Allocating, multiplying, QE | FT Alphaville

Allocating, multiplying, QE

This is an interesting way to announce that the Treasury’s given authorisation for the Bank of England to begin quantitative easing…

… via an interview with The Telegraph:

[UK Chancellor] Alistair Darling is this week expected to give the Bank of England formal approval to effectively print more money to kick-start the British economy. The Bank will be able to spend up to £150 billion in the coming months to buy-up company and Government debts.

The policy, known as quantitative easing, will be used to inject more money into the economy. It is now deemed necessary as interest rates rapidly approach zero. The Chancellor is expected to sanction the scheme on Thursday in a formal exchange of letters with Mervyn King, the Governor of the Bank of England.

To be clear, this is the authorisation for £150bn of unsterilised reserve-funded asset purchases (mostly gilts) — quantitative easing that effectively increases the money supply, diminishing the relative value of one’s debt (and err, savings) and helping to support asset prices. The BoE has already got the go-ahead for buying up to £50bn of sterilised financial assets — so-called qualitative easing to improve corporate credit.

Since UK QE is a given at this point, discussion is inevitably turning to the size of the measure and its efficacy.

JP Morgan’s Malcolm Barr has an interesting note on the subject today.

In this debate, two specific sets of portfolio decisions are important. First is the stability of the demand for bank liabilities from those who hold gilts or other assets the BoE may purchase (who are predominantly the life assurance and pension funds), relative to the size of their balance sheet. Second is the stability of the demand for central bank reserves from the UK banking system relative to the size of its balance sheet. In the first instance, BoE purchases of gilts are likely to mean a UK pension fund or life insurere sees its holding if gilts fall, and its holding of deposits at its clearing bank rise. The clearing banks will see its deposit liabilitie to the pension fund/life insurer rise, but its reserve assets at the BoE will also rise by the same amount. The ratio of the banking sector’s balance sheet to its holding of central bank reserves plus cash is sometime referred to as the ‘money multiplier’, a label which implies that the size of the banking sectors balance sheet can reliable be expressed as a multiple of their holding of reserves.

Pushing more reserves into the system (via QE) therefore is meant to have two effects: Firstly, it encourages gilt holders to try and offload the cash they receive from selling gilts, pushing up the prices of other assets. Secondly it encourages banks to lend as they try to re-establish their target ratio of reserves to their balance sheet.

It’s basic money multiplier stuff and by JPM’s calculations a £10bn rise in reserves would prompt a £120bn rise in lending to the real economy, pushing the annual growth rate of M4 up by about 7 percentage points. However, Barr sees a problem with this:

The problem with this story should be clear from examining the chart below. It suggests the “money multiplier” calculated using M4 loans as above,  which plunged as the BoE reformed its money market operations and began paying interest on reserves in 2006, has fallen very sharply over the second half of 2008 (from near 15 to 12). The banking system has been holding a much higher ratio of safe, liquid and interest bearing reserves to its overall balance sheet as the financial shock has hit. Rate cuts reduce the incentive to hold reserves. But the banks will find themselves with an additional liability to insurance and pension funds in the first instance (deposits they will suspect will be liquidated over time) versus uncertain returns on their lending. Our best guess is that the collapse in the “money multiplier” is likely to accelerate as QE begins, with banks quite happy to sit on larger amounts of reserves held as assets against a liability of deposits held by former gilt holders. The chart will hence look a like what happened in mid 2006.

This is similar to what happened to the US after it started QE last year; even with a massive bout of QEasing, the inflationary effect of the policy measure was mitigated by the dearth of bank lending — the money multiplier was broken.

You could argue in the UK case that the life insurers and pension funds will do their bit and try to turn their newly-increased deposits into purchases of other assets, but, Barr sees difficulties here too:

… a number of asset markets are falling to multi year lows, raising the incentive to hold safe assets. The national accounts suggest holdings of cash and deposits has risen from near 5% of total assets to 7% (about £40bn) over the first three quarters of 2008 alone. The 3Q national accounts suggest insurance and pension funds held £235bn of their assets in gilts (11.5% of the total), with £145bn in deposits (7.1% of the balance sheet). £150bn in gilt purchases from this group alone would amount to a doubling in their holdings of cash, and reduce their gilt holdings by almost two thirds. But the UK government is likely to be running a budget deficit exceeding £100bn before we begin to account for issuance relating to financial sector measuresWith plausible magnitudes for net issuance of government paper of a similar magnitude to those being discussed for QE, it is difficult to see the resultant portfolio shift for gilt holders as being large relative to their decisions on asset allocation as a whole.

In short, then, QE is by no means a cure-all.

Related links:
Where’s our QE? – FT Alphaville
Alistair Darling expected to give Bank of England approval to ‘print more money’ – The Telegraph