Update: Read Prof Farmer’s response to readers’ comments
By Roger E. A. Farmer
There is a widespread perception that quantitative easing is synonymous with increasing the money supply. But it is more than that. In 2006, the Bank of England began to pay interest on the reserves of commercial banks held at the Bank. QE, in conjunction with the payment of interest on reserves, allows the Bank to influence the short term interest rate and at the same time, to influence the prices of long term assets. This new flexibility is the key to understanding how to prevent inflation without creating another Great Depression.
Critics of QE argue that it does not create jobs and that it will cause inflation. They are wrong on both counts. QE is a new tool that should become a permanent feature of monetary policy even after the UK economy recovers from the current recession.
The Bank is one of a growing number of central banks that follows the policy of inflation targeting. Traditionally, that has meant that the Bank sets the interest rate to try to control inflation. If inflation starts to rise, the Bank raises the interest rate. If it starts to fall, the Bank lowers the interest rate. By maintaining a low and stable rate of inflation the Bank hopes to generate the best environment to preserve high employment and stable growth.
This month, UK inflation was above its target range and the governor of the Bank was required to write to the chancellor of the exchequer to explain why monetary policy had overshot its target. Mervyn King, the governor, argued that inflation was high because of temporary factors such as VAT and fuel price increases. He explained that the Bank’s monetary policy committee was more concerned about the possible risk of deflation. But what if the MPC is wrong and inflation starts to reappear in earnest? Then the Bank will face a dilemma. If it starts to raise interest rates to choke off inflation, it will also kill job creation and the UK economy will move further into recession and perhaps even into another Great Depression.
As I argue in my new book, this recession is different from all of the previous post-war recessions. The UK interest rate is close to zero just as it was during the Great Depression. Because the Bank cannot lower the interest rate below zero, traditional monetary policy doesn’t work anymore. The Bank has responded by adopting a new tool; QE.
Academics and policymakers who write about inflation targeting have long been concerned with what constitutes the right definition of a price index. Should the Bank target a pure goods price index, as Ben Bernanke, US Federal Reserve chairman, and Prof Mark Gertler of New York University argued in an academic paper from 2001, or should it target a broader index that includes asset prices as was argued in 1973 by the UCLA economists Armen Alchian and Ben Klein?
The issue of how to define inflation has huge practical consequences. If the Bank had targeted an index that included asset price inflation in the 1990s, it might have pricked the dot-com boom bubble or the housing price bubble of the early 2000s by raising the interest rate. Perhaps we would have avoided the 2008 Great Recession.
However, there is a cost to targeting a price index that includes asset prices: we may lose out on years of high growth when the Bank reacts to asset price inflation. There is also a cost to the alternative policy of targeting only goods price inflation. The eventual recession, when an asset price bubble bursts, may be catastrophic.
The policy of QE removes the dilemma of whether to target a price index that includes asset prices, or one that does not. It allows us to control goods price inflation and asset price inflation separately. By raising or lowering the interest rate on short term loans, central bankers can influence goods price inflation. By buying or selling long-term assets they can influence asset price inflation.
Why would the Bank’s MPC want to do this? It is important to maintain stable goods price inflation to promote high employment and stable growth. It is just as important to maintain stable asset prices so that business owners can have confidence that their hard work will pay off. QE, in conjunction with the payment of interest on reserves, provides the Bank with the tools to control goods price inflation and asset price inflation at the same time.
Critics of QE point to the fact that it has led to a huge increase in the asset portfolio of the Bank. They worry that QE will prove to be inflationary once the economy begins to recover. That is a real concern, and for that reason, the question of how to unwind QE when inflation reappears is of great importance. There is a right way and a wrong way to unwind QE that depends on what’s happening in the asset markets at the time that inflation emerges.
One scenario is that inflation will be accompanied by a recovery in asset prices, substantial job growth and falling unemployment. In that case, the right way to unwind QE is to raise short term interest rates by selling long term bonds. This is the policy advocated by traditionalists such as Charles Plosser, Philadelphia Fed president.
A second, more troublesome scenario, is one of falling asset prices in which there is nevertheless a reappearance of price and wage inflation. In this scenario, the response of raising short term interest rates by selling long-term assets would reduce inflation. But the cost would be a catastrophic fall in asset prices and an unnecessary increase in unemployment as consumers and business owners cut back on spending.
In my view, the right response to a rise in inflation in an environment of continuing high unemployment is to raise short term interest rates. At the same time, the Bank must continue to support asset prices by buying long bonds or, better still, by directly purchasing stocks. Accompanying the increase in the interest rate, the Bank would need to pay interest on reserves at market rates to prevent an explosion of domestic credit.
QE is not a substitute for traditional monetary policy that works by raising the money supply as some have argued. It is an alternative to fiscal stimulus. QE works by providing a predictable environment in which consumers will have the confidence to purchase goods and investors will have the confidence to create jobs.
Related reading:
We need more quantitative easing to create jobs – FT Economists’ Forum
Uncooperative QE – FT Alphaville
The BoE behind closed doors – surprisingly philosophical – FT Alphaville
Prof Farmer is chair of the economics department at UCLA and the author of two books on the current global economic crisis. How the Economy Works: Confidence, Crashes and Self-Fulfilling Prophecies, is written for the general reader and specialist alike and Expectations, Employment and Prices is written for academics and professional economists. Both are newly released by Oxford University Press. © Roger E. A. Farmer
