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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