The Financial Crisis of 2007–9 saw interest rates in the UK and Europe at historically low levels. Low interest rates appeared to have a limited stimulus effect on economies, and central banks looked at other options to generate economic activity, with quantitative easing (QE) being an important tool for both the Bank of England, and later the ECB.
One concern that has been raised with such a policy is the possible long-term effect on prices – if billions of euros and pounds are being pumped into economies, then the money supply will surely rise and, as the quantity theory suggests, will make it more likely that inflation will accelerate in the future. The Bank of England had, as of January 2019, financed £435 billion (€485bn) through QE and the ECB had financed €2.5 trillion (£2.24tn). Whether the increase in the money supply will lead to inflation depends on how other elements of the Fisher identity change. It has been suggested that QE will lead to a reduction in the velocity of circulation, and the rate at which Y increases (which is very much dependent on capacity in the economy) might mean the impact on inflation might not be as great as some feared. One concern that has been raised is that QE might be used as a tool of monetary financing – in other words, the central bank ‘giving’ money to government to finance spending, which is inflationary because it increases the money supply.
The argument is that government bonds are issued to fund government deficits – the difference between tax receipts and government expenditure. If central banks buy debt from financial markets and take it onto their balance sheets, this is, in effect, financing government spending, which would be akin to overt monetary financing (OMF).
OMF is when central banks ‘print money’ to finance government spending. This approach might remove fiscal discipline and lead to inflationary pressures building. With many governments struggling to manage deficits, it is possible to propose an argument along the lines of the following: if the central bank buys government bonds, the interest rate on government bonds falls and as a result government borrowing costs are lower. In addition, if the central bank is buying government bonds, what happens to the interest on these bonds – should the interest be accounted for on the central bank’s accounts or on the government’s (since it has issued the bonds)? The ECB is forbidden under its charter to engage in monetary financing. Monetary financing is also frowned upon by many other countries, but where is the tipping point? There is a fine line between central bank open market operations involving government bonds and monetary financing largely depending on how different transactions are defined.
The counter-argument is that QE requires money to be ‘printed’ by central banks, not for handing to people to spend but for the purchase of securities in financial markets. In this way, what is happening is that assets are being transferred within the financial system – in some cases, private firms are transferring bonds to the central bank’s accounts and receiving deposits in return which are recorded in its account. In other cases, it is a transfer of assets between the government and the central bank – the central bank is acquiring government bonds and cash is indirectly going to the government. This might be seen as pretty much the same as monetary financing, except that in the long run the monetary base need not rise and as a result inflation may not result –
unlike overt monetary financing.
If inflationary pressures do start to increase, will the central bank be able to spot when it is starting and take action in sufficient time to choke off any acceleration in prices over and above target rates? One way might be to destroy money in the same way that it was created, through reversing QE by selling back bonds, taking money out of the economy and thus reducing the money supply. The success of such a policy depends on whether the central bank can indeed spot inflationary pressures at the time, and whether they can act sufficiently early to be able to have an impact. Politically, this might prove difficult, because unwinding QE would send a message to the markets that inflationary pressures are rising, and that the economy is about to be squeezed. The ECB announced it was ending its asset purchasing programme in December 2018.
Critics of QE have argued that the billions spent by central banks have not found their way through to the real economy (to people who spend more money on consumption), but instead have just been absorbed by the financial system to correct balance sheets. In addition, one other effect of QE is to feed its way through to exchange rates, as wealth holders with more liquidity as a result of QE, sell off pounds and euros, which weakens currencies. A weaker pound or euro benefits exporters but means importers face higher costs which can further feed through to inflation.
Critical Thinking Questions
1 What effect would an increase in the money supply of 10 per cent have on the price level? On what does your answer depend?
2 Why would government borrowing costs fall if the central bank buys government bonds as part of an asset purchasing programme (QE)?
3 What is ‘monetary financing’ and why is it considered a taboo?
4 Assume that the pound weakens as a result of QE. What will be the effects of this on the economy, and what would determine the relative size of the effects?
5 Assume that QE leads to a fall in the velocity of circulation. Use the equation of exchange to show what the effect on the price level would be under different scenarios (i.e. assume M, V and Y all change by different amounts).