Economics Weekly - Aggressive quantitative easing is underway; Weekly economic data preview - Final UK & US Q4 2008 GDP & a plethora of key speeche
Economics Weekly 23
easing is underway
An increasing number of
central banks are directly expanding money supplyâ€¦
More and more central
banks seem to be embarking on the process of injecting money directly into
their economy through expansion of their balance sheets, or â€˜quantitative
easingâ€™ in the modern jargon. Last month the Bank of England announced that it
would buy Â£150bn of bonds, of which Â£100bn will be government securities. Last
week, the Japanese central bank raised monthly purchases of government bonds to
Y1.8tn and the US Fed said it would buy $300bn of longer dated US debt and $750bn of
agency debt. This process of balance sheet expansion is simply one where
central banks buy securities from the private sector or from the government
without an offsetting sale of its own or government paper. In fact, it is not a
new approach or even an unusual one; so unconventional it is not but it has been
little used. The Bank of Japan used it between 2001 and 2006 to try and end its
financial crisis (it did not work) and the US Fed started buying private sector
debt from September 2008 though not government debt. Currently, the ECB has not
embarked on quantitative easing at all. It used to be more common practice to
use this tool to both increase and decrease money supply as a way of
controlling price inflation and influence economic growth but it went out of
fashion because it became associated with excessively higher price inflation.
â€¦as interest rates have
been cut to effectively zeroâ€¦
The reason why
quantitative easing is being reactivated is that after interest rates were cut
to record lows in many countries â€“ effectively exhausting their use as a
monetary tool - and after a plethora of other measures to kick start economic
growth and to deal with the credit crisis, the turmoil in financial markets
still continues and economic growth is weakening. Up until September last year
when the Fed started to buy private sector and agency debt (Freddie Mac and
Fannie Mae), most of the efforts to deal with the credit and financial market
crisis did not involve an attempt to increase the monetary base (notes and
coins in circulation and bank reserves at the central bank).
Effectively, the many
efforts to kick start financial markets with emergency loans, liquidity back
stops and the purchases of private sector debt was offset by sales of central
bank bills so that the impact on base money was relatively small. However,
these efforts did lead to a sharp expansion in global central bank balance
sheets, as shown in chart a. This highlights the international coordination of
the efforts being taken by the US, UK and EU central banks to
provide the private sector in these economies with the sort of liquidity it is
no longer able or willing to provide itself. (In Japanâ€™s case, the rise in its
central bank balance sheet has been smaller because its financial system was
less directly affected by the solvency issues raised by the credit crisis.)
This action by these
central banks probably prevented the collapse of the financial system in these economies,
and so prevented the dire consequences this would have meant for the world
economy in general. But they have not stopped turmoil in financial markets nor
prevented the economic downturn from getting deeper. This seems to be where
quantitative easing comes in; especially since government fiscal balances have
perhaps expanded as far as they can without triggering an adverse reaction in
bond markets. The idea behind
quantitative easing is to boost money supply (see chart b) and so raise
economic growth at a time when price inflation is expected to stay low because
of a large negative output gap that is resulting from actual output falling far
below potential in the world economy at large.
â€¦this runs a risk of
accelerating price inflation in the future if it is not reversed quickly enoughâ€¦
The quantitative monetary
policy approach being adopted stems from an old concept in economics that MV=PT.
The M is money supply, the V is the velocity circulation of that money in the
economy, the P is price inflation and the T is the level or value of
transactions in the economy. Directly boosting M can lead straight to price
inflation P if it occurs at a time when the economy is already operating at
full capacity. But if the boost to M occurs when the economy is operating below
its potential, then all it will do is to cause P to not fall by as much as it
would without a boost to M. This is in fact one of the explicit aims of current
monetary policy - to boost price inflation so that the economy does not suffer
from deflation, or falling prices, by raising economic activity by providing
liquidity to households and companies to spend and so increase T. The reason is
a fear amongst central banks that a falling M weakens T and P together. To avoid
this, P needs to be boosted. This is something that the Bank of England in
particular has pointed to in its inflation forecast, which is that there is a
risk of price deflation as actual CPI undershoots the 2% inflation target. However,
there are risks with this approach in the current environment. One is that the
proceeds from the purchase of private sector debt, in particular from the
banking sector, simply gets saved. One sign of this would be if quantitative
easing boosts base money (money in circulation and bank reserves at the central
bank) but does not boost broad money; this would do nothing to either boost
economic growth or prevent deflation. This is in fact exactly what happened in
Japan and why quantitative easing did not work there; base money supply
increased but broad money supply did not as the banks saved the money they
received by raising their reserves at the Bank of Japan and not lending it on,
and so P continued to fall or stayed flat and economic growth stagnated. To
avoid this, the central banks in the UK, US and elsewhere where
quantitative easing is being tried, may not pay interest on deposits of money
held at the central bank other than that required for prudential liquidity
reasons. Of course, another risk is that even if M or board money increases,
there could be an offsetting fall in V, so that prices and economic growth
still do not recover.
