I initially planned to post this in November. However the economic outlook was confused at the time, typical of a turn in the economy, and since I wanted to encourage readers to make their own decision I decided to wait a couple of months.

The Bank of England helpfully provide a pamphlet to explain Quantitative Easing (Q.E.) http://www.bankofengland.co.uk/monetarypolicy/assetpurchases.htm#

In this the Bank explains that its approach to Q.E. is to purchase assets from private sector institutions, banks, pension funds, insurance companies and non-financial firms, for example. They do this to ensure that the risk of banks holding on to the money is ameliorated. If the Bank buys gilts from a commercial bank the money will end up as reserves of that bank and is capable of being lent on, subject to the bank’s desired reserve ratio. If the Bank buys its gilts from a non-financial firm or a pension fund the money will eventually end up in a deposit account in a bank, where it is available for lending on, subject to the bank’s required reserve ratio. The money supply effect will therefore be similar.

In its pamphlet the Bank describes it monitoring process. It will monitor

1. The terms and conditions offered on loans?
2. Are corporate debt markets easier for companies to borrow in?
3. What is happening to asset prices (such as shares and house prices)?
4. Are banks lending again?
5. What is happening to the supply of money?
6. Is household spending increasing?
7. Is company expenditure increasing?
8. What is trend in inflation?

Whilst the Central Bank is buying government securities and lowering the interest rate, the government, struggling to deal with reduced tax revenue as a result of the recession, will be selling government securities and finding it is helped by the central bank buying them in. This is called ‘monetizing’ the government’s debt.

In effect the government is printing money to buy its own debt. There is a risk that the government will become addicted to monetizing its debt, pimping its central bank to buy more and more. The classic case is, of course, Zimbabwe where things went so far that in the end the currency had to be junked. In truth many Central Banks are up to it.

But this is not the only economic stimulation in the UK. There is the matter of the governments deficit budget spending. Currently in excess of £175 bn in the current financial year this provides a huge stimulus. Moreover Prime Minister Gorden Brown is driven not by financial prudence, but by a constant concern for his image and by his reckless desire for reelection  at any cost, to anyone. As a result we are told that this stimulation will go on for years. This season should remind us that after the gifts of the kings there followed the slaughter of the innocents!

This gives the chancellor and the Bank three choices. The first is to stop or reverse Q.E. whilst continuing with the budgetary stimulus. The second is to continue or stop Q.E. whilst reducing the budget deficit by a material amount. The third is a mixture of the two. For example this could mean stopping Q.E. whilst making some adjustment to the deficit by increasing taxes generally or cutting government expenditure. A start on the latter has been made by the recent increase in VAT back to its original 17.5%.

If Q.E. is not reversed there are two key risks. The first is that there will be a large stock of bonds in the Bank’s hands “overhanging” the market. This is likely to lead to higher volatility and possibly higher interest rates as a result. The second risk is inflation, possibly severe inflation, and a return to a credit boom. The risk of cutting budgetary expenditure is increased unemployment and reduced demand in the economy.  It seems that you are dammed if you do and dammed if you don’t!

So, let us get back to basics and see what is happening to the eight indicators of the Bank of England.

1. Loan terms. A recent report in the International Financial Review was entitled “From Famine to Feast – a review of the corporate bond market”. The bond markets were open for the entire investment grade spread
2. In Europe certainly corporate borrowing appears easier.
3. Asset prices are increasing
4. Banks are lending but the government has had to increase its support for SMEs
5. The liquidity preference of corporations and individuals is still high
6. We have seen record retail spending this Christmas
7. The trend of company expenditure is not yet clear.
8. Inflation is increasing.

So, what should the Bank of England do? Is it time to reverse Q.E. or are the hints of the Chancellor, that there will be budget cuts, sufficient to dissuade them from this action?

Why not make your own choice and take part in the polls on the sidebar?

Next post will be on climate and weather and how the government and local authorities could have made better forecasts of the chance of cold weather than they appear to have done. There really is no place for the string of excuses we have been treated to!