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Cowley: QE is not working - gilts are effectively worthless

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

It is a vexed question. Interestingly, literally as we write, Adam Posen of the Bank’s monetary policy committee is suggesting in an interview on Bloomberg that, 'It would not be the end of the world were the MPC, as part of its monetary policy efforts, to buy things other than gilts.' This is as much as an admission of failure.

The rumpus over RBS boss Stephen Hester and his bonus (augmented by the disgracing of Fred Goodwin and the removal of his knighthood) has only served to highlight, once more, the problems that have come with the Labour government’s equity investment in the Lloyds Banking Group and Royal Bank of Scotland.

Although there have been three occasions when the share purchases have been in profit, things took a turn for the worse in 2011 and now the UK public is around £13bn offside on the investment.

The government bought shares in Lloyds and RBS with the aim of stabilising the UK financial system, but the loss on the investment highlights the risks.

The US Federal Reserve has bought equities in the past, but buying and selling shares is not a skill-set that is known to be highly developed at the Bank and it is not a realistic option for the next phase of QE – especially when the capital (duration) risks already inside the Bank are already so tangible.

Lifting loans out of the banks may be a way forward which would be to ape the recent program of the European Central Bank to a certain degree. The policy would become: ‘Give us your rubbishy bank loans and we will exchange them for crisp new pounds so that you can go and help the economy’. This must be a tempting thought given the dire state of UK GDP and the prospect of years of government spending restraint to come.

Buy corporate bonds

Instead, the Bank might like to start buying something that would actually help the economy and on which they stand a fighting chance of making a profit – corporate bonds. If QE is really about reducing the cost of capital for private enterprise then there would be no better way of supporting the economy at this time.

Simultaneously, the relatively illiquid corporate bond market would be easier to manipulate and a lot less money would have to be thrown at it to get substantial results.

A further QE program of £50 billion - £75 billion in the corporate bond markets would have a substantially bigger effect than all of the gilt purchases put together.

The problem for the Bank is that they need to get money into the hands of companies which are close to the real economy, companies that will buy UK goods and services and employ UK voters. Not big corporates like Shell or BP, but the type of company typically issuing bonds in the BBB—B area of the credit rating spectrum.

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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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