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Struggling To Make Sense Of Quantitative Easing

14:18 18Nov10 HEARD ON THE STREET: Struggling To Make Sense Of Quantitative Easing



What exactly is the point of quantitative easing? Two weeks after the U.S. Federal Reserve decided to buy $600 billion of government bonds, the debate still rages. Yet even to ask the question is "ill-judged", according to the governor of the Bank of England. QE is a respectable monetary tool that has been written about in textbooks for a very long time, Mervyn King said last week. To attack the instrument - rather than the decision to use it - is "bizarre". But the lack of clarity from central bankers over their motives may actually mean QE ends up doing more harm than good.

Mr. King is certainly right there's nothing new about QE. It was used in Japan in the Nineties, where it proved ineffectual. And it was used in Germany in the Thirties, where it worked rather too well, triggering hyperinflation. Presumably the textbook version of QE advocates government bond buying on a scale somewhere between Japan and the Weimar Republic, but no central banker has yet said what the optimal scale might be. The U.K. has already purchased 30% of the existing stock of national debt, and the Monetary Policy Committee is clearly willing to countenance buying much more.

The question is what all this government bond buying is supposed to achieve. Mr. King last week was unequivocal, pointing to lower bond yields as evidence the policy in the U.K. had worked. That would be impressive if it were true. But unfortunately for Mr. King, U.K. government bond yields actually rose during the period the BOE was buying bonds and have only fallen to record lows since it stopped. That experience corresponds with that of the U.S. where bond yields have risen since the Fed's bond-buying announcement.

Of course, not so long ago Mr. King and his BOE colleagues dismissed any suggestion that QE was targeting bond yields, acutely sensitive to any suggestion they were trying to artificially lower government borrowing costs. Instead, the BOE used to talk about how QE was designed to boost broad money growth. But embarrassingly, broad money growth - based on the BOE's favored measure which excludes financial intermediaries - has remained stubbornly below 2% for the last year.

Meanwhile, other explanations for QE abound. The Chinese believe the U.S. is using QE to attempt an underhand devaluation of the dollar - a view apparently shared by former Fed chairman Alan Greenspan. Others believe the purpose of QE could and should be to provide liquidity to the banking system, both via the accumulation of cash deposits and the increased supply of funds to buy bank bonds. On this analysis, QE is akin to the European Central Bank's unlimited liquidity operations - and may in fact be one of the few channels via which QE could be said to have been a genuine success.

Given so many competing views, it's no wonder people are confused. Some economists have concluded the attitude of central banks to QE is to shoot first and declare whatever they hit is the target. But that is hardly a recipe to instill confidence, perhaps the most important channel through which QE is likely to work. In fact, confusion over motives could even act to damage confidence if the markets start to question a central bank's commitment to fighting inflation and willingness to unwind QE. It is hard to feel confident about how QE will end if you don't know why it was begun.
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Comments

  • Masomnia
    Masomnia Posts: 19,506 Forumite
    Part of the Furniture 10,000 Posts Name Dropper
    I wrote about just this topic in my application to the Bank of England Graduate Scheme :p
    “I could see that, if not actually disgruntled, he was far from being gruntled.” - P.G. Wodehouse
  • Lets face it.

    They don't buy anything.


    They press a several numbers on a laptop somewhere & there we have it. $600bn.
    Not Again
  • The ultimate aim, as I see it in purest form, is deliberately to create inflation, which in turn, ultimately devalues the £ against world currencies. So each £1 billion of debt ultimately becomes lower and lower over time to the extent it can be paid off far more easily.

    I guess it is the most 'efficient' method of making every single member of the UK public pay their dues proportionately. We all get poorer by inflation in direct proportion to our wealth and spending. VAT doesn't work because it doesn't get at unspent wealth. Extra income tax doesn't work because so many don't pay it.

