Inflation Thoughts: Shouldn’t Money Supply Increase When BoE Prints Money

Overall, there were few surprise elements in the Bank of England’s Inflation Report.

First, the Bank of England (BoE) did not rule out more asset purchases when the current £50bn buying is completed in early May. The CPI main projection was revised slightly higher on a medium horizon and the Bank sees inflation at 1.8% on the two-year horizon. With the inflation below target in the medium term, the BoE implicitly says that more asset purchases could come to push up prices. The CPI projection was probably lifted only because of the decline in forward market interest rates compared with the November report. We guess the Bank’s economists find it difficult to build the inflationary impact of QE into their quarterly macro model, BEQM.

Secondly, the Bank of England didn’t promise more QE either. It would, however, have been a surprise though as the BoE lifted the asset purchase target by £50bn to £325bn and never pre-commits to more gilt buying. The recent “reverse Operation Twist” in which the BoE buys more short-dated gilts and less longer-dated, see “Flash Comment: BoE does another £50bn QE – buying strategy changed”, is intended to distort the gilt market less and match the DMO’s issuances better.

Thirdly, it is clear that the Bank of England is somewhat puzzled about the effects of the asset purchases. Specifically, the Inflation Report noted that “it is difficult to account for the weakness in money in Q4. The MPC’s purchases of gilts in Q4 were associated with some reduction in the holdings of gilts in the non-bank private sector, which should have boosted the deposits of those investors and, therefore, broad money”.

There are, however, some potential factors that could explain this conundrum: “First, market contacts suggest that some investors have chosen to reinvest the proceeds of gilt sales in other liquid assets, which would reduce money if such assets were ultimately purchased from outside the non-bank private sector. […]Second, some financial institutions in the non-bank private sector may have borrowed money from banks to buy gilts in Q3 in anticipation of further asset purchases being announced by the MPC. […]Third, large intragroup movements of capital by some banks at the end of the year are likely to have reduced money growth, relative to its rate in the absence of those transfers”.

Our conclusion is that the Bank of England will continue to buy gilts for most of 2012. The Inflation Report hasn’t changed this view. The year-end estimate remains at £400bn. What clearly worries the BoE is the QE’s lack of impact, with money growth absent. “QE doesn’t have diminishing returns [to scale] ‘in principle’, a hard-pressed Governor said at the press conference but theory sometimes deviates from reality. To make QE more effective and to encourage banks to start lending rather than parking cash at the BoE, the Monetary Policy Committee could cut the reserve rate to zero. That would be a wake-up call to banks and have an immediate effect on the money supply.