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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 March 2009

 

Aggressive quantitative easing is underway

 

An increasing number of central banks are directly expanding money supply…

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 ‘quantitative easing’ in the modern jargon. Last month the Bank of England announced that it would buy £150bn of bonds, of which £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.

 

…as interest rates have been cut to effectively zero…

The reason why quantitative easing is being reactivated is that after interest rates were cut to record lows in many countries – 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 Japan’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.

 

…this runs a risk of accelerating price inflation in the future if it is not reversed quickly enough…

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.

Trevor Williams, Chief Economist, Corporate Markets

 

Weekly economic data preview 23 March 2009

 

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 makers’ speeches feature, offering to add addition insight into their interpretation of current economic and banking events and the likely policy implications. BoE members’ testimonies to the House of Commons Treasury Select Committee, US Fed Chairman Bernanke and Treasury Secretary Geithner’s testimony to the House Financial Panel over AIG and SNB Chairman Roth’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 £2.5bn and £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 business  March will widen the debate about the ECB’s next steps to ease monetary policy.

 

􀂄 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 corporations’ net surplus (which may have shrunk). In addition, the CBI distributive trades’ 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.

 

􀂄 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 Fed’s benchmark inflation rate, although off December’s low, may have grown only very modestly, by 0.1%, in February.

 

􀂄 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 $50 a barrel level last week) and the 8% rise in €/$ 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 ECB’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 makers’ 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.

Nichola James, Senior Economist

 

Economic Research,
Lloyds TSB Corporate
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