Does QE cause deflation?
In the leader column of City AM today, Allister Heath argues that quantitative easing should be stopped because it will lead to inflation. Set aside for a moment the fact that this is the whole point of it. Is he right that it will actually succeed in causing inflation?
Scott Sumner (consistent with mainstream monetary theory) points out that an increase in the money supply is only inflationary if it is expected to be permanent.
And is QE a permanent increase? Not necessarily. On the contrary: QE in isolation makes the money supply smaller.
Under QE, the Bank of England has issued £200 billion of new currency and used it to buy bonds (mostly gilts) in the private market. (The Federal Reserve has done something similar, with a higher proportion of corporate and mortgage-backed bonds.)
So there's now £200 billion more sterling than there used to be - it's fair to say the money supply is bigger. What will happen next year - or in five years time, or thirty years when all the bonds have matured?
As those bonds come due, their issuers will have to pay the face value, plus interest, to the holder of the bond - the Bank of England. A £1 billion 10-year gilt maturing in 2010, which the Bank of England may have purchased for £1.35 billion, will require the government to pay £1.4 billion to the Bank next year (one more year of interest having accrued).
What will the Bank do with the money that comes back into its vaults? Nothing, unless they explicitly decide otherwise. The money is an asset of the Bank and as soon as it's paid back to them, it will disappear.
Thus, the money supply will be reduced by £1.4 billion - cancelling the £1.35 billion increase and a further net reduction of £50 million.
The Bank is buying gilts which mature in between 5 and 25 years. If the average is 15 years, and the size of the programme is £200 billion, then around £100 billion will be drained from the money supply as a result of QE. This needs to be discounted either by the predicted Bank policy rate or by expected inflation, so the exact size of the effect is hard to predict. But a reasonable estimate is £50 billion or about 30% of the UK's monetary base.
So, unless the Bank says otherwise, far from being a permanent increase, QE is actually a permanent net reduction in the money supply. Orthodox monetary theory says this should cause not inflation but deflation.
If this logic is correct, then either:
- QE is not causing inflation
- QE is causing inflation because the Bank is expected to make the money supply increase permanent
- QE is causing inflation because the theory of permanent increase is wrong
If case 1: it's a clever way of boosting short-term activity without (apparently) an inflationary impact. Nice idea, but completely counter to the goals of QE.
If case 2: The Bank can do whatever it wants in future years, including increasing the money supply to counter the effects of maturing bonds. If markets are assuming they will do this, it provides another explanation for why long-term interest rates are falling: the long-term path of policy rates will be lower than it would otherwise be. The other reason for falling rates is that QE provides extra demand and keeps the prices of bonds higher, but the interest rate path is probably a stronger effect.
If case 3, there's a behavioural explanation: the extra money in the economy boosts immediate spending even though people should rationally expect a reduction in the future money supply. Clarity on this may need to await a theory of expectations.
So which is it? Is QE a mistaken policy? Is orthodox theory wrong? Or are the policy and theory both right, and markets are revealing an expectation of future policy? If so, are their expectations right? Time for the central banks to clear this up.
(This argument is strengthened by the fact that the expansion of the monetary base does not seem to be going into general circulation, but that is a distinct problem).