Global
QE2
March 05, 2009

By Manoj Pradhan | London

The RMS Queen Elizabeth was the largest passenger ship ever built when she first set sail in 1938 – a record that was not bettered for 56 years. RMS Queen Elizabeth 2 took over as the flagship when the Queen Elizabeth was retired in 1968. The record of another QE, the quantitative easing in Japan in 2001–06, may not hold quite as long. The new QE2 – the second coming of quantitative easing – has been upon us since September 2008. QE in Japan succeeded admirably in helping to restore growth and quelling deflationary pressures, and we see no reason to conclude that QE2 will not work. QE2 has shown surprising synchronization among its participants – the Fed, the ECB, the BoJ and the BoE. While there are no guarantees that QE2 will work, we are optimistic that it will be an important force in moving the economy onto the path to recovery. However, we also expect QE2 to raise a policy dilemma in the future. Central banks may find it difficult to roll back quantitative easing as well as policy rate cuts before economic recovery is entrenched, raising the risk of inflation further down the road.

QE2 is different from its predecessor. QE2 has been different from its predecessor in a couple of essential ways. First, it was instituted at the first sign of a major financial shock in September 2008, while the BoJ only used QE as a last resort in 2001, following a decade of economic stagnation and deflationary pressures. Second, it has multiple central banks as participants, thereby potentially increasing its potency. Below we outline some important elements of QE2.

Passive QE has been synchronized. There is greater coordination in the QE regimes than is commonly understood. G4 central banks delivered passive QE in September 2008, about a month before they engaged in coordinated cuts in their respective policy rates. In response to the common shock to financial markets in September 2008, central banks allowed market participants to borrow heavily under a variety of liquidity schemes instituted by the central banks, using a wide range of financial securities as collateral. Under normal market conditions, central banks would subsequently have sterilized these transactions to keep the monetary base steady. However, central banks chose not to do this and allowed excess reserves and the monetary base to jump – and QE2 was ‘launched’.

Active QE strategies show synchronization too. Central banks’ strategies for purchasing assets also show synchronization with the Fed, the BoJ and (most likely) the BoE opting to purchase risky securities. The Fed has already started purchasing high quality commercial paper, mortgage-backed securities issued by the GSEs, and Agency debt issued by these institutions. The BoJ has announced that it will purchase bank stock, commercial paper and corporate bonds. In addition, the Fed has stated that it could potentially buy Treasury bonds, the BoJ has increased its purchases of government securities and the BoE will also likely purchase government securities as part of the active QE package. For more details on the path that the BoE will likely take, please see the closely related article by David Miles and Melanie Baker on QE in the UK.

This may explain the preferences of the Fed, the BoJ and the BoE, as well as the constraints that the ECB faces. Unlike the other three, the ECB has no direct institutional backing from the governments of the euro area should it incur losses as a result of extraordinary policies such as active QE. Note, however, that the ECB is capitalized by the national euro area central banks, which in turn are backstopped by their national governments in the case of losses. The Fed and the BoJ have the backing of governments should losses be incurred. The Fed, however, has the added advantage that the MBS securities and the Agency debt it is purchasing are both backed by the Treasury. Buying Treasury bonds therefore is not as important from a risk point of view for the Fed. The BoE requires the permission of the Treasury to conduct operations that may result in losses – and a reply from the UK Treasury to the BoE’s request is due on Thursday. In spite of the (expected) approval, the BoE is unlikely to take on as much credit risk as possible and will therefore likely purchase government securities along with corporate bonds.

Impact on the Economy

Will QE ‘work’? There is no guarantee that QE (or indeed any policy for that matter) will put the economy on the path to recovery, but we are optimistic that QE will do the trick. We give four reasons for this optimistic outlook:

First, QE1 in Japan was successful. Rapid increase in M1 growth was followed by economic recovery in the form of higher GDP growth and a lessening of deflationary pressures. As we have argued in the past, we are better placed than Japan in its ‘lost decade’, so we see no reason to suggest that QE2 will not be at least as effective (see The Global Monetary Analyst: Neither the Great Depression nor Japan, November 19, 2008). 

