I noted yesterday, the US is to start a second round of quantitative easing and there is a chance that the UK will follow suit.
Quantitative easing is not easy to understand. One commentator asked a pretty logical question yesterday:
I have what might be a very dumb question, so apologies in advance. My understanding is that the BoE is buying Gilts directly from the Treasury, for which it pays with new money that it effectively creates. Is this not the case? Or if not, in what way are the commercial or investment banks involved?
Thank you.
That's not so dumb, but there are some mistaken assumptions inherent in it. First, the Bank of England does not buy gilts straight from the Treasury. This, apparently, breaches EU requirements.It also undermine the (I think implicit) agreement between the Treasury and the money markets that they will always buy all gilts that the Treasury has to offer,which constitutes an effective underwriting agreement.
What the Bank of England does instead is buy gilts from commercial banks and other institutions, such as pension funds. About 99% of all quantitative easing was used to buy gilts in this way.
But of course, if the Bank of England is buying second-hand gilts then they need not buy them at the original issue price. If, as is likely, the gilts that the Bank of England were buying had been an issue for some time then it is highly likely that the coupon or nominal interest rate paid upon them was somewhat higher the current gilt rate, which is at an all-time low. That does, however, mean that the price at which the gilts were being repurchased was above the original issue value because this is the way in which the market adjusts the nominal or coupon interest rate on gilts to the current prevailing market rate. s the rate falls, the price goes up, and vice versa.
It was in this way that the banks profited enormously from quantitative easing. Because the government was, effectively, forcing the price of gilts up by pushing the interest rate down in pursuit of its monetary policy the bank , without having to take any action or initiative of their own, make a profit.
How much profit that was is hard to guess at. It would be invaluable if research was undertaken to establish this. But I suspect that a significant part of the £199 billion of spending on QE was turned, almost immediately into profit by UK based banks. It is this fact, and nothing else, that restored bank profitability and bank bonuses in 2009.
This may have achieved a result: the banks were more liquid as a result. I think that the wrong way of recapitalising the banks. It would have been substantially more honest to acquire equity stakes in them. But what this process did not do was a) mean that the Bank of England directly supported the deficit, although of course by implication it did or b) mean that more money was available to the economy as a whole. The banks who sold the gilts kept the proceeds on their balance sheets. Other institutions who made sales used the funds to inflate other asset prices.
I believe QE can work. But QE1 was captured by the banks.
That’s why QE2 has to be different.
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Richard, The current Asset Purchase Facility report shows that the make up of the securities bought is £198.3bn of gilts versus £1.6bn of corporate bonds.
On the basis that buying 2nd hand gilts just allows the financial services industry to carry on business as usual (i.e. proprietary trading, bonuses, no lender to business etc.) what are the issues surrounding why the mix has not been more in favour of directly purchasing corporate bonds and getting money into “real” businesses? Is it purely inflationary fears? I am still getting to grips with the economics of all this! 🙂
I understood that November 3rd was the deadline for the major banks to sign-up to the code of conduct regarding their tax dealings. When Geo.Osborne appeared on the Andrew Marr Show a few weeks ago, just four had signed-up at that time. I’ve googled around, but can find no report on the final number of signatories. What’s happened? Do you know? Has the deadline been extended?
[…] right, of course. As i have explained, QE in this form is good at boosting bank profits. And it also does squeeze gilts out of the savings market — by (perversely at a time of […]
[…] of my commentators asked late last night: I understood that November 3rd was the deadline for the major banks to sign-up to […]
Thank you for the explanation.
Would you happen to know what EU regulation/requirement prevents the BoE from simply buying gilts from the Treasury. This seems to be the root of the problem. Are we sure that the same regulation/requirement would not prevent advancing the liquidity directly to other recipients?
@Million Dollar Babe
The Maastricht Treaty forbids treasuries having overdrafts with their central banks
QE is an artifice to get round that
Get rid of the law, I say
[…] right, of course. As i have explained, QE in this form is good at boosting bank profits. And it also does squeeze gilts out of the savings market — by (perversely at a time of […]
“It was in this way that the banks profited enormously from quantitative easing. Because the government was, effectively, forcing the price of gilts up by pushing the interest rate down in pursuit of its monetary policy the bank , without having to take any action or initiative of their own, make a profit.”
They are , however, exchanging an income earning asset {gilts} for a non income earning asset {cash}? Has the amount of currency in circulation increased?
According to B. Benanke “Although asset purchases are relatively unfamiliar as a tool of monetary policy, some concerns about this approach are overstated. Critics have, for example, worried that it will lead to excessive increases in the money supply and ultimately to significant increases in inflation.
Our earlier use of this policy approach had little effect on the amount of currency in circulation or on other broad measures of the money supply, such as bank deposits. Nor did it result in higher inflation. We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time. The Fed is committed to both parts of its dual mandate and will take all measures necessary to keep inflation low and stable.”
http://www.washingtonpost.com/wp-dyn/content/article/2010/11/03/AR2010110307372.html