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It’s time to halt quantitative easing

Allister Heath
ONE of the most important pieces of data is also one of the hardest to understand. Working out how much money is circulating at any one time in the economy is the Holy Grail of macroeconomics; those who can make sense of it have a huge advantage when it comes to predicting inflation, stock and house prices, interest rates and even growth. It is a crucial question for the Bank of England, which will on Thursday decide whether to end quantitative easing.

A big enough increase in the supply of money boosts prices – of goods, wages, assets or all three. Consumers, firms and investors try and keep a certain proportion of their wealth in low-yielding cash to guard against emergencies – but surplus cash is soon spent on goods or services, used to pay down debt, invested in securities or property, or earmarked to hire staff or expand a business in other ways. So a rise in the money supply means higher demand for goods and assets and hence higher prices. Conversely, a drop in the amount of money forces prices down and can cause a recession. Ultimately, the Bank of England controls the money supply; it could print £500bn in notes and coins tomorrow and hand them out to everybody in the country, triggering instant hyperinflation. More rationally, the whole point of QE was to ensure the money supply didn’t
collapse as a result of the crisis.

That’s the basic story – but unfortunately in practice it is not that simple. It is hard to know what “money” is – notes and coins, sure, bank accounts, also fine, but what about other liquid assets? Economists constantly argue about where to draw the line. And it is not just the amount of money that counts – it is also the ever-changing speed at which it changes hand, a concept known as velocity. The higher this is, the less money is required to have the same effect. No wonder everybody disagrees about the significance of the money supply stats.

Yesterday’s figures showed the money supply (excluding holdings of non-bank financial intermediaries) grew just 1.1 per cent last year and fell back over the past three months. So should we panic? Do we need more quantitative easing? Simon Ward, chief economist at Henderson, is the best source on these maters; he is relaxed. The demand for money has dropped because interest rates are low and people are less worried about the future; this has boosted velocity, putting upwards pressure on prices.

Only the non-bank financial sector cut back its money holdings, led by insurance companies, pension funds and other investment managers. They have become more confident, selling cash and buying assets. Meanwhile, money holdings of households and private non-financial firms rose 2.6 per cent in the year to December; non-financial companies’ are up 4.2 per cent. Households’ holdings of money rose £23bn during 2009 and inflows to unit trusts and open-ended investment companies exceeded £25bn, up from £4bn in 2008. People are shifting funds from savings accounts into instant-access accounts – either in anticipation of increasing spending or of paying down debt. And the corporate liquidity ratio – money holdings divided by bank loans – has recovered.

Of course, the Bank may need to inject more liquidity into the economy later this year if conditions deteriorate. But at the moment it does seem as if there is enough money about, while inflation has crept up. The Bank should take the plunge on Thursday and halt QE.
allister.heath@cityam.com