Second, in the US and to a lesser extent in the euro area, rapid growth in the monetary base (due primarily to the surge in excess reserves) since September – passive QE – has been followed by a rapid increase in demand deposits and M1. (One reason for the rapid increase in M1 in the US might be the transfer of money-market mutual funds (not a part of M1) and similar deposits to safer, guaranteed bank deposits. However, if that were the primary reason for the surge, then we would observe no change in M2 (which includes both M1 and money market mutual fund deposits). However, M2 also grew noticeably over the same period.) Results for the UK and Japan are not as constructive yet, probably because the monetary base has been very volatile in the UK and it has seen relatively weak growth in Japan.

Third, the purchase of risky assets chosen by the Fed, the BoJ and the BoE (expected) amounts to a jump-starting of the standard monetary transmission mechanism. Under normal conditions, policy rate cuts should translate into lower yields through a chain of asset substitution. Investors looking for higher yields would start buying longer-dated bonds, lowering their yield. A similar search for yield leads investors to the credit curve, which in turn would push corporate and mortgage yields lower. Ultimately, the lower cost of borrowing would raise the incentives for households and firms to borrow and spend. By directly purchasing mortgage-backed and corporate securities with the aim of pushing their yields lower, central banks are hoping to bypass the early part of the transmission mechanism which has faltered so far. By reducing the cost of borrowing for households and firms directly, a weak but nevertheless positive response from households and firms can be expected.

Finally, QE is not being run in isolation. Rather, it has been introduced along with other policy measures including near-zero policy rates, bank recapitalization, loss-insurance, deposit guarantees and fiscal policy. QE is likely to play an important role, along with these other measures, in restoring growth as they feed off each other.

Does QE Introduce Inflation Risk?

In a speech on February 18, Chairman Bernanke argued that the expansion of the Fed’s balance sheet was not likely to cause inflation because 1) such an expansion could be reversed quite quickly, 2) inflation was expected to stay low for some time given weak global economic activity and low commodity prices. However, he added, the timing and pace of the shrinking of the balance sheet will depend on the Fed’s “assessment of the condition of credit markets and the prospect for the economy”. We think getting the timing and the pace right is exactly where the Fed will face a policy dilemma.

Consider the following scenarios: 1) QE actually does not help the economy at all, and economic recovery takes place on its own merits once the excesses have worked themselves off; 2) QE is very effective and helps the economy recover, and 3) QE is ineffective in reality, but the economy begins to recover soon; therefore, it is difficult to say whether QE has been effective or not. In the first circumstance, central banks can safely roll back QE without hurting the economy, thereby eliminating any threat to inflation. But, under the second or the third scenario, central banks cannot be sure that they can roll back QE before they are convinced that economic recovery can be sustained without the crutch of QE. If the recovery is anaemic, as we expect it to be, it could be a while before central banks can safely dub the recovery to be sustainable. In the meantime, they would be reluctant to aggressively and simultaneously roll back QE and the aggressive rate cuts they have delivered. This dilemma casts the die for the risk of higher inflation.

In summary, there is a striking synchronization among the QE measures that different central banks have used. While success is far from guaranteed, we are optimistic that QE2 will play an important role in restoring growth. The rolling back of these regimes will be complicated, however, by the desire of the central bank to ensure a sustainable recovery. This will mean leaving QE and/or low policy rates in place for longer, raising the risk of inflation. RMS Queen Elizabeth and RMS QE2 both did their jobs with an abundance of grace before they were retired. QE in Japan successfully performed its task and was also retired. The waters are choppier than they have been for a very long time, but QE2 holds similar promise.

Understanding QE

Defining quantitative easing. Quantitative Easing (QE) is in operation when the central bank allows or indeed pursues a rapid expansion of the monetary base.

