this time.

So long as this atmosphere prevails it is difficult to see QE making much headway. What might spark an investment and expansion upturn is a move in the budget next spring to raise the threshold for VAT, radical measures to take the SME sector out of tax, and indeed, more generous funding of schemes to increase labour hiring by small firms. It would be deeply worrying if a turbo-sized move on QE were to fall flat, leaving both the Bank of England and the Treasury with an empty armoury.