Continuing the game of pin the tail on the economic donkey

It’s a cosmic game of pin the tail on the donkey. The tail is the amount of money creation that the Bank of England deliberates over. The donkey is the British economy.

The Bank has just voted to increase its money creation exercise to £200 billion. A £25 billion increase is a little less than had been expected.

The Monetary Policy Committee is marginally less worried than thought about last month’s shock news that the economy is still in recession. It may be marginally more worried about the prospective inflationary consequences of its epic money creation scheme than the City believed.

What we can say now is that Britain is the undisputed QE world champion, that this policy has been pushed further than any developed country in modern history.

So ‘is QE working?’ is now a £200 billion pound question.

Passing judgement on quantitative easing (QE) is a bit like divining the impact of water fluoridation on Britain’s dental standards. You can see some sparklier teeth in Britain’s credit markets, but is all of that really down to the Bank’s extraordinary experiment?

The most tangible impact has been on the market for government debt, where the Bank of England has gobbled up the extra government debt, lowering the price the Treasury pays by over a full percentage point.

Today’s news saw a sell-off in that market, with that interest rate increasing by 0.1 per cent. The markets clearly see the fact that there will be “just 25 billion” of QE in the next three months, as a high watermark for the policy (QE to date has been running at £25bn every month).

David Cameron warned in his Tory party conference speech that QE had to stop at some point, and only then would we see the true demand for British government debt. We are now close to that point.

So what’s it achieved? Well there has been a flurry of larger companies that have bypassed the stodgy banks, by raising money from capital markets to reduce bank debt. Typically they issue corporate bonds sold to the likes of pensions and insurance companies. This is part of the story of how QE has helped the economy.

But it is impossible to say what proportion of this extra lending has come as a result of the Bank’s experimental policies and what has come from a general improvement in sentiment.

So QE has disproportionately helped larger companies rather than smaller companies. It has helped banks too. It may have helped pump up asset prices around the world. And, indirectly it has clearly contributed to a helpful fall in the value of sterling. Not quite a devaluation, but not a million miles away from it either.

The donkey has been kicking a little in the past few days. There have been some strong manufacturing and services sector survey numbers earlier in the week. But there were more bad numbers out today.

So the question remains about when this policy gets unwound. When does quantitative tightening begin? Well it’s never been done before. And the Bank will want to be completely certain that the donkey is alive and kicking, before they remove its tail.

As part of the QE arrangements the Chancellor and the Bank of England Governor Mervyn King swap letters. Normally it is an eminently forgettable spot of legalese.

Not this time.

The Chancellor chose to use the letter to issue what can only be termed ‘a gentle prod’ aimed at the Bank of England. Mr Darling appears to want the Bank to use QE to lend to companies directly by buying so-called commercial paper. This hasn’t happened so far.