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Quantitative easing: can we expect inflation?

John Whittaker, Lancaster University
Updated version online January 2012

The following is extracted from A Note on Monetary Policy, one of the resources made available through the Lecture Notes page of the TRUE wiki for Money, Banking and Finance. This text is licensed as Creative Commons, some rights reserved.

In the UK, the Bank of England bought £200 billion of medium and long-term government bonds (gilts) between March 2009 and March 2010, which it still holds (see balance sheet, page 2). This quantitative easing (QE) programme can be considered as an extension of monetary policy.It is an attempt to provide further stimulus to economic activity given that bank rate cannot be reduced below zero and, at 0.5%, it is effectively at its lower limit.

There have been two QE programmes so far in the United States. In the first, the Federal Reserve purchased of $1.7 trillion of assets, mainly US government bonds and mortgage-backed securities; in the second, the Fed bought a further $600 billion of government debt and it has now begun ‘operation twist’: the purchase of $400bn long-term US government debt in exchange for short-term debt. In the eurozone, the European Central Bank has bought €217bn (January 2012) of government debts of the ‘peripheral’ countries (Greece, Portugal, Ireland, Spain and Italy) to try to hold down yields on these debts. The ECB does not call this policy quantitative easing, but it amounts to the same thing.

To the extent that QE in the UK had a useful effect, the channel by which it worked was via a reduction in medium and longer term rates of interest: interest rates on government debt fell by about 1% during 2009 (the "weight of funds" effect: footnote 12) and corporate yields also fell as lenders sought substitutes for the bonds bought by the Bank of England. While monetary policy in "normal" times is the Bank's choice of the very-short-term bank rate, QE seems to give the Bank an additional handle over longer term interest rates. Whether or not the reduction in yields was caused by QE, it was helpful to businesses that could finance themselves by issuing debt.

It was also hoped that QE would encourage banks to increase their lending, given that much of the cash that the banks received as a result of QE remained as bank reserves at the bank of England (balance sheet, page 2). However, bank lending remains constrained both by supply and demand. Having recently burnt their fingers, banks are looking much more carefully at risk and have increased their lending margins (see chart, page 5), while their borrowers,  individuals and firms, are trying to save rather than taking on more debt, given anxiety about future income and cash flow.

The Bank of England has recently suggested that it may undertake more QE. But there are doubts that this would have any stimulatory effect at all, as there is little room for long rates to fall further. Some members of the Monetary Policy Committee have also argued that this stimulus could cause a return of inflation.

This inflation worry arises from the claim that QE constitutes "monetisation" of government debt – the Bank of England is paying for government spending with new "money" (cash reserves). The increase in bank reserves means an increase in the monetary base, M0 (defined as banknotes and coin plus bank reserves) and the quantity theory of money says that the price level rises roughly in proportion to the money supply, measured as M0 or some broader measure such as M4 which includes deposits in banks.

The problem with this reasoning is that it ignores the mechanism by which inflation is caused. Inflation is rising prices of goods, and it is caused by excess demand for goods, something that is notably absent at present. Consistent with this, M4 has hardly been growing at all because bank lending is not growing. If and when inflation threatens to return, the Bank says it will be withdrawing QE. Even without a withdrawal of QE, there is nothing to prevent the Bank achieving higher interest rates by raising its bank rate on bank reserves and its repo loans.

Having said that, inflation is the one sure way in which the government could write off some of its debt, as described above in Section 2.3. When the UK economy does eventually return to sustainable economic growth, the government may thus be tempted to lean on the Bank of England to continue its "soft" monetary policy for longer than is strictly consistent with its inflation target.

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