An Agenda for Gold?

For those familiar with this blog, they will know that I am not overly supportive of a gold standard currency, but that I think that it is better than the current fiat money system (see here for my alternative). As things stand, we can now see the dangers in the current fiat system, which is the ongoing debasement of many currencies through money printing (QE- Quantitative Easing).

It never does any harm to emphasise the point that so-called QE is absolutely no different from running a physical printing press, even though there are occasional commentators who try to suggest it is different. Creating money by electronically crediting a bank with previously non-existent money is no different from running a printing press and shipping the newly printed money into the bank's vault. In both cases, money is created and an asset is purchased. It is just that the former does so without the bothersome necessity of running a physical printing press. I suspect that, if the central banks were to be undertaking the old-fashioned printing press method, there would be greater outcry against the policy of QE. Trucks filled with newly printed money arriving at banks would focus minds and attention on what is taking place. As it is, the modern method of money printing is just abstract enough to obscure the reality of what is taking place.

However, it seems that commentators are now starting to see that there is something wrong with the new policy of printing our way out of troubles, and the gold standard is moving up the agenda. This from Forbes:

There is nowhere left to hide. America’s governing elites begin to internalize the magnitude of their failure to generate jobs. CBO now predicts worse than 8% unemployment until 2014. America begins to engage, seriously, with the implications of the faltering dollar and reconsider the appeal of the gold standard. From The New Yorker to The National Interest to The Washington Monthly to The Nixon Foundation, thoughts turn to gold.

The linkage between returning to a gold standard and the urge to print money is obviously related. Once again, there is talk of printing money in the US, or QE3:

As Wall Street parses the message the Federal Reserve chairman sent in his speech Friday from Jackson Hole, the narrative that has taken hold includes, on one level or another, more action to help boost the markets and the economy.

That was supported Monday with key endorsements from Fed presidents Charles Evans and Narayana Kocherlokota, who both said they either would support further monetary measures or a continuation of the ones already in place.

Whether future moves come in the form of traditional quantitative easing or something else is what Bernanke and other Fed officials must decide between now and the next Open Markets Committee meeting on Sept. 20. The expectation for easing was heightened when Bernanke said the meeting would be extended from one to two days, indicating that serious consideration would be given to additional monetary measures.

The UK is also flirting with another round of money printing, with this from the Guardian:

Hopes of a fresh round of quantitative easing in the UK increased on Thursday after Martin Weale, of the Bank of England's monetary policy committee (MPC), used a speech in Doncaster to say there is "undoubtedly scope" for the radical recession-busting policy to be extended.

Weale, who was one of two hawks advocating an increase in interest rates until he changed his vote at this month's meeting, said the Bank could restart quantitative easing if oil prices continue to fall and the sovereign debt crisis in the eurozone worsens.

Warning that events on the continent are a greater threat to the UK economy than the slowdown in America, Weale said: "There is undoubtedly scope for further asset purchases to trigger further reductions in yields on government debt should the need arise."

The European Central Bank (ECB) is more constrained, with an inbuilt philosophical opposition to printing money:

New York professor Nouriel Roubini called on the ECB to reverse monetary tightening immediately given the darkening global picture. "It should reduce rates to zero, and make big purchases of government bonds," he said.

Frankfurt is unlikely to heed the advice. The bank's president Jean-Claude Trichet, last week stuck to his anti-inflation script and said "we do not do QE".

The ECB began buying Spanish and Italian bonds for the first time yesterday, causing 10-year yields to plunge by 90 basis points. However, an ECB statement over the weekend came with too many strings to satisfy investors. The bank is likely to be tested over coming weeks.

David Marsh, co-chairman of OMFIF, said the statement was "half-hearted" and suggested that dissenting German hawks were imposing limits. "The ECB is clearly not going in with all guns blazing," he said.

Notwithstanding the growing discussion of a gold standard, one of the great curiosities about QE is how it has now entered into mainstream commentary as if it were a perfectly reasonable thing to do. There are all sorts of justifications given for the policy, but the lack of any remit for central banks to undertake the policy is quietly ignored or forgotten. The most obvious case of this is the Bank of England, which is supposed to use monetary policy to target inflation. Despite several years of overshooting the inflation target, as can be seen from the earlier quote, QE is back on the agenda in the UK. How is it that the Bank of England's remit is forgotten by so many commentators?

