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Just follow the money

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Stephanie Flanders | 13:01 GMT, Friday, 6 February 2009

A lot of economic policy is easier said than done. But quantitative easing is one that's easier done than said.

It's such an ugly phrase - you can see why news editors would do everything they can to avoid it. But the governors of the British and American central banks hate it as well.

Both have tied themselves in knots over the last few weeks trying to show how their policies differ from quantitative easing - or (because I can't bear to repeat it again) QE.

king_bernanke203.jpgIn his speech last month at the LSE (13 January), Ben Bernanke said that the Fed was doing "credit easing", and that it was "conceptually distinct" from QE. A week later, Mervyn King said [63Kb PDF] that the Bank purchases of assets under the new Asset Purchase Facility would be "unconventional unconventional policies", as distinct from the more "conventional" QE. [See update below for more on the Asset Purchase Facility.]

I get it. Things are complicated - especially monetary policy things. Central bankers, of all people, have to be precise.

But it's odd that two former teachers, previously known for their crystal clarity, should decide now is the time to be wilfully complex.

I suspect that the real reason they want to distance themselves from QE is that from there, it's only a small leap for commentators to a phrase that people understand only too well: printing money.

But here's the funny thing: they may not be doing QE. But they are very definitely printing money.

Here's the simplest way of looking at all of this. (I'm afraid it's not the shortest.)

In normal times, monetary policy is about indirectly controlling the supply of credit in the economy by controlling its price. Cheap money means more lending by banks; having higher interest rates encourages less.

There is no direct targeting of the amount of money banks have in their accounts, or lend out to customers. You simply set the base rate at what you think is an appropriate level and see what happens.

But when interest rates are at or close to zero, everything changes. You can't make money cheaper any more, so you have to target the amount of cash more directly: in classic "QE", by targeting the amount of cash the commercial banks have in their accounts with the central bank.

That's (mainly) what the Japanese central bank did from 2001 onwards. Instead of targeting the interest rate, they adopted a target for the banks' balances with the Bank of Japan, which they attempted to meet by purchasing government securities from the banks, paid for with freshly-minted cash.

The more bonds the banks bought, the more cash they built up in their accounts with the BoJ. That, in turn, expanded the monetary base, also known as "high-powered money" (or M0).

By itself, that didn't do much to help the economy. As I pointed out yesterday, banks have to do something with it to increase "broad money" and get it out into the economy. In Japan's case, a lot of the money just sat in the banks' accounts and didn't achieve much at all.

Right. So that's QE. What about "credit easing"? That is what the Fed is now doing. It involves buying a mixture of bonds and securities in different markets with the direct goal of increasing liquidity in those markets, pushing up prices and cutting yields (the price being inversely proportionate to the yield).

Now that expands the Fed's balance sheet - just as with QE. To the extent that bank balances with the Fed go up, it also increases the monetary base. But, says Bernanke, it's not QE - because the rise in the monetary base is a side effect of the policy, not the goal.

If you think that sounds like a distinction without a difference, you're not alone.

Mervyn King is on slightly stronger ground when he says that purchases by the Asset Purchase Facility are not QE, at least under current arrangements. That's because they'll be bankrolled by the government.

Every pound spent by the Bank on corporate assets will be matched by the sale of an equivalent amount of Treasury bills. So, theoretically, M0 will not change and there'll be no quantitative ease.

But, as my colleague Robert Peston has pointed out, the T-bills that are supposedly offsetting the cash created by buying assets are pretty cash-like themselves.

Banks, in particular, are likely to treat them like cash. Which would suggest that even the initial non-monetary use of the facility would in practice have monetary implications.

The gnomes of Threadneedle Street will protest that it's the formal expansion of the monetary base that matters for QE. But if that's the way they want to play it, you could argue that all their many efforts to provide liquidity to banks have effectively been a form of QE.

As a result of those policies, the monetary base grew by 35% in the second half of 2008 alone. And the Bank's balance sheet expanded by around 160%.

The Special Liquidity Scheme and the decision to provide cash against a wider range of collateral have explicitly encouraged banks to build up more central bank reserves. The Fed's special operations have done likewise.

As I mentioned last week, one result of all these liquidity operations has been to push overnight rates below the official interest rate - in fact, not just in the US but also in the UK. Even though keeping that overnight rate close to the Bank rate is supposed to be their number one goal.

In other words, they have been concerned about the quantity of money sloshing round, not just the price. That sounds awfully like QE.

By now, the three people still reading this will be asking: "and the point is...?" The point is: forget about QE or not QE. Just follow the money.

Both the Fed and the Bank of England have been pushing money at the banks for the past 18 months - and for good reason. In the process they have massively expanded their balance sheets. And that, in the words of Ben Bernanke, is "effectively printing money".

Printing money may or may not be the same as QE. It may or may not be "unconventional". What matters is whether it works.

Update 1620: The Bank of England now has a news release and a Market Notice [76Kb pdf] about the Asset Purchase Facility.


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