The mechanics. The monetary base is the sum of currency in circulation and reserve balances of commercial banks (the balances that commercial banks maintain with the central bank). Suppose the central bank lends the commercial bank electronic cash (i.e., simply adds the amount to the credit balance of the commercial bank held at the Fed) in return for a financial security as collateral. The collateral security sits on the asset side of the central bank’s balance sheet, and the central bank credits the reserve balance of the commercial bank, which sits on the liability side of the central bank’s balance sheet, with (electronic) cash. Under normal circumstances, if the increase in reserve balances (and hence the monetary base) is unwelcome, the central bank would simply sell some securities in the open market to reduce the cash balances of commercial banks – an operation known as ‘sterilization’. Effectively, the central bank replaces the security previously held by banks with either cash or with a safe, liquid government security if the first transaction is sterilized. Under quantitative easing, however, the central bank would conduct the first transaction without sterilizing it, thus allowing the reserve balance of the commercial bank, and therefore the monetary base, to expand. For more details, see Quantitative Easing: What Is it and How Might it Work? by David Miles and Melanie Baker, March 2, 2009, and Revenge of the M’s by David Greenlaw, November 18, 2008.

‘Passive’ and ‘active’ QE. We distinguish between two types of QE, passive and active, depending on the degree of control that the central bank exerts over the increase in the monetary base.

Passive QE. In response to credit market stress, central banks put into place many programs to increase liquidity in the financial system. These programs allowed eligible financial institutions to approach the central bank, hand in government or other securities as collateral, and receive (electronic) cash in their account at the central bank. The programs were instituted by the central bank but the participation was entirely up to private institutions so that the central bank cannot perfectly control the size of the monetary base through this type of QE. We place all such programs in the category of passive QE.

Active QE, on the other hand, consists of all outright purchases of risky or government securities funded simply by crediting the seller’s account (directly if the asset is purchased from an eligible counterparty, indirectly if not) with electronic cash*. Such purchases also lead to an increase in the size of the central bank balance sheet and an increase in reserve balances and the monetary base. Crucially, through the outright purchases the central bank has perfect control on how much it can increase the monetary base. The only limit to the increase in the balance sheet is the government’s willingness or ability to backstop potential losses on the asset on the central bank’s balance sheet. 

QE to M1. For the QE regime to work, some of the electronic cash in the reserve balances held by the Fed has to be converted into demand deposits of non-banks (which are an important part of M1). This can be done either (i) when an asset is purchased from a non-bank and the seller of the asset puts the funds into a checking account, or (ii) when commercial banks make loans or buy assets, crediting the demand deposit account of the borrower/seller. Either way it sets into motion a chain of demand deposits because commercial banks are only required to hold a fraction of the demand deposits (say 10%) as reserves. They can use the remaining 90% to buy more assets or make more loans, thereby creating multiple demand deposits on the basis of one transaction. An increase in M1 is therefore an essential first step to QE getting some traction in the economy. The problem, of course, has been that in the current environment, banks have been reluctant to do much with their reserve balances. They have preferred to park their reserves with central banks and earn very low yields.

*Note that the purchases of risky assets carried out by the BoE on behalf of the UK Treasury as part of the Asset Purchase Facility are funded by the sale of treasury bills and thus are not quantitative easing as the impact on the monetary base is sterilized.

Important Disclosure Information at the end of this Forum

UK
Quantitative Easing: What Is it and How Might it Work?
March 05, 2009

By David K. Miles and Melanie Baker, CFA | London

The MPC has clearly signalled that further policy easing is very likely.  Further easing will very likely come in the form of ‘quantitative easing’.  It now looks very likely that the BoE will soon start buying gilts and other assets with the stated aim of increasing the money supply (i.e., unsterilised asset purchases).  

We analyse what quantitative easing is, how it might be done and whether and how it might work.  While it is far from clear that quantitative easing (QE) will achieve very much in the current environment, we think it is worth a try.  The degree to which it is effective will crucially depend on which assets are purchased.  Here, there is likely to be a trade-off: the more like cash the assets purchased are (in terms of liquidity, maturity and credit risk), the less likely quantitative easing is to have a substantial effect. But the less cash-like the assets purchased are, the more risk of loss the central bank (and ultimately the government) will be taking. 

What Is it That the Bank of England Is Going to Do?

The label ‘quantitative easing’ has been used fairly broadly to describe a number of different central bank actions.  In the UK’s case, what the Bank of England (and the Treasury) have proposed is unsterilised purchases by the Bank of England of gilts and any assets which are already part of the proposed Asset Purchase Facility (private sector assets including commercial paper and corporate bonds).