It seems that there is a growing divide in mainstream commentary on the policy of printing money, with some expressing fear about the consequence of the policy and moving back to the idea of a gold standard, and others supporting the policy as a magic bullet for the economic woes that are assailing so many economies. At the heart of the debate is the question of inflation, with those who are anti-QE arguing that it is inflationary, and those in favour suggesting that the lack of massive inflation following early QE demonstrates that the fears of inflation are exaggerated. A good explanation comes from Liam Halligan:

The reality is QE has already done an awful lot of damage. America has expanded its base money supply three-fold in two and a half years – from 6pc to 18pc of national income. But even this jaw-dropping measure hasn't led to much of an expansion in monetary measures, such as M2 that include bank lending, precisely because the banks, for all the propaganda to the contrary, are still determined not to lend. They can make more money simply channelling QE money into stocks and other investments.

Crucially, the banks also remain petrified of counter-party risk in the inter-bank market. Many of them, disgracefully, are still concealing vast sub-prime losses in off-balance-sheet vehicles. So they assume other banks are doing the same. Such mistrust between the banks – "we're lying, so they must be lying" – gums up the wheels of finance and starves even creditworthy firms of the funds needed to invest and create jobs.

That's why M2 has remained flat, despite a massive expansion of base money. The way to break the deadlock, though, isn't to do more QE, but to end inter-bank torpor by forcing "full disclosure" of bank losses. Such disclosure is barely happening, on either side of the Atlantic. The UK's monetary base has also tripled, while producing – for the same non-disclosure reasons as in the US – only minimal growth in M2.

Liam Halligan has captured one element of the reason for the lack of inflation, and another is the exporting of inflation through the 'carry trade', as the Wall Street Journal reports:

For much of the past two years global investors borrowed dollars and Japanese yen at the rock-bottom interest rates set by the U.S. Federal Reserve and the Bank of Japan and then poured that cheap money into currencies like the Australian dollar and Mexican peso to earn much higher interest rates.

Now, those popular "carry trades," which profited from a difference in interest rates as high as 12 percentage points in Brazil's case, are starting to unwind as investors lose faith in the outlook for global growth and fret over financial turmoil. If it continues, it will bring an end to a rally in emerging market and commodity-based currencies that began shortly after the Fed slashed rates to near zero at the end of 2008 and it could drive up borrowing costs for banks, companies and even households in those countries.

That unwinding could be cut short if the Fed's announcement Tuesday that it would keep its target interest rates at "exceptionally low" levels "at least through mid-2013" makes carry trades attractive again. But the problem with the strategy is that it is only profitable if currencies are either stable or if the funding currency is falling against the investing currency. And if the past week's bout of global financial turmoil persists and puts emerging market and commodity currencies under more pressure, many investors will be forced to throw in the towel and buy back dollars.

The problems of the carry trade for the recipients has led to reactions to try to prevent the inflows of 'cheap' money, such as Brazil establishing capital controls:

Brazil has been vocal on one of the themes put on the table by France as G-20 chair: how to better police capital flows globally. Several emerging countries, including Brazil, have been faced with buoyant capital flows in search of higher yields, which have put upward pressure on their currencies and hurt their exports.

Countries have reacted by imposing capital controls or intervening on their currency in a unilateral way. This has prompted the G-20 to try and coordinate capital controls better, so as to avoid adverse impact on growth from disorderly moves.

This is what I had to say in TFR magazine in December 2009:

But there is also another factor, there is increasing talk of a US dollar ‘carry trade’, as a result of dramatically increased liquidity combined with near zero interest rates.

The idea is simply that a good return on investment can be made by borrowing at a low interest rate in one country, and investing in another that has a higher interest rate. In doing so, the inflationary effects of printing money are exported to the country that is the destination for the carry trade.

This was what happened when Japan resorted to quantitative easing, with the printed money going west in the yen carry trade, acting as one of the sources of excess liquidity for the credit bubbles that burst in 2007 and 2008. There is less talk of a sterling carry trade, but it’s fair to assume that, with monetary circumstances similar to the US, something similar may be taking place there (albeit on a much smaller scale).

The interesting point here is that, as a result of the carry trade, Japan itself did not experience the inflationary effects of printing money. The case of Japan is cited as the reason why inflation will not take place in the UK and US. However, there is a fundamental difference between the UK, the US and Japan.

