It has now been more than five years since the financial and banking crisis first broke, and many developed economies are still struggling with high unemployment, weak or negative growth, and precious little hope that things will get better. After experimenting with a range of ‘non-standard’ measures, the world’s two largest central banks have now signalled that they are prepared to go even further. In the UK, the Old Lady of Threadneedle St is definitely lagging behind.
Yesterday’s announcement of QE3 from the US Federal Reserve was especially striking, and more than the markets expected. With the unemployment rate still above 8%, the Fed had a clear mandate to provide further stimulus to the stuttering US economy. But the way in which it did so marked a new chapter in the crisis.
To date, central bankers around the world have been pulling various plans out of Ben Bernanke’s 2002 ‘playbook’ for combating deflation (and weak growth). Outright asset purchases of government bonds (BoE), signalling that short-term rates will be held low for a considerable time (Fed) and even massive three-year lending to banks against a wide range of assets (ECB) are all policy prescriptions that ‘Helicopter Ben’ set out.
One critical distinction with asset purchases, however, is whether the central bank announces a set quantity of purchases, or opts instead for potentially unlimited amounts. Yesterday was the first time that the Fed explicitly opted for the latter. In common with the ECB, which effectively made the same announcement last week (subject to governments agreeing not to spend too much), the Fed has now promised to keep on expanding its balance sheet until the economy recovers. As the central bank has a monopoly on money, it can quite happily do this.
What is more, the Fed is again explicitly targeting mortgage-backed securities rather than government bonds. This is a clear recognition that QE is only really effective if it manages to lower ‘real world’ interest rates – not the yields quoted on financial markets, but interest rates like the ones that households pay to borrow money. The Fed wants to ensure that its stimulus reaches the right part of the economy. In some sense, there are echoes of the ECB’s new purchase programme here – its outright monetary transactions (OMTs) will target what the ECB thinks are dislocations in government bond markets. Both central banks are committing unlimited sums and targeting the specific areas where they think the transmission of monetary policy has become log jammed.
All of this will make for uncomfortable reading in the BoE Governor’s office. Mervyn King has long shied away from unlimited asset purchases, preferring to announce fixed lumps. The problem with this, as a policy, is that it is less credible in terms of the impact on market interest rates. He also regards any intervention to target specific credit premia or market dislocations as totally off-limits. And because the government mistakenly gave the choice of what assets to buy to the Bank, instead of the MPC, he cannot be outvoted on this point.
The Fed and the ECB, while focusing on their own issues, have inadvertently shone a light on the flaws in King’s logic. The choice of what assets to buy is an important monetary policy decision, not just an operational issue. Nor are fixed amounts of purchases as good a guide for markets as unlimited commitments – only the latter can effectively cap yields or risk premia. Despite this, King is unlikely to change tack any time soon. We can only hope that the next BoE Governor is not as intransigent.