In the first instance, these purchases (from non-banks) are likely to find their way into higher sterling bank balances with commercial banks and also higher reserve balances by those banks with the BoE (see What Is Quantitative Easing? below).  So they increase M4 and also base money. This is what ‘printing money’ means. 

Central bank buying of any asset − gilts, corporate bonds or even houses and secondhand cars − will have this effect and could be described as ‘printing money’.  However, there is very likely a big difference between buying gilts (which are already very liquid) and buying other types of asset.  This is largely because buying other types of asset is more likely to have a big impact on the price (and liquidity) of those assets.  And if it included direct purchases of newly issued corporate securities, this would directly provide new funds to the corporate sector. 

What Is Quantitative Easing?

Quantitative easing in the UK would reflect a decision by the MPC to change the way it conducts monetary policy.  Rather than try to closely control the price of money (short-term interest rates), the central bank tries to more closely control the quantity of money.  In the case of the Bank of England, asset purchases by the central bank will lead to an increase in deposits (of the sellers of the assets) with the UK banking system, raising commercial bank reserves held at the central bank. 

Unlike the Asset Purchase Facility already in operation, these asset purchases won’t be funded by the issuance of Treasury securities (which effectively withdraws money from the economy, offsetting the injection of money from the purchase of the assets).  The Bank of England will buy assets in exchange for, effectively, a cheque from the Bank of England.  The seller then deposits the cheque at its bank which (assuming it banks directly with the Bank of England) results in that amount being added to the commercial bank’s reserves at the Bank of England.  The seller of the asset has less of one type of asset (e.g., gilts) and more cash.  The commercial bank has more deposit liabilities and increased assets at the Bank of England.  The Bank of England has increased liabilities in the form of commercial bank reserves and increased assets in the form of the securities it has purchased.  Money has been created (‘printed’). 

Note that the Bank of England carries out similar operations all the time in order to help the banks match their reserves at the Bank of England with their target level. 

What Is Base Money?

Base money is notes and coins circulating in the economy plus the reserves held by the central bank on behalf of commercial banks.  The unsterilised asset purchases described above increase base money by increasing the reserves held at the central bank.

In the UK there is no longer a published series for ‘base money’ or M0; but the Bank of England does publish series for notes and coins circulating and for reserves separately (though in the case of the latter, the series is discontinuous thanks to a major change in money market operations in mid-2006).

What Is M4?

M4 is the UK’s measure of broad money.  It consists largely of UK private sector (other than the bank/building societies holdings of: 1) sterling notes and coin and 2) sterling deposits.

In the UK, M4 therefore includes the bank deposits of so called ‘other financial institutions’.  This can include business between, for example, a bank and a securitization special purpose vehicle which is part of the same group.  This can confuse the interpretation of M4 in the UK, so it is often useful to refer to M4 excluding ‘other financial corporations’.

QE Is Not the Same as ‘Helicopter Drops’ of Money

The purchase of the asset by the Bank of England does not, in itself, increase anyone’s wealth, so there is no direct boost to spending power.  It is not like a helicopter drop of money.  The Bank of England is indeed handing over money − but it wants something in return: this is a helicopter that drops stuff but also sucks things up.  If someone sells a gilt to the Bank of England, the market value of that seller’s wealth does not go up at all (assuming that the Bank of England is not buying at a premium to the market price).  Further, the liquidity of the seller’s portfolio doesn’t even change much either, since both gilts and cash are very liquid.

If you want to think of a pure helicopter drop, that is more analogous to a fiscal expansion financed by the central bank. Here is how that could work: suppose the government sends a cheque for £1000 to every adult in the UK. It also sells (roughly) £45 billion of gilts needed to finance it.  It then gets the Bank of England to buy those gilts (or an equivalent amount of existing ones, which has the same effect).  This money financed increase in the fiscal deficit is more like a helicopter drop of money. The level of people’s nominal wealth is increased (and that additional wealth is directly in the hands of private sector agents).  This is not quantitative easing.  Quantitative easing is less than this − it involves swapping one asset (which the Bank of England buys) for cash (a bank deposit).

Why Might Quantitative Easing Work?

