Charles Bean: Quantitative easing and the economic outlook
Speech by Mr Charles Bean, Deputy Governor for Monetary Policy of the Bank of England,
to the Scottish Council for Development and Industry, Glasgow, 21 February 2012.
* * *
Good evening! I doubt that many of you will be aware that the Bank of England was actually
founded, in 1694, by a Scotsman named William Paterson. Our original purpose was to raise
the funds to enable the King to finance his foreign military adventures. But Paterson soon
parted company with his fellow directors, leaving the Bank the following year.
Rather more of you may be aware that same William Paterson became the financial brains
behind the Darien scheme, a project to establish a Scottish colony in Panama that could act
as trading post between the Atlantic and the Pacific. Unfortunately, just about everything that
could go wrong with the project did, resulting in not only the deaths of many of the colonists,
but also substantial financial losses for the many Scottish people who had backed the
scheme. According to historians, the Darien disaster and its financial consequences
contributed directly to the pressures leading to the 1707 Act of Union between England and
Scotland.
The possible dissolution of that union is, of course, now on the agenda. Whether or not
Scotland becomes an independent country once again is a matter for the Scottish people to
decide. If the referendum should result in a vote in favour of an independent Scotland, the
associated monetary arrangements would then be one of many matters needing to be
settled. But the exact form of those arrangements would be for the Westminster and Scottish
parliaments to decide, not the Bank of England.
Until asked to do otherwise, the Bank will continue to use the powers delegated to us by the
UK Parliament to try to deliver, to the best of our ability, monetary and financial stability for
the United Kingdom as it stands, including being represented here through our Agency in
Scotland. In keeping with that, my remarks tonight will focus not on what may, or may not,
happen to the UK's monetary arrangements some years down the road, but rather on our
more immediate economic prospects and the actions that the Bank's Monetary Policy
Committee has taken to try to sustain the recovery.
As you will be aware, last October the Monetary Policy Committee resumed its purchases of
government debt, financed by the issuance of additional claims on the
Bank of England - so-called quantitative easing. At our most recent policy meeting less than
a fortnight ago, we voted to make a further £50 billion of purchases, which will take the total
sum bought to £325 billion. To give you some context, that represents about a fifth of the
annual output of the United Kingdom and around a third of the total stock of UK government
debt in issue.
Why did we decide to inject further monetary stimulus into the economy? And how likely is it
to be effective? We started quantitative easing in March 2009 in the aftermath of the collapse
of Lehman Brothers, as the UK economy was undergoing its deepest post-war contraction.
Bank Rate was almost as low as it could go and further stimulus was necessary to put a floor
under demand and get the economy growing again. All told we bought £200 billion of gilts
during that initial phase of quantitative easing.
Quantitative easing essentially involves trading one liability of the state - gilts - for
another - monetary claims on the Bank of England. We aim to buy mainly from non-bank
private financial institutions, such as pension funds and insurance companies, not from the
banks, as is sometimes erroneously claimed1. When we buy a gilt, we simply credit the bank
account of the seller with an appropriate sum. If the seller were indifferent between holding
the gilt and holding the associated bank deposit, that is where things would stop. But
because deposits tend to yield less than gilts and assets such as corporate bonds and
equities, the seller is likely to want to buy some other asset instead. The consequence is
upward pressure on the prices of a whole range of assets, including corporate bonds and
equities. That increases the availability, and reduces the cost, of finance to corporates. It also
boosts the value of people's wealth, which should encourage more spending.
As I noted a moment ago, we aim to acquire the gilts from institutions other than banks. But
as a by-product of the purchase, banks will find that they have both more customer deposits
and an increase in their claims on us (what are known as bank reserves). That may
encourage them to increase their lending, though in the particular circumstances prevailing
during and after the financial crisis, we expected this effect to be quite weak. That is in line
with the observed weakness in bank lending over the past three years.
Our analysis of the first phase of quantitative easing suggests bond yields were around one
percentage point lower than they would otherwise have been. And UK equity prices rose
50% during the programme, though only a small part of that is likely to be down to
quantitative easing. That made it cheaper for companies to access finance through the
capital markets and issuance was indeed strong during 2009. But the ultimate aim was to
sustain demand. Though we cannot be sure what would have happened in the absence of
our asset purchases, our internal work suggests that the first phase of quantitative easing
boosted the level of activity by around 11⁄2-2%.
