Quantitative easing in the U.K.
Thirty years ago, it was “Anarchy in the U.K.” as Britain tried to get away from its role as the sick man of Europe. That meant civil unrest, high inflation and a weak economy. Margaret Thatcher was seen by many as the solution. Today, the British economy is sick again and there is anotherready solution to hand: quantitative easing a.k.a printing money:
Everyone knows a shiny new bridge when they see one. Quantitative easing, on the other hand, has been a mystery to all but hardened anoraks until zero interest rates started to loom late last year. Policymakers worldwide now pin their hopes on quantitative easing’s ability to complement traditional fiscal stimuli as a means of boosting demand. Even if they feel boosting money supply worth a try, few have a genuine conviction that it will work. There are three big problems with central banks buying unsterilised financial assets. The first is signalling. The normal process of tinkering with interest rates is based on eons of data on the effect on growth and inflation. That in turn provides a framework round which future rate moves can be forecast. Quantitative easing, however, is messy. That calls for clear targets. But based on what? Targeting particular measures of money supply, bank lending (as Japan did) or long-dated gilt yields is tricky.
Even with targets, the second problem is working out exactly how much quantitative easing is enough. Very simply, whether raising the money in circulation boosts incomes depends also on what economists call the “velocity” of money. If those selling assets to the central bank simply put their spoils on deposit, for example, the potential boost from the increase in money will be tempered. Knowing the velocity of money therefore is crucial. Yet this number is hard to pin down.
The final headache lies in selecting which assets to buy. As the Bank of England showed last week, most central banks go for government bonds. But these tend to be owned by financial institutions, not the ailing companies and households that need the money most. Besides, government bonds are already super liquid. It would be preferable for central banks to swap cash for harder-to-shift assets such as commercial paper. Another plus would be that purchases of such assets would remove their liquidity discount, giving the likes of the Bank at least a fighting chance of recovering their money when things finally recover enough to sell again.
So now we know that the U.K. is down with the printing money programme. So what? What will that mean to the average British citizen? Well, if the price action in today’s market is any judge it means two things clearly: a weak British pound and lower interest rates. First, there is Sterling:
The pound fell against the dollar and the euro as HSBC Holdings Plc, Europe’s largest bank, dropped to a 12-year low on concern over bad loans at its U.S. unit.
The British currency also weakened against the Japanese yen and the Swiss franc as HSBC declined as much as 14 percent, driving the FTSE 350 Banks Index as much as 10 percent lower. Lloyds Banking Group Plc said March 7 it would place 260 billion pounds ($367 billion) of assets into a state insurance program, capping losses and giving the government a stake that may rise to 75 percent.
“Banking stocks in the U.K. are under pressure today,” said Steven Barrow, head of G10 currency research at Standard Bank Plc in London. “That backdrop is negative for sterling.”
The pound fell to $1.3948 as of 9:16 a.m. in London, from $1.4094 yesterday. It weakened to 90.42 pence per euro, from 89.78 pence. The U.K. currency fell to 137.45 yen from 138.49 and to 1.6199 Swiss francs from 1.6326.
The Bloomberg article points to HSBC’s woes as a cause for Sterling’s weakness. Don’t be fooled. Everyone knows that printing money and strong currencies don’t mix. Because Mervyn King is going out back to his garden to his money tree to pluck off a few billion in notes to pay for Gilts, currency traders expect higher inflation down the line. And that means the British currency is worth less.
On the other hand, that does not necessarily mean that interest rates must rise. After all, the BoE is buying up gilts and artificially suppressing their yield. Yet again, Bloomberg seems to miss this connection.
U.K. 10-year gilt yields slid to the lowest level in at least 20 years and the pound fell as bank shares tumbled and policy makers prepared to buy government bonds to inject cash into the shrinking economy.
Yields on gilts maturing from five years to 30 years dropped after Lloyds Banking Group Plc ceded control to the government and HSBC Holdings Plc sank as much as 14 percent in London trading. The Bank of England said March 5 it plans to spend 75 billion pounds ($104 billion) buying corporate debt and government assets that have between five and 25 years to mature.
“This banking-nationalization talk is keeping banking stocks well depressed and that’s supportive for gilts,” said Orlando Green, a fixed-income strategist in London at Calyon, the investment-banking unit of France’s Credit Agricole SA. “The five- to 25-year part of the curve is going to be well supported given that quantitative easing is going to be centering around the 10-year region.”
The 10-year gilt yield dropped as much as 11 basis points to 2.95 percent, the lowest level since Bloomberg began tracking the data in 1989. The security yielded 3.05 percent as of 1:18 p.m. in London. The 4.5 percent note due March 2019 rose 0.05, or 50 pence per 1,000-pound face amount, to 112.37.
