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Monetary life-jacket

6 October 2011 By Ian Campbell

The Bank of England has launched its lifeboat early. Its calculation is that the euro storm, bad now, may get a lot worse, with worrying implications for UK banks, exports and growth. But whether the monetary lifeboat can keep the UK economy from sinking will remain in doubt. If the purchase of 75 billion pounds of government bonds isn’t enough, there may well be more – but also calls for bolder fiscal policy.

The central bank has been brave. It is ignoring the current 4.5 percent rate of consumer inflation and launching a lifeboat that is bigger than expected, to try to move markets. Gilt yields will be lower. That should bring down rates on long-term loans and mortgages. Stocks may be buoyed. And the pound may be softer – at least against the dollar.

The aim of the new quantitative easing programme, QE2, will be to boost the money supply, confidence, credit and GDP growth. The risk of disappointment is large. The knock-on effects of QE1 have not been impressive. The broad money supply has contracted by 1.1 percent in the past year and lending to businesses is down by 4 percent. But it would have been worse without QE.

The already frail UK could easily start sinking if the euro zone crisis leads to a regional decline. The UK’s Monetary Policy Committee must be surprised by the European Central Bank’s cautious decision not to cut its own interest rate.

The British government, like the central bank, believes in action now. The otherwise bold BoE may however resist government pressure to find ways to channel credit direct to companies. But its two rounds of bond purchases are meaningful. They will amount to 275 billion pounds, close to matching two years of the UK government’s enormous deficit. Any upward pressure on government financing costs has been avoided.

That helps to give the government room to amend fiscal policy should recession hit. The government would have to make that risky decision. But the BoE can say it put its own boat out.


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