During the period of the carry trade, Japan was generating a large current account surplus, so the flood of yen onto the market did not result in significant currency weakness. By contrast, both the UK and US have been (and continue) to run large current account deficits. In both cases the currency is already sitting on weak foundations and, therefore, export of the dollar and sterling into the carry trade will simply put more pressure on the value of those currencies. They are flooding the market with currencies for which there is already a potential over-supply.

What we can see is a problem looming on the horizon. Output in both the UK and US has fallen (and is still falling in the UK), which means that some of the effects of the reduction in credit are already ‘eaten up’.

Furthermore, the governments of both countries are stepping in to fill the void of private credit contraction with government borrowing. If the money sitting in central banks were to enter into the economy, there would be a real increase in the money supply and this would cause rapid inflation. On the other hand, if the money exits the economy via the carry trade, it will severely weaken both nations’ currencies and re-enter the economy through the back door of import-price inflation.

At the moment, the increase in money has not entered into the real economy, but it will do at some point. I suspect that it will be through the back door of the carry trade.

What we can see in Liam Halligan's analysis and my own explanation is the reason why it is that we do not currently see massive (or hyper) inflation in the money printing economies. However, what we can also see is the potential for inflation to start a rapid upwards climb in the QE economies. The only way that the money supply might be reduced is to reverse the QE, which would mean selling the government bonds that have already been purchased and destroying the proceeds of the sale. Could markets absorb such a sale when government debt is already flooding the markets? It seems improbable.

For the proponents of QE, the lack of massive inflation is used as a justification for continuation of the policy. For those who are arguing for a return to gold, they can see that somehow, at some point in time, the massive expansion of the monetary base in QE countries must eventually see a rise in inflation. For the latter, they are not always clear in their understanding/explanation of why massive inflation has not taken place. However, their instinct that QE must eventually have a price is correct. Furthermore, the price is already being paid around the world as easy money has flooded into other economies. That in turn is creating distortions in markets, and those distortions will ripple back towards the countries that caused the problem in the first place. Again in TFR, this is what I had to say about 'extreme policy' in the context of the 'carry trade':

From enactment to (unpredictable) result, there is a period during which the effects of the policy build and interact with the results of other policies and the markets, both domestic and international.

It can therefore often take a long time before the full effects become apparent. As they do become apparent, the other actors respond with their own policy provision, and the effects of that policy will again take time to impact.

Among all of the major economies, the responses to the economic crisis have been extreme policy making. We are only now seeing the full impacts of those policies, and the reactions to those policies are building. The underlying problem is that, the more extreme the policy of one actor, the more likely that the response of another actor will be extreme. The world economy is a dynamic system, and the actions of each policy will, in the end, lead to a response from other actors in the world economy.

As such, when actor ‘A’ pulls on policy lever ‘X’, they really cannot see the outcome of their own actions. The larger the actor, and the more extreme the policy, the greater the chance that the reaction of other actors will also be extreme. The greater the reaction of these actors, the greater the reaction that will be forthcoming in response.

And so it continues, creating an ever more unstable system; the more the levers are pulled, and the harder that they pull on them, the greater the potential for the policy intentions to be confounded, and the greater the general instability.

We can see this instability taking place. We see, for example, the Swiss taking ever more radical measures to try to lower the value of their currency in the face of the 'safe haven' purchases of their currency. We can see the instability in the surge in the gold price. We can see the instability in the on-off panics in markets. Every day we see more examples of the instability.

One way or another, the effects of extreme policies such as QE ripple out into the global economy, only to eventually wash back in unpredictable forms. The great conceit of the policymakers is that they think that they know what they are doing. In the end, the call for a return to a gold standard is really a call for the policymakers to take their hands off the levers of monetary policy, as they do not really understand what happens when they pull on the levers.

Bank of England Bills and Printing Money

Regular readers may remember that, some time ago, I sent some questions to the Bank of England regarding quantitative easing (QE - printing money), following an offer by the deputy governor to answer QE questions. I sent an email on July 16th, and now have a response. Before looking at the reply, these were my questions:

1. Reuters has reported on the 9th July that, following no announcement of an extension of the policy of QE by the Bank of England, bond yields rose sharply. Bearing in mind that just the possibility of an end to the policy caused this reaction, does this not suggest to you that QE is propping up the Bond Market?

2. The CPI has finally dipped below the 2% target that the Bank of England uses in setting monetary policy, but is still not far enough off target to require a letter of explanation. I believe that the Governor of the Bank of England has identified QE as an untried unconventional policy with uncertain outcomes. Bearing in mind that during all but the last week, CPI has not fallen below target, how can such an untested policy be justified? In particular, with monetary stability as a key aim, how can such an unconventional policy be justified?