The yield on the security posted its biggest two-day drop since at least 1989 in the final two days of last week, shedding 58 basis points, after policy makers announced the asset-buying program on March 5 and cut the main interest rate to 0.50 percent, the lowest level in the bank’s 315-year history.
To my mind the price action in currencies and Gilts has everything to do with quantitative easing and much less to do with bank stocks. The Bank of England is committed to supporting its economy by lowering the price of credit. Quantitative easing means a depreciating currency and lower interest rates.
Let’s see what effect this has down the line.
Sources
Quantitative easing – FT.com
Pound Falls Against Dollar, Euro as HSBC Drops on Loans Concern – Bloomberg.com
U.K. 10-Year Yield Drops to Lowest Since 1989 on Bank Concern – Bloomberg.com
Tom,
You make a good point. The U.S., I feel, is a bit different given its role as a safe haven and the reserve currency. Were the U.K. to have been in the U.S.’s position, things might have turned out differently. That said, I reckon the U.S. has been much more aggressive than Europe in looking to fight this thing and that makes the U.S. more attractive as you indicate.
In the end, this is one grand experiment, and I am waiting to see how things unfold because it is far from clear what the medium-term implications will be.
Thanks for your insight, Tom.
Ed,
Theoretically QE should produce the results you project but so far the experience in the U.S. has been the opposite. The currency and interest rates have increased. The relative state of other economies and their willingness or ability to engage in QE might have some implications.
In other words to the extent QE strengthens a sick economy while others continue to slide it might perversely result in a stronger currency.
Ed – please – help me out here. QE means falling rates along the curve as the BOE buys Gilts. When the eventual time comes to sterilize and the Bank needs to sell Gilts, who in their right mind is going to buy (anything other than short-term Bills) knowing they’ll be sitting on a certain loss as inflation picks up? If this is true, what do you think are the ramifications of this?
Stevie, I see what the BoE is doing as easier to control than what the Fed is doing – not that easier is 100% advisable. But the BoE print money in exchange for gilts. If and when the economy responds, they can sell those gilts in the market as anyone else would do. They don’t need to worry about gain or loss because the BoE can print money at will.
The problems I see are that they may react too slowly to mop up the excess money, Sterling dives or inflation picks up. Contrast this with the Fed which is buying potentially toxic assets and you do have a problem as to where the willing buyers will be for these assets.
Ed – thanks a lot for this response, but I’m really slow on the uptake so please humor me. Yes, the BoE don’t need to worry about gain or loss and they print money in exchange for gilts sold to them by let’s say “anyone”. When the time comes for sterilization and for “anyone” to relinquish some of the extra money they got, why should they? Yes, as you say, the Bank can sell in the market, but why should “anyone” be on the other end buying at anything other than very distressed prices, as selling by the Bank would mean “job done”, inflation’s back. So rates would need to back-up a lot for “anyone” to start buying again. If this means the Bank makes a whopping loss, wouldn’t that mean the Bank has to print even more to cover it? I’m feeling my way in the dark here and any light you can shed would be deeply appreciated as understanding all this seems the key to the economic future and I can’t get a proper explanation anywhere.
Steivie, the BoE are just another market participant in the Gilts market where Gilts are bought and sold daily. So if there are 10 participants that might bid for a bond at a given price, now there are 11. So, at the margin, the BoE should have relatively little impact on price.
The problem you note of course is if the BoE issue a wall of money, say trillions of pounds of QE money. The degree to which the BoE need to get into the market and buy Gilts is a lot greater there and I am sceptical as to whether they could mop up the excess liquidity before rates and inflation start to rise.
So, on the whole, dovish types tend to think the BoE can do it — they can mop up the excess liquidity. Those like you and me are more sceptical and believe higher inflation and higher interest rates will be manifest in short order AFTER the economy rebounds.
Also, take a look at this Wikipedia entry:
https://en.wikipedia.org/wiki/Open_market_operations
It’s on the Fed but applies here as well.
Ed – thanks…and thanks for the link that i’ll try and digest.
Of course, UK govt borrowing going forward is going to be a big figure – and then maybe they need to sterilize on top of it all and on top of all that there’s going to be a General Election – so there aint going to be any real tightening before that, even if there needs to be….
Ed – coincidently, this just appeared right on topic:
https://www.telegraph.co.uk/finance/financetopics/recession/4967505/Inflation-will-kill-the-gilt-rally-in-the-end.html
I saw that. Funny, huh? I put it in the news feed. The long and short of it is: printing money is the definition of inflation. The only reason one won’t see inflation is because the velocity of money is decreasing.