What we do when interest rates fail

What we do when interest rates fail
Mervyn King sets out the future for monetary policy, writes Edmund Conway

Last Updated: 8:13PM GMT 20 Jan 2009
You know things have come to a pretty pass when the Bank of England Governor admits that his main tool for influencing the economy – the UK benchmark interest rate – is no longer working.
But that is precisely what Mervyn King did last night. In a remarkable speech, he told Britons for the first time to brace themselves for quantitative easing. His acknowledgement that the UK central bank will have to resort to this drastic new method – used rarely in the history of finance – is likely to go down as one of the landmark moments in the financial crisis.
Equally striking as his confirmation that the Bank may soon embark on a policy of directly pumping cash into the economy was his stark description of the scale of the current malaise. Activity and confidence throughout the global economy had "fallen off a cliff", he said, with shares in London falling at one of the fastest rates in history and exports and output from here to the Far East dropping dramatically.
It is only against such a backdrop that such drastic action is necessary, he said. The plan the Bank intends to follow bears some resemblance to the scheme already in place in the US. The Bank has been granted permission by the Treasury to spend up to £50bn on assets, which it will then keep on its books with a view to selling them off later. The assets, which include commercial bonds and asset-backed securities, will be bought off private investors in the secondary markets – but this time the Bank will give them cash in return for the investments. The result will be an expansion of the Bank's balance sheet. For those who really follow such things, this is not quantitative easing, but what Ben Bernanke recently described as "credit easing".
In Mr King's words, which are worth quoting at length: "The disruption to the banking system has impaired the effectiveness of our conventional interest rate instrument. And with Bank Rate already at its lowest level in the Bank's history, it is sensible for the [Monetary Policy Committee] to prepare for the possibility – and I stress that we are not there yet – that it may need to move beyond the conventional instrument of Bank Rate and consider a range of unconventional measures.
"They would take the form of purchases by the Bank of England of a range of financial assets in order to expand the amount of reserves held by commercial banks and to increase the availability of credit to companies. That should encourage the banking system to expand the supply of broad money by lending to the private sector and also help companies to raise finance from capital markets."
The new asset purchase scheme will in fact give the Bank two powers beyond the ability to expand its own balance sheet. The first is to influence the pricing of a particular species of investment. If it believes the markets for certain corporate bonds are frozen, for instance, it may concentrate on buying them to help improve liquidity.
Second, and perhaps most importantly of all, it can, with the permission of the Treasury, opt to under-fund the Government's budget deficit. This means selling off fewer gilts than is necessary to pay for the assets, and is similar to what Japan did in the late 1990s, and what the Federal Reserve has now moved onto now. This is real quantitative easing. Interestingly, however, Mr King was reticent on how and when such a move would take place. It is hardly surprising. This kind of central bank activity has the potential to be highly inflationary. That should not be an immediate concern, given that the UK is now facing deflation.

http://www.telegraph.co.uk/finance/comment/edmundconway/4299635/What-we-do-when-interest-rates-fail.html