3. With regards to exit strategies for QE, the Bank of England Quarterly Bulletin for 2009 Q2 states that 'Alternatively, the supply of reserves could be reduced without asset sales, through the issuance of short-term Bank of England bills.' Is this policy? If so, can you confirm exactly when and under what circumstances you will finally sell the gilts that have been purchased?

4. A secondary question as a follow on to question 3. If the purpose of QE is not to monetize government debt, then why would you not sell gilts at the end of QE policy? Do you have concerns that the existing expansion of gilt issuance would preclude the sale as the sale might destabilise the gilt market? Is this not a recognition that the gilt market can not support the level of issuance?

The BoE took the trouble to write to me with some answers in an email but, they also referred me to other general answer to questions on their website, pointing me to answers 1, 6, 11 and 13 in particular. I will use the answers from the email and some of the general answers in this post, but you may wish to see the originals general answers in full.

The first point to note is that there was no direct answer to my question (1) in any of the answers that were provided. It appears that the Bank of England does not want to comment on whether they might be propping up the bond market. It might be argued that, in purchasing bonds, the intention is to hold down yields, but I think the implication of a spike in yields on a mere sniff of an end to QE goes beyond this. The question is, of course, an indirect way of asking whether the BoE is monetising government debt. This they have answered, and this is from the email they sent:

Quantitative easing has not been carried out to help the government meet its financing needs, and asset purchases by the Bank have not been made to keep gilt yields at a particular level. Other things being equal, yields can be expected to fall in response to the Bank’s gilt purchases.

In the general answers, they add that monetization of government debt would infringe upon article 101 of the Maastricht treaty, and that they are not being forced to make up a shortfall between government debt and expenditure:

The key point is that the Bank is not being forced to create money in order to cover the gap between the government’s tax income and its spending commitments. If it were carried out to finance the budget deficit, it would be a violation of Article 101 of the Maastricht Treaty (which the United Kingdom must abide by, even though it is not a member of the euro zone). [...]

Central banks routinely buy and sell government debt in the secondary market as part of their normal operations in the money markets and such operations are not deemed to amount to monetary financing under the Maastricht Treaty.

The interesting word in this answer is forced, as it is not apparent where this word has come from. This is the original article 101:

1. Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments.

2. Paragraph 1 shall not apply to publicly owned credit institutions which, in the context of the supply of reserves by central banks, shall be given the same treatment by national central banks and the ECB as private credit institutions.

The interesting point in this article is that the direct purchase of government debt is actually prohibited, but there is nothing to prevent indirect purchases (as they point out). At the same time, it is not apparent where this idea of 'forced' has appeared from. The implication of this is that, if the BoE were to monetize debt without being forced, this would all be right and proper. It is a most puzzling answer...

With regards to the question about why the policy is being enacted whilst CPI has barely moved below target, this is the answer in the email:

The objective of the MPC remains to hit the Chancellor’s 2% CPI inflation target. Therefore the MPC continues to focus on the medium term prospects for inflation when setting monetary policy. The MPC judged in March that in the absence of a further monetary policy stimulus, the growing margin of spare capacity created by the recession would push inflation significantly below the target in the medium term. With Bank Rate already almost as low as it could go, the MPC decided that a substantial stimulus through quantitative easing was warranted. That was the reason for embarking on unconventional monetary policy. Central banks routinely buy and sell government debt in the secondary market as part of their normal operations in the money markets. What distinguishes quantitative easing from normal operations is their scale and the length of time for which the assets are likely to be held.

There is nothing new in this answer. The BoE been wrong in their inflation forecasts up to now, such that the expected fall in the CPI has not taken place ....it is not clear therefore why QE is still being enacted, as it is freely admitted that it is 'unconventional' and therefore carries with it risks that are unknown? Under their own considerations, it will take at least 6 months for the impact of the policy to be felt, so it is not the policy that has prevented deflation. Deflation has simply not happened.

Questions (3) and (4) generated some interesting answers, with this from the general answers:

When it comes to tightening policy, the MPC will have two instruments available: raising Bank Rate; and selling back assets. Removing money from circulation can be achieved by selling the assets back to the private sector. The MPC will be likely to use a combination of raising Bank Rate and selling back assets, although the precise sequencing and the relative importance of the two instruments will be considered month by month at each MPC meeting. The Bank will seek to sell the assets it owns in an orderly fashion in order not to disrupt the market for government debt.

