Demystifying the magic of central banks

Strategic support

These days, however, interest rate changes are not the main game in town. Instead, the focus is on whether the central bank should ‘print money’ – expand its balance sheet by buying securities such as government bonds – and, if so, by how much and in what form. This policy has become known as quantitative easing (QE).

At the moment, QE is being used in conjunction with increased borrowing by the Treasury. Under this arrangement, the Treasury dishes out extra money to companies and other recipients via government stimulus measures. It finances this through the issuance of gilts, which are largely bought by the Bank of England.

Some commentators have suggested that there is a more effective way of deploying monetary support, namely through so-called ‘helicopter money’ – a term coined by famed American economist Milton Friedman that captures the idea of a helicopter dropping dollar bills onto the citizens below. The practical equivalent might be the central bank crediting everybody’s bank account with a certain amount of money.

This is, to an extent, what is happening under today’s QE policy. Certain sectors of the economy are receiving payments, and they are receiving them via stimulus from the government, funded largely by the Bank of England.

Is there a serious problem with the current policy? No. The overwhelming need at the moment is to keep the economy going and to prevent a deeper economic crisis. Admittedly, ‘printing money’ sounds unorthodox and naturally arouses in people the suspicion that a burst of inflation is inevitable. But in practice there is no immediate inflationary danger.

QE within limits

There are limits to how far QE can be pushed, and there are dangers. The amount of government debt in the economy in relation to GDP (the debt-to-GDP ratio) cannot rise without limit, as the interest on the debt would eventually consume all the government’s tax revenue. Long before that point, any government would either default on its debt or resort to inflation to reduce the debt’s real value. To avoid this fate, at some point the debt ratio will need to be stabilised or brought down.

Contrary to much commentary, however, this does not necessarily require significantly higher taxes or significantly lower government spending. The key solution to debt is economic growth. Admittedly, the government will have to be careful in its spending habits. But the debt ratio can be stabilised and eventually brought down if spending rises at a slower rate than GDP. Meanwhile, to foster economic growth, tax rises must be avoided.

When the economy eventually recovers, the Bank of England will need to take steps to prevent inflation from picking up, including deterring the banks from excessive lending. This will involve a reduction in their huge deposits with the Bank, perhaps by effectively ‘freezing’ them – disallowing the banks from lending this money. It may also have to sell government bonds back to the market as a way to regulate the money supply and control inflation. It is unlikely to impose much higher official interest rates, not least because it will want to keep the cost of government borrowing low.

With regard to inflation, the authorities will have a choice. They may well decide to stick to the current objective of keeping inflation at 2% per annum. But it wouldn’t be surprising if they decided to aim for a slightly higher rate, perhaps 3%.

You can begin to see the outline of a rather interesting world for investors. Negative real interest rates would result in year-on-year losses after inflation for holders of ordinary deposits, and probably for most bondholders as well. This, combined with continued – and perhaps higher – inflation, as well as stronger economic growth, may produce a good environment for equities.

It is also likely to favour residential property – although it’s difficult to predict how other factors, including the economic fallout from the coronavirus and possible future tax rises on wealth and property in particular, might offset these circumstances.

Yet how to ensure stronger economic growth? That is the $64,000 question. There are many possible ways. But beyond providing cheap finance for the government, and keeping interest rates low and the financial system liquid, none lies in the bailiwick of central banks. They have a vital role in preventing us from falling into an economic abyss. But they don’t hold the keys to economic salvation.

The opinions expressed by third parties are their own and are not necessarily shared by St. James’s Place Wealth Management.

The full version of this article first appeared in issue 106 of the St. James’s Place Investor magazine.

Roger Bootle is Chairman of Capital Economics and the author of the recently published book The AI Economy.