Responding to former Monetary Policy Committee member Andrew Sentance, Tory MP Matthew Hancock said that in the past QE hadn’t produced inflation, and that there was no reason to think that it would this time.
“Inflation is falling, it fell very sharply over the last month, the bank predicts that it will continue to do so over the coming months, there are some very good reasons for that,” he told Radio 4.
He’s probably right, as well.
The inflation that newly created money causes is determined by the so-called ‘velocity’ of that money. This is effectively the rate at which money repeatedly gets used in transactions once it has entered use.
The reason for this is quite simple if you think about it – if the Governor of the Bank of England secretly created a trillion pounds of money but held it in a locked (virtual) room in the Bank and never alerted a soul to its existence, it would not cause inflation. It may as well not exist, it has no contact with the wider economy.
But if a trillion pounds were created and used to pay workers to build a (bloody big) high speed rail network, those workers would probably have spent most of the money they had received in wages by the end of the month.
The businesses that they had spent that money in would be exposed to a massive increase in cash coming into their coffers. They would in turn use that money to expand, pay their staff, spend it on capital goods, and it would filter through to the wider economy.
To everyone there would be more money around, the amount of money actually being used in the economy would increase in comparison to the real goods and services, and each pound would represent less real wealth. Inflation would occur.
Not quite a locked room
Back in the real world, what the Bank is doing is not quite locking the money in a secret room never to be used, but it doesn’t filter through to the wider economy at anywhere near the same rate as paying it to workers.
The effects of purchasing Government debt are broadly limited to lowering yields on government debt – because buying up the debt raises effective demand for it, hence record low interest rates on Government bonds. This may have a knock on effect in terms of investors who deal in government bonds (pension funds, etc) but for the most part, the transaction stops after the bank has bought the debt and does little else.
The banks don’t necessarily go on to spend the money again like a worker would because banks spend (lend out) their money when they see a profitable opportunity – and at the moment they don’t see profitable opportunities
So inflation is unlikely to happen after another round of QE. But there’s a flipside to this – because money that enters the economy isn’t actually being spent, the money supply to businesses hasn’t actually increased as it did in the contrived High Speed Rail example. Because no one but the state is really exposed to the new money, and the state doesn’t really care, there isn’t really a stimulatory effect.
So the Bank of England isn’t quite secretly printing money and keeping it in a locked room on Threadneedle Street – it’s printing money and carting it down the road to the other banks in the City, where banks will keep it in a locked room there for a bit.
The people crying about inflation are wrong; but this also means that any suggestion that QE is likely to stimulate the economy beyond raising the confidence of the misinformed is wrong as well. Likewise, calls to spend the money on real projects would probably stimulate the economy as the money entered the wider economy, but would probably be inflationary as well as the money would be of a higher velocity. If, though, as the Bank predicts, we’re entering a period of deflation, that might not be such a bad thing in moderation.