The type of quantitative easing proposed in the UK could work through several different (and not mutually inconsistent) channels:  1) It could make the banks want to lend out the extra deposits they get.  2) It increases the money held by the sellers of the assets and that might influence their behaviour.  3) It could bring down gilt yields.  4) It could bring down the cost of borrowing by corporates more directly. 

1) Encouraging Bank Lending

It could make banks want to use some (maybe most) of the extra M4 deposits to lend.  As the level of deposits (which are liabilities for that bank) increases, rather than simply park all this as a reserve asset with the central bank earning a very low rate of interest, the commercial bank might decide to lend this money out for a higher return.  The immediate impact of QE is to increase the liquidity of the commercial bank (it now has a higher amount of liquid assets and liabilities) and its wholesale funding gap (the gap between loans to customers and deposits from customers) has decreased.  As a result, it may feel more comfortable holding assets which are less liquid (e.g., loans to companies and households).  How likely this is, however, would depend on why the bank was not lending to them in the first place.

2) It Increases the Money Held by the Sellers of the Assets

The sellers of the assets concerned receive money (cash). The question is, what do they do next?  Clearly, what the sellers of assets to the central bank decide to do with the proceeds is important.  The positive impact of this on the real economy would be more powerful, the less cash-like the original asset purchased by the Bank of England was.  If a pension fund, for example, were to receive cash for a cash-like asset (e.g. short-dated gilts), it is not obvious that it will go out and buy corporate bonds or commercial property.  It would be more likely to look to buy such assets if the asset purchased by the central bank were further out along the risk curve.

In the case of the central bank buying gilts (and especially short-dated gilts), one very liquid asset is simply being swapped for another.  Therefore, in and of itself, the seller’s behaviour is unlikely to change much.  Further, the new cash holdings are unlikely to be in the hands of ‘cash strapped’ private non-financial corporates or households (but are rather more likely to go into the hands of other financial corporations, for example pension funds, insurers and hedge funds).

If the assets the central bank buys are not close substitutes for cash, it is more likely that their price would rise significantly.  And their sale might prompt the seller to use the cash to buy other assets − for example corporate bonds − that would then affect the prices of those assets and help get cash to the non-financial corporate sector. None of this is likely to be very powerful if the central bank buys short-dated gilts. 

3) It Could Lower Gilt Yields

Purchases of gilts in a size sufficient to significantly increase the money supply would probably be big enough to lower gilt yields (see Embarking on Unconventional Measures, February 11, 2009 by M. Baker, M. Gargh et al.).  In itself, this benefits current holders of gilts and makes it cheaper and potentially easier for the government itself to borrow. 

4) It Could Directly Bring Down Lending Costs of Corporates

Quantitative easing may be done (at least partly) through purchasing corporate bonds or commercial paper.  Purchases of such assets are likely to increase their liquidity, increase the confidence of other investors in the market that they can sell such assets and therefore potentially make it easier for companies to issue such instruments.  It also transfers risk from the private to the public sector (the Bank of England takes on credit risk that it does not in the case of buying gilts).  Purchases of such private sector securities, whether sterilised or not, have been dubbed by some as ‘qualitative easing’.  In fact, the government has already gone down this road (with sterilised operations by the BoE on behalf of the government as part of the £50 billion Asset Purchase Facility). As noted, the cost of corporate borrowing could also be bought down indirectly through channel 2.

Why Might QE Prove Ineffective? 

Just because M4 increases, that doesn’t mean it has any substantive impact on the wider economy.  In particular, unsterilised purchases of assets would not necessarily mean banks lend more even though they get more deposits.  Whether that works depends on why they are not lending now.  Is it a lack of funding or concern that the likely return on new lending is poor because of the economic outlook and the overstretched balance sheets of potential borrowers?  No one has a good idea on which of these is the dominant factor today, and so we cannot have a lot of faith that quantitative easing will directly boost lending. 

1) The Money Generated May Stay Out of the ‘Real Economy’

The money generated from quantitative easing may plausibly remain within the non-bank financial sector (who are large holders of the gilts that the Bank of England will want to purchase) and the banks.  The money could also go to the overseas sector (another substantial holder of gilts).  This money might be held offshore in sterling or be converted into foreign currency, resulting in a (potentially helpful) exchange rate effect, but still no guarantee that the money would end up in the hands of households and non-financial companies. 

