Wednesday, September 30, 2009

Questions on Bank Policy

Readers Question from: Gilts bought by the Bank of England

What do you think of the policy - (Gilts being bought by the Bank of England?)

Firstly, it is hard to evaluate the policy as it has not been implemented on such as a scale before. We are charting unknown territory. Also at the moment, the economy is exhibiting unusual behaviour. We are in the middle of a liquidity trap where, for example, a cut in interest rates is not stimulating demand for money. At the moment, the purchase of gilts seems to have had only a limited effect on stimulating bank lending. It appears many banks are just benefiting from selling gilts to the Bank of England. However, although the impact of the policy is so far limited, the Bank will be encouraged at the tentative signs of growth.

However, rather than buying government gilts, the Bank of England may have more impact by buying corporate bonds and increasing bank deposits of firms directly, rather than indirectly through banks.

What do you think of that (inflationary) pressure?

Quantitative easing has so far had little impact on inflationary pressure. Though the increase in the money stock sounds impressive, it has mostly been absorbed by banks in their balance sheets. Tax rises and higher oil prices may push up the CPI in 2010, but, the underlying inflation rate remains low because of the spare capacity and high levels of unemployment. At the moment, it is hard to see any inflationary risk.

And what do you think the Bank can achieve if inflation expectations remain muted?

I think the bank will want inflation expectations to remain fairly muted. Ideally, they will be targetting inflation of 2%. However, they will definitely want to avoid expectations of deflation which could cause a fall in consumer spending as people wait for prices to fall.

If inflation was too low some economists suggest you can either
  • Pursue negative interest rates (charge banks for holding money or withdraw)
  • Give money directly to consumers - e.g. a helicopter drop / money gift mentioned by Milton Friedman

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