Sir Mervyn King was in apocalyptic mood last Thursday. “This is the most serious financial crisis we have seen, at least since the 1930s, if not ever” he said in a TV interview. Though voices were raised to denounce such “scaremongering”, I fear that Sir Mervyn’s comments may prove to be only too right given the deepening crisis in the Eurozone. The deep malaise in western economies, which erupted in 2007 when the global money markets froze over, has not gone away. It has morphed. True, there have been remissions in the gloom, but we must now be prepared for the next global financial storm if, or rather when, it blows up.
The Governor was of course speaking after the Bank’s Monetary Policy Committee had voted for another £75bn of quantitative easing. Perhaps the timing was a bit of a surprise, though the September MPC minutes had softened us up for more QE, and the amount was certainly more than expected. But, in my view, it was absolutely the right decision. The economy needs all the support it can get and whilst the Chancellor sticks to his fiscal retrenchment package (rightly in my view) monetary easing is one of the most obvious alternatives.
The ONS released its latest estimate of the 2011Q2 GDP figure only last Wednesday, revising quarterly growth down to 0.1%. Household consumption fell 0.8% and there was, very disappointingly, a deterioration in the net trade balance. The ONS attributed some of the weakness to special factors including the Royal Wedding, but no explanations (excuses) can disguise the underlying problems. The economy has almost flat-lined since autumn last year. Unemployment is now rising significantly and surveys suggest that, though there may some growth in the third quarter, it will be modest. Meanwhile our major export markets, the Eurozone and the US, are stuttering which can only dampen our growth prospects further. More monetary stimulus seems well in order.
Granted inflation is running ahead of the Bank’s 2% target, which presents the Bank with a dilemma. Should King go for an attempted quick kill on inflation, damaging growth and employment, or should he do all he can to maintain the recovery, thus arguably undermining his anti-inflationary credibility? He has obviously gone for the latter trusting that inflation will fall back to target when the recent commodity price increases, over which he has no direct control, work through the system and fall out of the annual calculation. Fortunately the Bank’s CPI inflation target does provide some latitude for interpretation. Given the fact that earnings growth is showing no signs of accelerating, no “wage-price spiral” is developing, this strikes me as a perfectly reasonable stance to take and defend.
Indeed I am not concerned about inflation. I’m far more concerned about deflation and the risk of a “double dip” recession, given the global instability and the lack of confidence and demand. The notion that QE can trigger Weimar-style hyperinflation when other indicators are so depressed strikes me as contrary in the extreme. I appreciate that one of the consequences of CPI inflation running ahead of earnings growth squeezes real incomes, but in times like this, policy decisions are all about difficult trade-offs. I appreciate too that savers are paying a big price for the Bank’s ultra-low interest rate policy by way of falling investment income. We would all like to be in the sunny uplands where we had strong non-inflationary growth. But we aren’t.
More QE is no instant solution for our economic ills. They are too great. But it should help economic growth. The Bank of England recently published its assessment of the effects of the original £200bn tranche of asset purchases, mainly gilts, announced in 2009. They estimated that GDP was 1½-2% higher than it otherwise would have been and CPI inflation was raised by ¾-1½%. The effect of QE was equivalent to 1.5-3% cut in the Bank Rate. These estimates were met with some scepticism and it is true that bank lending didn’t increase as some may have initially hoped. But commercial banks are under great pressure from the regulators to meet tougher capital requirements, thus restraining lending, and have been shrinking their balance sheets. Without QE the situation would surely have been worse. Consider the counter-factual. The fact that the British economy has not fully recovered following previous rounds of QE is not evidence that it failed to “work” and was a waste of time. One could also come to a similar conclusion about the Bank’s unprecedented cuts in interest rates.
The exact impact of the current £75bn of QE, or the Asset Purchase Programme to give its formal title, cannot be known in advance of course. But, if nothing else, it should help the banking sector at a time of renewed difficulties in the financial markets, reflecting the on-going Eurozone crisis. To quote the Bank of England: “…vulnerabilities associated with the indebtedness of some euro-area sovereigns and banks have resulted in severe strains in bank funding markets and financial markets more generally”. QE should help the banks with their funding and, by giving a shot in the arm to the capital markets, with meeting their capital requirements. Indeed one can be forgiven for thinking that one of the main reasons, or even the main reason, for more QE is to shore up the banking sector as the Eurozone crisis deepens.
So I applaud the Bank’s actions. They are clearly prepared to act preemptively in a crisis. And there could be more QE to come.