2) Banks Can Hoard the Money

Banks could just hoard the money in Bank of England reserves, earning the current policy rate (or, potentially in the Bank of England’s operational standing deposit facility earning the policy rate minus 25bp).  (Each reserves period runs between the monthly scheduled MPC meetings, and reserve scheme members undertake to maintain a level of reserves within a percentage range of a target they choose (averaging across reserve balances at the end of each calendar day over the whole monthlong period).  This percentage band is +/-10% currently.  The banks can use the Operational Standing Facilities to give banks a means to manage unexpected ‘frictional’ payments shocks.)  Alternatively, the banks may not want to hold the extra deposits as reserves and that would effectively push short-term money-market rates to zero (which they are near already).  However, the incentive to do this may not be big given high levels of uncertainty over the UK economy and banking system and when reserves at the central bank earn interest.

There is already evidence that the operational standing deposit facility has been used substantially in recent months (£5 billion, averaging holdings over the month in December and January).  The Bank of England could discourage this from happening by, for example, changing the rate at which deposits above reserve levels are remunerated or (more extremely) by removing the operational standing deposit facility altogether.  The Bank of England already reserves the right to “seek to satisfy itself that the use of the facility is consistent with (that facility’s) purposes”.  The Bank might also consider making the reserves that commercial banks hold with the Bank of England pay less, or no, interest and make the level of reserves held by the commercial banks less discretionary.  They could then seek to reduce the level of reserves being held if it felt that reserve levels had become excessive.  This would require a significant shift in the way the Bank of England currently operates.

3) Communication and Expectations

Quantitative easing may be more difficult to monitor and understand than changing the policy interest rate.  Signalling may also be problematic.  Depending how their strategy is communicated by the MPC (and the language that the government uses), this could have a significant impact on perceptions of Bank of England independence.  Effects of quantitative easing on bond yields and asset prices will partly depend on expectations about when and to what degree quantitative easing will be rolled back.  Those expectations will depend on how the MPC communicates its quantitative easing strategy.  It is not clear how the MPC will approach these issues; we may get the first indicator as early as March 5 when the MPC may formally embark on quantitative easing.

4) Regulation and Fiscal Policy

-           FSA regulatory change.  Forthcoming regulatory changes mean that banks will need to hold significantly more liquid assets (and in particular gilts) than they do currently (see Regulatory Upheaval for Banks and Gilts by Laurence Mutkin, February 23, 2009).  That gives the banks an additional incentive to either park the deposit inflows that they get as a result of QE as reserves at the central bank. Or they might simply try to buy more gilts.  This makes it harder to argue that the first priority of banks will be to lend some of the money out. 

-           Government planned gilt issuance.  By buying in the secondary market, the Bank of England is indirectly monetizing the deficit (Maastricht rules would prevent it from directly financing the deficit).  There is a danger with any quantitative easing that a finance ministry takes the opportunity of its central bank buying more government bonds to issue more bonds (pressuring the central bank into yet more quantitative easing).  Central Bank financing of fiscal stimulus, however, would be potentially very powerful (and analogous to previously mentioned helicopter drops). 

The Relationship Between Money and Output/Prices

There is an accounting identity – and no more than that – linking a measure of the stock of money (M) and the level of nominal incomes. This is: MV = PT, where M = money, V = velocity of money (the frequency of which money is spent), P = the price level and T (or Y) = the level of real transactions/output.

Quantitative easing is likely to be successful in raising M, but it could simply reduce V if the sellers of assets to the central bank are happy to see the funds switched into bank deposits and sit there (as ‘money’, M).

But, V may not fall, and this is why quantitative easing is worth trying…because if MV does rise, then with real income growth depressed, it is highly likely that it will mean that T (real incomes) will rise rather than largely feed through to higher prices (P).  

How Should the BoE Proceed?