Having finished the first programme of purchases in early 2010, why then did we deem it
necessary to restart the programme last October and extend it at our February meeting?
During late 2009 and through 2010, a recovery of sorts appeared to be taking hold and, by
the beginning of last year, some of us were starting to think that the time to begin
withdrawing some of the monetary stimulus might be starting to draw near. As the year wore
on, though, it became increasingly clear that the underlying growth rate was moderating.
To begin with, that reflected a continuing squeeze on household real incomes, and thus on
spending, resulting from the increase in the standard rate of VAT in January and the impact
of higher energy and import prices. In fact, real household income declined a total of 21⁄2% in
the two years after output troughed, whereas in normal conditions it might have been
expected to rise about 5% in that time. But since last August, the deterioration also seems to
have reflected heightened concerns about the prospects for the euro area. That was
reflected in much tighter funding conditions for European banks, including those in the United
Kingdom, and increased caution on the part of businesses both in regards to hiring and
capital spending. Output is reported to have contracted by 0.2% in the final quarter, though
some of the business surveys at the start of this year suggest that the economy may again
be expanding.
It was that deterioration in the outlook that led us to restart our asset purchases in October.
Despite the recent more encouraging signs, we continue to expect underlying growth to
remain sluggish in the first half of the year (the actual data are likely to move somewhat
erratically because of the extra holiday associated with the Queen's Diamond Jubilee). But
inflation has been falling sharply, down from its peak of 5.2% in September to 3.6% in
January and is likely to continue declining as increases in energy prices a year ago drop out
of the calculation. That means that the long-lasting squeeze on household real incomes is
also starting to ease. In turn, that should facilitate a modest pickup in household spending;
the upbeat retail sales figures announced at the end of last week may be a sign this is
already starting to happen. But while growth should gradually strengthen, the continuing
headwinds from the unwinding of excessive debt and the Government's continuing fiscal
consolidation mean that the pace of recovery is likely to remain moderate by historical
standards.
As a consequence, a margin of unused capacity and labour in the economy is likely to persist
for some while yet, helping to ensure that domestically generated inflation - presently
running around 11⁄2%, depending on exactly how one chooses to measure it - should stay
subdued. Indeed, in the absence of the extra £50 billion of gilt purchases announced two
weeks ago, we judged that inflation would be rather more likely than not to undershoot our
2% target in the medium term. That was why we decided that it was necessary to do more.
Moreover, the longer capacity lies idle, the more likely it is to be scrapped completely. And
the longer people are out of work, the more likely they are to become disconnected from the
labour market altogether. So there is an added incentive to getting the recovery back on
track quickly.
The euro area represents the biggest single downside risk to this picture. Greece is the
country in the headlines right now, but several countries of the euro-area periphery face, in
varying degrees, a challenging mixture of unsustainably high public and/or private
indebtedness and weak competitiveness. Correcting those problems requires: fiscal
consolidation; bank recapitalisation; and a rebalancing of demand towards net exports. The
first two are under way, but the third is harder to achieve in a monetary union where no
exchange rate movement is possible to bring about the necessary improvement in
international competitiveness. At best, these countries face an extended period of very low
growth while the necessary adjustments take place. And while this morning's agreement
between the Greek government and the euro-area authorities is certainly welcome, there still
remains a possibility that events could unfold in a disorderly and damaging fashion at some
stage in the future.
The linkages to the United Kingdom from such a disorderly outcome would be threefold.
First, and most obviously, almost half our exports go the euro area, so weak growth there
has a rather direct spillover on to us. Second, although UK banks' exposures to
governments, households and businesses in the affected countries are generally
manageable, they do have exposures to, and get finance from, euro-area banks which are
more heavily exposed. A disorderly outcome in the euro area could then result in a tightening
of the availability of funds to UK banks as a result of this interconnectedness and thus also in
the credit extended to UK households and businesses. Third, a bad outcome would probably
knock confidence and lead UK households and businesses to hunker down and postpone
spending.