And this is the answer sent in the email:

The market for UK government debt is one of the deepest and most liquid financial markets in the world. Nevertheless, buying and selling large quantities of assets quickly is likely to influence prices.If the MPC decides that it wants to reduce the quantity of reserve balances held by the banks, it could issue Bank of England bills in exchange for the reserves, rather than selling the Bank’s holdings of government debt back to the non-bank private sector. The assets could then be sold back in an orderly fashion over a longer time period. Whether the Bank issues extra bills in exchange for the reserves or not will ultimately be a technical decision that will be taken with a view to market conditions at the time [emphasis added].

It is notable that they do not mention the sale of Bank of England bills in the general answers, but instead simply say they will sell 'assets'. It is apparent that I was correct in thinking that the BoE is not planning to sell the government debt back into the market for a long time, but is rather planning on tightening monetary policy through issuance of Bank of England bills. This is still not public knowledge, and I am uncertain that the distinction would be understood.

The BoE are right to assert that any quick sale of the bonds would influence prices, but this bumps up against a fundamental concern. How might the BoE sell the bonds into the market at any time during which there is already such massive issuance of new debt? How long will the BoE have to hang onto the government debt, and what market conditions might be considered opportune for selling the bonds?

The bottom line is that the BoE will not be reversing the QE policy in what might be seen as a conventional way (e.g. selling the original assets back). It might be argued that there is no conventional way in an unconventional policy, but I do not believe that open market operations, the nearest equivalent, would allow for assets to be purchased and held in this way. With such a radical policy, it would be expected that the BoE would have clear criteria for a return of the bonds to the market in an orderly way, and under what circumstances they might sell them.

The logic of QE is that, should an upturn in the money supply or inflation become apparent, they will need to reverse the policy. However, this would not mean an immediate tightening of the money supply, but would likely be a progressive tightening. Just as interest rates are not normally altered by large increments, or the policy of QE undertaken in one large 'dollop', there is no reason why the end of QE should be undertaken as a 'dollop'.

There is no discussion of any detail, because the Bank of England will certainly know that, with government issuance of debt flooding the market, there is absolutely no time in the foreseeable future at which they might offload the bonds without causing a crisis. The BoE's holding of government debt is simply too large...The only reason that any other method might be used for monetary tightening is that the amount of debt being issued by the government can simply not be digested by the markets. There is more debt being issued than demand. The BoE is simply filling the hole in demand.

As another concern, this is a quote from the general answers, on reselling of BoE holdings of bonds:

It is possible that gilt prices will fall, thus raising the corresponding interest rates, when the Bank starts to sell its holdings. Subject to achieving the 2% inflation target in the medium term, any sales will be co-ordinated with the Debt Management Office so as to limit any adverse impact on the functioning of the gilt market.

This should be a matter of some concern. The BoE will be co-ordinating the sale with the DMO, which is the arm of government that raises finance. There should be no direct linkage between the activity of monetary policy and the issuance of government debt. The BoE has no business in ensuring that the government might be able to finance their debts or at what rate, and is now admitting that their operations are now (at least partly) being controlled by the central government through the DMO.

This is the basic problem; if the government were not issuing too much debt, then there would be no need for the co-ordination, as a steady offloading of the debt would not unduly interfere with the market. Also, if a private institutions were to co-ordinate with the DMO there would be outrage. The BoE and the DMO acting together is, quite literally, rigging the market.

What we have is a situation where the BoE is preparing to find reasons to hang on to government debt, and to not return the debt to the market (where it belongs) without the permission of (sorry, co-ordination with) the DMO. All the while, they continue to purchase more debt, despite the fact that CPI is still at a level at which there is no need even for a letter of explanation.

Over and above the answers to my questions, there were some interesting points in the general answers. For example, they go to some lengths to distance themselves from the idea that what they are doing is a variant of the Zimbabwe problem. This is the disingenuous explanation:

In the Weimar Republic and Zimbabwe, the central bank printed money to finance government expenditure. This vastly increased the money supply, and hence prices rose rapidly. This is not happening in the United Kingdom. Here, the Bank is buying assets from the private sector to stimulate the wider economy, because otherwise we risk undershooting, rather than overshooting, the inflation target. Quantitative easing is not carried out to help the government meet its financing needs. When the economy recovers, most of the purchased assets will be sold back to investors, reducing the money supply.