    Before the floating £, our old friend Harold Wilson did a major devaluation for (I believe) similar reasons. His theory being "It won't affect the pound in your pocket". That is true 'tomorrow' because today a pint of milk costs a shilling, tomorrow it also costs a shilling. But in those days, we manufactured things and so even a television cost £80 yesterday, and £80 tomorrow (because it was made in Britain). Now we make nothing, and import virtually everything, your bananas cost 50p yesterday, but will cost 60p tomorrow because of the devaluation. Hence high inflation. Higher wage demands then create more domestic inflation (under Harold) and so the television ultimately goes up to £90 - but with a bigger delay. Once the pound is devalued enough, you can pay off the debts more easily.
  • Really2
    Really2 Posts: 12,397 Forumite
    10,000 Posts Combo Breaker
    My Simple view.

    It increases the volume of money at the same time as decreasing it's value.

    Say you have £1,000,000,000 which equals $1,600,000,000

    You create £1,000,000

    So you now have £1,001,000,000 which still equals $1,600,000,000

    What was the point? Well it depends on where this money is. If money that would usually (in normal times) be lent is used to shore up banks balance sheets this causes money availability to contract.
    So if this (QE) is used to buy bank assets it is easy to see why you would think it should increase lending, making things a bit more "normal"

    The problem of inflation would happen when things do get back to normal (healthy bank balance sheets and normal lending). But then the BOE could then start to remove the QE money gradually. Hopefully stopping an inflationary boom (wage cycle) . The removal of money should have a similar affect to what we have seen with banks now, the less money there is floating about the less there is to recycle through loans etc.
  • purch
    purch Posts: 9,865 Forumite
    14:18 18Nov10 Struggling To Make Sense Of Quantitative Easing



    What exactly is the point of quantitative easing?


    Well if you don't know Monkface, what hope is there for the rest of us :eek:
    'In nature, there are neither rewards nor punishments - there are Consequences.'
  • vivatifosi
    vivatifosi Posts: 18,746 Forumite
    Part of the Furniture 10,000 Posts Mortgage-free Glee! PPI Party Pooper
    Masomnia wrote: »
    I wrote about just this topic in my application to the Bank of England Graduate Scheme :p

    Are you now on the MPC?;)
    Please stay safe in the sun and learn the A-E of melanoma: A = asymmetry, B = irregular borders, C= different colours, D= diameter, larger than 6mm, E = evolving, is your mole changing? Most moles are not cancerous, any doubts, please check next time you visit your GP.
  • purch
    purch Posts: 9,865 Forumite
    edited 18 November 2010 pm30 4:34PM
    I think a lot of this 'talk' about devaluing the currency is way overdone.

    The Dollar Index DXY was trading around 80 at the end of 2004, and it's not that far away now.

    Listening to the doomsters talk you would think it had dropped substantially over that period, but as usual they are talking ...... :eek:

    At the same time, GBP was clearly overvalued for much of the decade, and a lot of the drop since late 2006 is a correction of that state.
    'In nature, there are neither rewards nor punishments - there are Consequences.'
  • Really2
    Really2 Posts: 12,397 Forumite
    10,000 Posts Combo Breaker
    purch wrote: »

    At the same time, GBP was clearly overvalued for much of the decade, and a lot of the drop since late 2006 is a correction of that state.

    I could not agree more, I always the £-$ normal range being $1.6-$1.8. What we saw the last decade was not normal at all.
  • Thrugelmir
    Thrugelmir Posts: 89,546 Forumite
    Part of the Furniture 10,000 Posts Name Dropper Photogenic
    Really2 wrote: »
    I could not agree more, I always the £-$ normal range being $1.6-$1.8. What we saw the last decade was not normal at all.

    Funny what we remember. I was thinking along the same lines then I recalled periods of votility. So out of interest I looked up mid point rates on Oanda for the 18th November from 1990-1999.

    90 - 1.96
    91 - 1.79
    92 - 1.52
    93 - 1.47
    94 - 1.56
    95 - 1.54
    96 - 1.66
    97 - 1.69
    98 - 1.67
    99 - 1.62

    So exchange rates do fluctuate more widely than we recall. :o
  • Guitar
    Guitar Posts: 157 Forumite
    Part of the Furniture 100 Posts Combo Breaker
    Someone needs to explain it in relation to the plot of Goldfinger. I'll understand it then.
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