There is little that the Monetary Policy Committee - or, indeed, the Government - can do to
influence the outcome of events beyond our shores. In particular, it would make little sense
to set the level of asset purchases so as to try to counteract an extreme event whose
likelihood, timing and magnitude we have no realistic way of assessing.
The latest extension of our asset purchase programme has proved controversial in some
quarters. Some commentators have questioned its likely effectiveness in stimulating
demand. Others have focussed on the undesirable distributional consequences.
As far as the effectiveness of the policy goes, the impact depends on what those who have
sold the gilts do with the money we give them in return, and how banks, businesses and
households respond to the resulting movements in asset prices and money holdings. It is
quite possible that the impact of a given quantum of purchases will be different at different
times and be sensitive to the prevailing economic conditions. But that is also the case with
changes in Bank Rate, where the effects can be equally uncertain.
Tracking the impact of the new round of purchases is also harder than before. Market
participants have increasingly come to anticipate our actions, so that asset prices tend to
move ahead of our decisions. That makes it difficult to isolate the impact on asset prices of
policy changes from the myriad of other things driving them. The fact that UK government
bond yields have fallen about a quarter percentage point more than those in Germany and
the United States since the late summer is, however, at least consistent with the effect we
expected. In any case, so far we have seen little to suggest that the effect on nominal
demand will be markedly at odds with that of our first round of purchases. But it is still rather
early to draw firm conclusions one way or the other.
Turning to the distributional consequences of the asset purchases, attention has focussed on
the downward impact on annuity rates, which have fallen about a percentage point over the
past three years since we started our purchases. That means someone2 with a
£100,000 pension pot, who could have expected that to yield an annual pension of a little
under £7,000 three years ago, would now get just under £6,000. That is a rather substantial
income loss. But it is only part of the story. Those pension funds will typically have been
invested in a mix of bonds and equities, with perhaps a bit of cash too. The rise in asset
prices as a result of quantitative easing consequently also raises the value of the pension
pot, providing an offset to the fall in annuity rates3. The impact of quantitative easing on
those approaching retirement is thus more complex than it seems at first blush.
More generally, the current extended period of rock-bottom interest rates has impacted
heavily on those holding most of their savings in deposit or short-term savings accounts, who
have seen negative real returns. Savers have every right to feel aggrieved at losing out; after
all, they did nothing to cause the financial crisis. But neither did most of those in work, who
have also seen a substantial squeeze in their real incomes. And unemployment, particularly
among the young, has risen as output has fallen. This is all a reflection of the hit to output
from the financial crisis. Output is still some 4% below its previous peak and more than
10% below where it would have been if the economy had simply continued growing at its
pre-crisis historical trend. There have been few winners over the past few years.
In a deep sense, the low level of real interest rates here and in the other advanced
economies is a reflection of the impact on the financial crisis. Heightened uncertainty and, for
some households, a desire to reduce their indebtedness have resulted in an increased
propensity to save. And the same heightened uncertainty has reduced the appetite of
businesses to invest and encouraged them to build up cash buffers. Substantial dissaving by
the public sector could offset that initially, but there are limits to how long the markets will
allow high deficits to be sustained. Fiscal consolidation was unavoidable at some juncture.
Given that, the stance of monetary policy needs to be loose in order to sustain demand. If we
had chosen to run a substantially tighter monetary policy, then that would only have served
to depress activity and raise unemployment even further. By slowing growth, it would also
make the task of fiscal consolidation and de-leveraging even more challenging. And by
providing a gloomier climate for business, it would also inhibit investment and slow the
necessary re-balancing of our economy towards manufacturing and internationally tradable
services.
Treating serious medical conditions often has unwanted side effects. But, unpleasant as
those side effects sometimes are, treatment is invariably better than the alternative. So it is
with the economic medicine of low interest rates and quantitative easing. The immediate
consequences may be unpalatable, but the sooner we can get the economy on the mend,
the sooner we can return policy to more normal settings and the better it will be for all
of us - savers, businesses and employees alike.
Thank you!