Simon Hebb: Quantitative question that waits for an answer

QE is a tool for the implementation of a nation’s monetary policy. It has involved the creation of new money by the central banks, which is then used to buy in government debt from financial institutions. The effect of this is to introduce greater liquidity into the financial system.

Monetary policy and fiscal policy, which is the balance of taxation and government spending, are a government’s two controls over its economy.

As we all know, western governments are cutting spending and raising taxes to greater or lesser degrees already, and are expected to continue this approach. This means that monetary policy needs to be used to stimulate the economy if a recession is to be avoided.

Monetary policy has effectively two elements: the volume of money in the economy, and the price of money. With interest rates at 0.5 per cent the price of money is at absolutely and historically low levels, and will remain so. The usual tool for central banks to encourage consumption and investment is the level of interest rates, but now there is no longer the potential to cut them.

Therefore, the volume of money is the critical element for maintaining and promoting economic activity.

The problem is that consumers and businesses are not increasing their spending. This being the case some central banks, such as the Federal Reserve and the Bank of England, have tried to inject money into their respective economies by means of QE.

There is furious debate about whether or not this is merely causing inflation. The concern is based upon the idea that money creates more purchasing power, and that if this does not generate more transactions, then it will lead to higher prices.

In defence of those who favour QE, it succeeded in halting powerful deflationary forces which derived from the credit crisis. It contributed to the maintenance of liquidity in the banking system, and it has reduced long term interest rates.

However it appears to have failed thus far to stimulate economic activity, and some commentators argue that it has caused commodity price inflation.

The naysayers argue that QE injects too much money into the system for the requirements of non-inflationary growth. But do they underestimate the degree to which the credit crisis continues to affect our lives?

Indebtedness of western consumers, corporates, banks and governments rose very substantially from the time of the Reagan and Thatcher reforms to 2009. It appears that a period of relative debt reduction is underway, and that it may continue for some years.

This view is supported by the fact that banks worldwide have to increase their capital relative to their loans, and that there remain many poor loans on their balance sheets which will have to be written off. It may be that the people who fear inflationary consequences from QE fail to grasp both the amount and the deflationary power of debt reduction and bank recapitalisation.

The global economy has to deal with the combination of inflationary impulses from emerging nations and the deflationary contraction in developed ones. Globally, there will not be an absence of either inflation or deflation in the coming years, similar to the period during the two decades prior to 2008/9. Then the falling prices of goods manufactured in emerging economies offset the inflationary consumption boom in “The West”. Now the balance is reversed, and the effect is to reduce disposable incomes in the USA and Europe. It is unlikely that there will be more QE this month. The Federal Reserve and the Bank of England may wait until such time as there is more evidence to support QE usage, and then they may use QE differently.

As regards timing, it would be entirely rational to await the moment when annual commodity price changes flatten out, which may occur around year end, or to see what US politicians agree for the stimulus strategy they are negotiating. The process of financial restructuring in Europe may be very deflationary or even reflationary. We expect progress on these issues over the coming months.

If any central bankers decide to engage in further QE, they might consider trying to inject money more directly into the economy, rather than simply buying government bonds. In 2009, the Fed bought mortgages in addition to government securities. Might central bankers be tempted to supply capital specifically for infrastructure investment or for recapitalising banks in Europe?

Whatever the machinations of politicians in “The West”, the odds are that QE, or some other form of asset purchase scheme, such as the European Financial Stability Fund, will become very substantially active again within the next six months.

• Simon Hebb is an investment manager at Harrogate-based Gore Browne Investment Management.