While we are sceptical on how effective quantitative easing will be, that does not mean we don’t think it is worth trying.  In particular, we are much less sceptical about the merits of so called qualitative or credit easing (buying a variety of private sector assets) than about ‘pure’ quantitative easing (just gilt purchases).  In our view, the Bank of England should decide to start buying gilts at its meeting on March 5.  It should continue purchasing privately issued assets as part of the APF alongside this, and when the initial £50 billion limit of the APF is reached, continue buying such privately issued assets on an unsterilised basis (alongside gilt purchases).  In terms of scale, asset purchases of around £40 billion would increase M4 (excluding bit held by financial firms) by 2-3% (assuming the money works its way out of the non-bank financial sector).  That would raise the growth from around the current level of just under 3%Y to a level between 5% and 6% − which is more consistent with trend growth and inflation at the target level.  Of course, if only a fraction of the QE fed through to bank deposits of the non-financial private sector, it would need to be done on a larger scale.

The Bank should also consider changing the incentives for banks to hoard cash, e.g., changing reserves procedures and deposit rates on standing facilities (if they haven’t already). 

Conclusion

We think the Bank of England don’t really have much to lose by trying quantitative easing (partly because it can quickly be reversed).  Quantitative easing should succeed in increasing M4 money supply.  But that does not mean it will have worked.  We think that there are two main factors that will determine how successful quantitative easing is in the UK: 1) what banks do with the money; 2) how close to cash is the asset the central bank purchases?  The less cash-like is the asset purchased, the more likely it will affect the behaviour of the seller and have a price and liquidity effect on that asset.

Asset Price Implications

For gilts, quantitative easing should be a positive, in our view.  Our interest rate strategists think that the Bank of England will buy gilts throughout the curve.  Coupled with the significant buying they expect to see from the banks (see again Regulatory Upheaval for Banks and Gilts by Laurence Mutkin, February 23, 2009), this buying should amount to a significant amount of demand, a countervailing force to the large amount of gilts the government will have to sell in the coming year.  They expect gilts to outperform other assets including both swaps and overseas government bond markets.

For equities, the effect of quantitative easing is less direct – since central bank buying of shares is a relatively remote prospect whereas buying gilts looks imminent.  Clearly, if QE does help make the recession less deep and more short-lived, it will be a positive for equities.

The downside risk in all this is that the credibility of the inflation targeting regime is undermined. But we see inflation pressures in the UK as very subdued; and QE can be reversed in due course.  Consequently, we see these downside risks as small.

Important Disclosure Information at the end of this Forum

Disclosure Statement

The information and opinions in Morgan Stanley research were prepared or are disseminated by Morgan Stanley & Co. Incorporated and/or Morgan Stanley C.T.V.M. S.A. and/or Morgan Stanley & Co. International plc and/or Morgan Stanley Japan Securities Co., Ltd. and/or Morgan Stanley Asia Limited and/or Morgan Stanley Asia (Singapore) Pte. (Registration number 199206298Z) and/or Morgan Stanley Asia (Singapore) Securities Pte Ltd (Registration number 200008434H) and/or Morgan Stanley Taiwan Limited and/or Morgan Stanley & Co International plc, Seoul Branch, and/or Morgan Stanley Australia Limited (A.B.N. 67 003 734 576, holder of Australian financial services licence No. 233742, which accepts responsibility for its contents), and/or Morgan Stanley India Company Private Limited and their affiliates (collectively, "Morgan Stanley"). As used in this disclosure section, Morgan Stanley includes RMB Morgan Stanley (Proprietary) Limited, Morgan Stanley & Co International plc and its affiliates.

Global Research Conflict Management Policy

Morgan Stanley Research observes our conflict management policy, available at www.morganstanley.com/institutional/research/conflictpolicies.

Important Disclosures

Morgan Stanley Research does not provide individually tailored investment advice. It has been prepared without regard to the circumstances and objectives of those who receive it. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages them to seek a financial adviser's advice. The appropriateness of an investment or strategy will depend on an investor's circumstances and objectives. Morgan Stanley Research is not an offer to buy or sell any security or to participate in any trading strategy. The value of and income from your investments may vary because of changes in interest rates or foreign exchange rates, securities prices or market indexes, operational or financial conditions of companies or other factors. Past performance is not necessarily a guide to future performance. Estimates of future performance are based on assumptions that may not be realized.

