Farewell QE - for now?

By Chris Dillow, 04 February 2010

The Bank of England decided today not to extend its quantitative easing policy beyond the £200bn it has already undertaken. Although this decision was widely expected, it is still rather curious.

But money growth now is much the same as it was then. If we exclude non-bank financial institutions, M4 has grown by just 2.6 per cent in the last 12 months. That's the same rate it was growing before QE began last year.

This does not necessarily mean QE has failed. It could well be that, had it not been for QE, the money stock would have slumped. Indeed, of the 6.5 per cent growth in overall M4 in the year to December, 10.6 percentage points came from the public sector: government borrowing and Bank buying of gilts. So private sector activity, such as bank lending, has tended to shrink the money stock.

Judged by the money stock, then, the case for QE seems as strong now as it was then. So why stop?

A big reason, I suspect, is that QE had a different motive. It was intended to affect investors' attitude to risk. Last March, people though there was a chance of a catastrophic collapse in the financial system. QE was an attempt to reassure investors that the Bank would do everything it could to stop this happening. It was an effort to reduce perceived tail risk. The fact that stock markets have risen since then, and corporate credit spreads have fallen, shows that this risk has receded. In this sense, QE can be ended.

Can we have economic growth without monetary growth?

However, we still have the problem that the money stock could shrink, now that QE has been withdrawn. In theory, this needn't necessarily stop the economic recovery. Basic economics (the equation of exchange, MV = PY) tells us that a shrinking money stock can be consistent with increasing economic activity, if money circulates faster - that is, if V, its velocity of circulation, rises.

But why might V rise? One hope lies in the fact that the expected real returns on bank deposits are low. This is partly because interest rates are low, but also because some people fear that the value of their money will be eroded by high inflation. Such low returns could tempt people to spend their cash rather than leave it on deposit. It's in this sense, I think, that we should interpret the Bank's claim that the "stock of past purchases [under the QE scheme], together with the low level of Bank Rate, would continue to impart a substantial monetary stimulus to the economy for some time to come." It will do so by raising some people's inflation expectations and thus their propensity to spend now.

For this to work, however, requires that interest rates stay low. In this sense, the ending of QE doesn't presage an early increase in Bank rate. Perhaps the opposite. Several economists expect rates to stay at 0.5 per cent for months. Azad Zangana at Schroders doesn't expect a rise until Q3, whilst James Knightley at ING Financial Markets expects the first rise to come in Q4.

Also, such a scenario would be very peculiar. It implies that money GDP will grow faster than the money stock. This would reverse the trend of recent decades, which is for the money stock to generally grow faster than nominal spending.

History, then, suggests we should we wary of the possibility that the economy can grow without monetary growth. In this context, one line from today's statement stands out: " The Committee will continue to monitor the appropriate scale of the asset purchase programme and further purchases would be made should the outlook warrant them."

It might do so.

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