..but that day still
seems a long way off and the main risk currently is one of recession and
deflation or falling prices
There are already signs
that the lack of confidence in the wider economy generally and worries about
solvency are leading to increased savings rather than increased spending by the
private sector generally. However, it is still early days and it is not clear
that this will be the final outcome of quantitative easing. By driving down
bond yields (see chart d) and making other riskier investments more attractive,
the aim is to encourage investment and spending. This means a flat government
yield curve, helping to keep down mortgage costs and so inhibit insolvencies
amongst households and companies, breaking the cycle of falling confidence. It
should also lead to a narrowing of the corporate bond spread, but this might
not happen until central banks start to buy company bonds directly and more
aggressively, see chart e.
Of course, this policy of
quantitative easing has to be reversed when economic growth starts to recover
as history suggests that price inflation could really take off. But for the
moment, the evidence is that this risk is still some way off. Hence,
quantitative easing is deemed necessary and will be implemented, as the
interest rate option (see chart c) has been exhausted and government spending
increases are close to their limits.
Final UK & US Q4 2008 GDP
& a plethora of key speeches
Only the Norwegian
Central Bank meets to set interest rates this week - we expect a 0.5% cut to
2%. But a plethora of key policy makersâ€™ speeches feature, offering to add
addition insight into their interpretation of current economic and banking
events and the likely policy implications. BoE membersâ€™ testimonies to the
House of Commons Treasury Select Committee, US Fed Chairman Bernanke and
Treasury Secretary Geithnerâ€™s testimony to the House Financial Panel over AIG
and SNB Chairman Rothâ€™s speech, all on Tuesday, are potentially among the most
important. Government bond markets will be kept busy with the US Treasury auctioning a
cumulative $94bn of 2, 5 and 7-year notes, while the UK BoE plans to purchase
another Â£2.5bn and Â£3.5bn worth of gilts in the secondary market on Monday and Wednesday,
respectively. In addition, the BoJ publishes minutes of its 18/19 February MPC
meeting, which may throw light on plans to provide up to Y1,000bn of loans to
large commercial bank in the wake of the stock market slump and plunging
exports. Key economic data releases include final Q4 2008 US and UK GDP national accounts
data. Also, inflation reports for February are published in the UK and the US, while European
businessMarch will widen the debate
about the ECBâ€™s next steps to ease monetary policy.
ô€‚„ UK GDP national accounts data are published on Friday. They will
confirm that the UK economy contracted by
1.5% on a quarterly basis in Q4 2008 and will provide the latest assessment of
the detailed breakdown of expenditure and output. This final release also
includes useful information including the household savings ratio
(which may have increased) and the private non-financial corporationsâ€™ net
surplus (which may have shrunk). In addition, the CBI distributive tradesâ€™
survey for March and the official retail sales release for February are likely
to underpin the view that consumer spending contracted in Q1. CPI inflation
data is also published - we forecast a fifth month of falling prices. The RPI
figure could decline on an annual basis, maybe by 1.3%; significant
disinflation has already taken place, from a high of 5% in September 2008 to a
low of 0.1% in January 2009.
ô€‚„ The final Q4 2008 US GDP release, due Thursday, is expected to
confirm a contraction of 6.2% on an annualised basis. The GDP deflator will
also attract attention, as it is expected to show that economy-wide inflation
has fallen dramatically. Information on economic
trends in Q1 include personal income & spending figures and existing &
new home sales data, both for February. Both sets of numbers are likely to
suggest more weakness in consumer activity. Moreover, durable goods orders (a
proxy for business investment) are likely to have contracted by 2.7% in
February, raising expectations of more deep cuts to come in US industrial output. The
core PCE deflator, the Fedâ€™s benchmark inflation rate, although off Decemberâ€™s
low, may have grown only very modestly, by 0.1%, in February.
ô€‚„ Eurozone economic news has brought little comfort in recent weeks.
Adding to the mix the new challenges faced by higher oil prices (WTI futures
breached the $50 a barrel level last week) and the 8% rise in â‚¬/$ this month,
the ECB is now under considerable pressure to make additional cuts in interest
rates and to follow the UK and the US in introducing unconventional monetary
easing measures. So, while another 0.5% cut in official interest rates to 1% at
the ECBâ€™s policy meeting next Thursday is very likely, the question is, should
and will the ECB do more? Undoubtedly, market participants will be gleaning ECB
policy makersâ€™ speeches until then for hints that it will join the US and the UK in introducing
quantitative easing. Pressure is likely to intensify on the data side, as EU-16
industrial orders are likely to confirm that investment goods production & exports
will continue to be major sources of contraction in Q1. Finally, business
survey data for March, including the PMI manufacturing & service surveys
and the key German IFO survey, are forecast to stay weak.
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