With the exception of information regarding Morgan Stanley, research prepared by Morgan Stanley Research personnel is based on public information. Morgan Stanley makes every effort to use reliable, comprehensive information, but we do not represent that it is accurate or complete. We have no obligation to tell you when opinions or information in Morgan Stanley Research change apart from when we intend to discontinue research coverage of a company. Facts and views in Morgan Stanley Research have not been reviewed by, and may not reflect information known to, professionals in other Morgan Stanley business areas, including investment banking personnel.

To our readers in Taiwan: Morgan Stanley Research is distributed by Morgan Stanley Taiwan Limited; it may not be distributed to or quoted or used by the public media without the express written consent of Morgan Stanley. To our readers in Hong Kong: Information is distributed in Hong Kong by and on behalf of, and is attributable to, Morgan Stanley Asia Limited as part of its regulated activities in Hong Kong; if you have any queries concerning it, contact our Hong Kong sales representatives.

Morgan Stanley Research is disseminated in Japan by Morgan Stanley Japan Securities Co., Ltd.; in Canada by Morgan Stanley Canada Limited, which has approved of and takes responsibility for its contents in Canada; in Germany by Morgan Stanley Bank AG, Frankfurt am Main, regulated by Bundesanstalt fuer Finanzdienstleistungsaufsicht (BaFin);in Spain by Morgan Stanley, S.V., S.A., a Morgan Stanley group company, supervised by the Spanish Securities Markets Commission(CNMV), which states that it is written and distributed in accordance with rules of conduct for financial research under Spanish regulations; in the US by Morgan Stanley & Co. Incorporated, which accepts responsibility for its contents. Morgan Stanley & Co. International plc, authorized and regulated by Financial Services Authority, disseminates in the UK research it has prepared, and approves solely for purposes of section 21 of the Financial Services and Markets Act 2000, research prepared by any affiliates. Private UK investors should obtain the advice of their Morgan Stanley & Co. International plc representative about the investments concerned. In Australia, Morgan Stanley Research and any access to it is intended only for "wholesale clients" within the meaning of the Australian Corporations Act. RMB Morgan Stanley (Proprietary) Limited is a member of the JSE Limited and regulated by the Financial Services Board in South Africa. RMB Morgan Stanley (Proprietary) Limited is a joint venture owned equally by Morgan Stanley International Holdings Inc. and RMB Investment Advisory (Proprietary) Limited, which is wholly owned by FirstRand Limited.

Trademarks and service marks in Morgan Stanley Research are their owners' property. Third-party data providers make no warranties or representations of the accuracy, completeness, or timeliness of their data and shall not have liability for any damages relating to such data. The Global Industry Classification Standard (GICS) was developed by and is the exclusive property of MSCI and S&P. Morgan Stanley bases projections, opinions, forecasts and trading strategies regarding the MSCI Country Index Series solely on public information. MSCI has not reviewed, approved or endorsed these projections, opinions, forecasts and trading strategies. Morgan Stanley has no influence on or control over MSCI's index compilation decisions. Morgan Stanley Research or portions of it may not be reprinted, sold or redistributed without the written consent of Morgan Stanley. Morgan Stanley research is disseminated and available primarily electronically, and, in some cases, in printed form. Additional information on recommended securities/instruments is available on request.

The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (DIFC Branch), regulated by the Dubai Financial Services Authority (the DFSA), and is directed at wholesale customers only, as defined by the DFSA. This research will only be made available to a wholesale customer who we are satisfied meets the regulatory criteria to be a client.

The information in Morgan Stanley Research is being communicated by Morgan Stanley & Co. International plc (QFC Branch), regulated by the Qatar Financial Centre Regulatory Authority (the QFCRA), and is directed at business customers and market counterparties only and is not intended for Retail Customers as defined by the QFCRA.

As required by the Capital Markets Board of Turkey, investment information, comments and recommendations stated here, are not within the scope of investment advisory activity. Investment advisory service is provided in accordance with a contract of engagement on investment advisory concluded between brokerage houses, portfolio management companies, non-deposit banks and clients. Comments and recommendations stated here rely on the individual opinions of the ones providing these comments and recommendations. These opinions may not fit to your financial status, risk and return preferences. For this reason, to make an investment decision by relying solely to this information stated here may not bring about outcomes that fit your expectations.