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Cowley: QE is not working - gilts are effectively worthless

by Stewart Cowley on Feb 08, 2012 at 00:01

Cowley: QE is not working - gilts are effectively worthless

The Bank of England is running out of options on what to do next.

The current Quantitative Easing (QE) program is fast approaching its end. The Bank now owns some £275 billion of gilts, which is close to 30% of the total market. This is a staggering amount and one that is not widely acknowledged and for which there has been little or no public debate.

What’s more, the effectiveness of the policy has to be questioned. The Bank implements QE through the so-called ‘portfolio channel’, whereby it buys gilts not from the government but from banks and pension funds and the like. The idea is that the cash is then sent into the economy…somehow.

No signs QE is working

But on any measure, there is precious little evidence that it is working.

For instance, lending to consumers fell £377 million in December. Even worse, year-on-year borrowing by consumers has taken a lurch back down, even from the low levels it had achieved in 2010/2011, which in itself was a fifth of the peak in 2004.

So whatever QE was meant to achieve, all it has really done is transfer a large amount of capital risk (duration) out of the hands of the private sector and into the hands of the state, through the agency of the Bank.

As we have pointed out in the past, there is some doubt as to how much more effect QE can possibly have when government bond yields fall below 2.5% – 3.0%. Amazingly, this is exactly where long-term gilt yields have gotten to recently.

Gilts are effectively worthless

At the same time, on a number of valuation metrics (against inflation or credit default costs for instance), gilts are effectively worthless as an investment, unless your primary concern is to hide your money away from a banking system that will be prone to shocks for some time to come, especially if there are further episodes of uncertainty coming out of Europe.

This shouldn’t be underestimated as a possible use for gilts in the future (you could liken them to a safety deposit box) as many sage commentators, like George Soros, are currently lining up to call the end of the euro in the years to come. Clearly, there is trouble ahead.

What to do next is matter of urgency

£275 billion is the maximum amount so far made available for QE so the Bank needs to consider urgently what to do next.

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3 comments so far. Why not have your say?

John A Clarke

Feb 08, 2012 at 15:17

I am disappointed that so much confusion continues to reign over what QE is supposed to do. Its primary purpose is not to increase bank lending--although this would happen if the banks had not been forced by regulators to hold substantially higher amounts of capital relative to their assets. Instead, its main objective is to compensate for weak bank lending. Therefore to suggest that the ongoing weakness in bank lending proves QE isn't working is unfair. Nor is it designed specifically to drive down long term interest rates. Instead, the purpose of QE is to directly increase the quantity of money and hence nominal national income. QE works by the Bank of England, financed by the issuance of new reserves to the commercial banks, purchasing gilts (or corporate bonds) from the non-bank private sector. As cash is deposited into the bank accounts of the sellers, the quantity of money is increased everything else being equal. But as this is likely to increase cash holdings above desired levels, the non-banks are likely to respond by buying other assets such as equities, driving up their price. The primary transmission mechanism of QE to the real economy--as Mervyn King has pointed out on numerous occasions-- is through positive wealth effects. I accept that monetary growth has stalled again in the three months to December despite the implementation of QE2, but this is because declining bank lending has offset the monetary injection from the Bank's asset purchases. Imagine how much lower the quantity of money, and hence the level of GDP, would be now had there been no QE.

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The City Grump

Feb 12, 2012 at 11:19

Suggest you read Liam Halligan in today's (12.2.12) Sunday Telegraph if you want to find out just how horrIfic QE is going to be for all of us thanks to the duplicity of politicians and the BoE.

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John A Clarke

Feb 13, 2012 at 10:47

Suggest you (and Mr Halligan) understand the difference between the expanding the monetary base and the quantity of broad money. The ratio of the base to broad money has oscillated wildly in the past with no implications for economic activity or inflation. The key relationship between "money" and the real economy--as Keynes recognised--is a broadly defined one and not the sum of notes and coin plus banks reserves held at the Bank of England. If the quantity of money thus defined is contracting, so too, over the medium term, will nominal GDP.

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