Why QE2 would be wrong for Britain

Allister Heath
THERE is a growing expectation that the Bank of England will eventually announce a renewed bout of quantitative easing (QE). Yet such a decision, supported by Adam Posen of the monetary policy committee, would be a mistake: the economy, while sluggish, is growing; the money supply is expanding; credit conditions are improving; and inflation remains high. We are deleveraging, at least in part, and trying to work through the poor investments of the boom years; this will mean many quarters of poor growth, declining house prices and weak credit. Such is life; the last thing we need is a fresh infusion of newly-minted money to kick-start another artificial and unsustainable boom.

The purpose of monetary policy should not be to micro-manage or fine-tune the economy. A central bank cannot aspire to become a central planner. Its mission should instead be to provide a neutral environment for businesses, making sure that the supply of money doesn’t suddenly surge ahead or collapse. QE was necessary last year; conditions at the time were extraordinarily bad. The decision to buy vast amounts of gilts ensured no collapse in the money supply and returned bond spreads to normal. The UK is in better shape today; there is no need for QE2.

Posen is wrong to argue that the UK faces years of Japanese-style stagnation and deflation. We do face a prolonged period of weak growth, for both demand-side and supply-side reasons, but for different reasons to Japan. In fact, as Michael Saunders of Citigroup aptly puts it, Posen’s claim that the UK is like Japan is a bad case of “faith-based” forecasting, given that we will not be able to prove or disprove the analogy for years.

Sterling is well below its 10-year average, boosting exports, whereas the yen surged in the 1990s. Goldman Sachs also highlights the loosening in monetary conditions in the UK: a combination of a weak pound, lower bond yields and higher equity prices makes the firm bullish for 2011. A second difference is that the UK banking system is on the mend: we don’t have zombie banks, unlike Japan; in the absence of a Eurozone sovereign default, UK banks will eventually sort out their balance sheets. A third difference is that nominal GDP growth is running at 5-6 per cent in the UK, much faster than Japan’s performance over the last 20 years. Unfortunately, most of this nominal growth comes from inflation – and only a small part from real increases in output. Our problem is stagflation, not deflation.

Most important of all, the money supply jumped 0.8 per cent in August and by 4.5 per cent at an annualised rate over the last three months (the year on year rate rose from 1.2 per cent to 1.6 per cent). Henderson’s Simon Ward calculates that the corporate liquidity ratio – deposits divided by borrowing – is at its highest level since early 2007. Firms are flush with cash, cutting debt and boosting investment.

Crucially, the velocity of money – the rate at which it changes hands, just as important as its rate of growth – jumped 4.3 per cent over the past year. When real interest rates were last negative in the 1970s, velocity also surged; it looks as if money supply growth of 1-2 per cent per year should be enough to finance real economic growth of about 2.5 per cent, with 2 per cent inflation.

There may of course be a case for QE2 at some point further down the line. But at the moment the Bank must stay put.