The Bank of England is printing money. Earlier this month, it announced another £150bn of quantitative easing (QE), taking this year’s total to £440bn. In one respect, however, this year’s round of QE is quite different from those of 2009-12.
To see this, we must understand how the money stock changes at all. The M4 measure of it is defined as the sterling bank deposits of non-bank residents. This definition means M4 can change only for a few reasons.
One way would be if UK residents buy goods, services or assets from overseas. When this happens, we transfer our sterling to foreigners. This shrinks the money stock on our definition. Conversely, if foreigners buy sterling assets (such as a UK company) our bank deposits will rise. This factor has usually had only a small or short-lived impact on M4 growth, so we’ll ignore it.
The second way it can change is via bank lending. If I take out a mortgage to buy your house, your bank deposits rise. The bank’s act of giving me a mortgage creates money from nothing. But banks don’t only raise the money stock. They can also reduce it. If a bank issues more shares, buyers of those shares see their money stock fall.
The third way M4 can change is via public sector activity. Government spending raises our bank deposits whilst taxes reduce them, so government borrowing adds to M4. When it issues gilts to UK residents, however, M4 shrinks as we exchange our bank deposits for government bonds.
Before the financial crisis of 2008-09, net lending was pretty much the only driver of monetary growth. During the crisis, though, this changed. Not only did banks stop lending, but they also issued shares as they recapitalised themselves. Banks therefore reduced the money stock.
The public sector, by contrast, added to the money stock. This was partly thanks to big government borrowing, but also to QE: the Bank of England bought gilts from the private sector, thereby handing money over to us.
This public sector contribution, however, only mitigated the fall in M4 caused by banks’ activities.
Which is where this time is different. Unlike in 2009-10, banks are now adding to M4, and the public sector is adding even more. Thanks to this, M4 has risen 12.3 per cent in the past 12 months, close to its fastest annual growth rate since 2009.
Is this inflationary? Only slightly. The gilt market’s medium-term inflation expectations are for only a small rise in inflation from current levels.
There are good reasons to think the market is right. For one thing, M4 has risen in part merely because financial institutions have exchanged gilts for cash. But although gilts are not defined as money, they are very much like it – a safe asset. It’s not clear that a swap of similar assets should have dramatic effects: this is why so many economists doubt the effectiveness of QE.
And for another, the recession and uncertainty about the course of the pandemic have added to demand for safe assets. The rise in the money stock is accompanied by a rise in demand for it.
But of course, this could change. As uncertainty fades, so too will demand for safe assets. The money the Bank of England has printed might then flow into goods, services and riskier assets. In fact, we’ve already seen the start of this with this month’s big rise in share prices. And as the pandemic recedes, we should see increased spending on goods and services too.
Yes, this should eventually raise prices. But this is a feature, not a bug: CPI inflation, at 0.7 per cent, is now below its 2 per cent target. If inflation does rise more than this, it’ll not be the higher money stock to blame so much as lower capacity, reduced competition and mismatches between supply and demand. So we shouldn’t blame the Bank.