A monetarist case against more UK QE

Conventional “quantitative easing” – such as Bank of England gilt purchases financed by creating bank reserves – works by boosting the (broad) money supply, with increased liquidity serving to stimulate spending on assets and goods / services, thereby lifting wealth, economic activity and prices. The case for more QE, therefore, rests on there being insufficient money in the economy to support trend real growth and on-target inflation.

The Bank of England’s favoured broad money measure, M4 excluding deposits held by financial intermediaries, or M4ex, rose by only 2.2% in the year to August, with a similar 2.3% annualised increase over the last three months. This is well below a historically-normal rate of expansion – M4ex, for example, rose by 6.3% annualised between 1998 and 2003, a period of relative “equilibrium” when inflation was close to target.

An assessment of monetary adequacy, however, must also take account of the velocity of circulation, shifts in which have an equivalent effect to money supply changes. Velocity was trending down in the earlier period but has risen since early 2009, probably reflecting negative real deposit interest rates, which have encouraged households and firms to reduce their money holdings. Accordingly, M4ex growth of only 1.25% annualised in the two years from the second quarter of 2009 supported nominal GDP expansion of an estimated 4.75% annualised – about the maximum likely to be consistent with 2% CPI inflation over the medium term.

M4ex, moreover, currently understates liquidity growth because it excludes money substitutes that have been growing rapidly – in particular, foreign currency deposits and repos conducted by the Debt Management Office. A broad liquidity measure incorporating these items as well as Treasury bills and National Savings instruments rose by 4.5% in the year to August, well above the 2.2% M4ex increase and up from only 0.9% a year ago – see chart.

Recent disappointing UK economic performance reflects an adverse real growth / inflation split rather than inadequate nominal GDP expansion symptomatic of a shortage of money. More QE could prove counter-productive by triggering renewed downward pressure on the exchange rate, thereby boosting import prices and delaying much-needed inflation relief.

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  • Anonymous

    It is good to see a reasoned argument that supports my simple gut feeling that tells me creating more cheap money to solve a debt problem isn’t going to work.   
    I once tried to be scientific about the problem of low interest rates by going on to the ONS and calculated that just under 1 billion / month was lost to purchases by having low interest rates.   My feeling was that this was an undercall because of the effect on the psyche of consumers: “We are poorer today, dear, lets not buy until next week or not at all.”    I gave up on the reasoned approach, not having much stamina, but what proportion would a billion / month be of total household spending?   Any idea?

  • Anonymous

    ” No matter how rapidly or how slowly the economy is growing, or
    how fast or slow the money is circulating, the aggregate amount of reserves will be
    exactly the same. So it should be clear that the quantity of central bank reserves held
    by the commercial banks is useless as an indicator of the effectiveness of Quantitative
    Easing.Now obviously we would prefer that the money circulates more rapidly….” Charles Bean said this and his assumption was that rapid circulation would indicate higher lending, which is not the case. My disagreement is with the portfolio transmission effect to the real economy. If the target of asset purchase is a safe-haven in-demand for regulatory buffers and collateral for repos / liquidity operations it aint going to find its way to productive investment in the real economy.

  • Simon Ward

    Thanks for your comment. Did you see this?

    http://www.telegraph.co.uk/finance/personalfinance/savings/8748791/Savers-miss-out-on-43bn-in-interest-since-March-2008.html

    Total household spending is running at about £79 billion per month. £1 billion = 1.25%.

  • Simon Ward

    Interesting. You seem to be suggesting a form of “liquidity trap”. Doesn’t that imply that QE isn’t inflationary?

  • Anonymous

    I agree that QE could well be inflationary via the exchange rate effect you mention. I am sceptical on its influence via credit supply. I could see it causing bubbles here and there. I am more convinced of the concerns to inflation discussed by Spencer Dale in his recent speech on impaired productivity caused by the fiancial crisis and its challenge to the output gap theory – see http://www.bankofengland.co.uk/publications/speeches/2011/speech519.pdf
    I would be interested in your view on this.