Note the misdirection in suggesting that they are buying 'assets' from the public sector. Whether directly or indirectly, they are buying government debt, and therefore they are supporting the purchase of government debt. Note also, that they are talking of when the economy recovers, and also implying that they will sell the government debt back. However, the prospect of sales of Bank of England bills in place of reselling the bonds directly contradicts this.

The last quote is one which is not of great importance in the big picture, but is indicative of the way in which the BoE is trying to bury the simple fact that they are printing money.

What is the difference between reserve balances and printing money?

Reserve balances are, in effect, electronic money held only by commercial banks and can only be used to settle transactions between them and with the Bank of England. The Bank issues paper currency in response to the demand for banknotes from the public. But reserves and notes both represent claims on the Bank of England (‘central bank money’) and the banks can exchange the reserves for notes, although as they receive Bank Rate on their reserves they will only do this if the notes are needed to meet, for instance, withdrawals of deposits. When the Bank buys assets under its quantitative easing programme, the bank account of the seller goes up by the value of the sale and their bank simultaneously acquires an equal quantity of reserves.

How this might differ from running money off a physical printing press and depositing the money in the vault of the recipient bank completely eludes me. In both cases, the recipient bank has the money available to them to do with as they wish, including converting reserve balances into bank notes. The implication here is that a reserve balance is not printing money, and whilst technically correct (there is no physical printing press) the outcome is identical.

In amongst such obfuscation, I would just like to highlight the one useful new piece of information that has emerged. It is apparent that the BoE holding of government debt is not going to be returned to the market for a long, long time. Whilst they have not said this directly, I believe that their direction is pretty clear. Their explanation for why they might not sell back the bonds in a rush is plausible, but there is nothing that would stop them from steadily selling - if the market were not already flooded.

This is the key point. The BoE have been stepping in to support issuance of government debt which would otherwise almost certainly not find sufficient buyers. The issuance of debt from the government is ongoing, and there is therefore no opportunity to sell the bonds in the foreseeable future. The Bank of England is therefore engaging on a policy of purchasing government debt which it will hold over a long period, and it is doing it with printed money.

It is, quite literally, monetization of government debt and, even if it was started as inflation policy (unlikely), it is now the only thing that is preventing government bankruptcy. That the BoE must hold on to the debt is an indictment of the government, and their fiscal incontinence. I have long argued that this is a policy of debt monetization, and the use of BoE bills to reverse QE is just further confirmation.

Note 1: Despite my cynical view of the BoE policy, I am always impressed with their polite approach in their answers. As a strong critic of the BoE, this is to their credit.

Note 2: Please accept my apologies for the lack of replies to many comments. My 'real life' is very busy at the moment, such that I am very pressed for time. I have even been forced to rush this post, even though it is one of the subjects of particular interest to me, and would have preferred a better researched post (finding article 101 in EU documentation exacerbated the problem, as it was not very easy to find). I hope that the rush does not show.

Questions for the Deputy Governor of the BoE

I have long been arguing that the Bank of England's purchase of gilts with printed money (so called quantitative easing - QE), has supported the UK bond market and that the Bank of England has effectively been monetizing the debt of the UK government. In my most recent post on the subject, I identified that overseas holders were selling gilts to the Bank of England, and that QE was supporting prices. In a slightly earlier post, I showed how the Bank of England rationale for QE made no sense whatsoever, and that it was just a cover for propping up the massive UK fiscal deficits. My criticisms of the policy date back to before it was even enacted, and I even predicted that it might be enacted as the fiscal situation deteriorated.

The fig leaf for such monetization has been that the action has been taken to prevent deflation. However, it is only now that the CPI measure of inflation that is targeted by the Bank of England has finally fallen below the target of 2%. Even now, it is just undershooting slightly at 1.8%. Even at slightly below target, it is difficult to see why such a radical policy of QE might be justified, as such a level does not even require a letter of explanation to be written.

I have returned to this well worn subject as yet more evidence of the necessity of QE to support gilt prices has emerged. In an earlier post I speculated that the Bank of England might be losing patience with the government's fiscal incontinence, and they have recently put on hold the possibility of extending QE beyond the original £125 billion of the original policy. The result is reported in the following from Reuters:

Government bonds tumbled on Thursday, propelling 10-year yields almost a fifth of a point higher after the Bank of England announced no increase to its quantitative easing programme.

With the economy still reeling after its sharpest contraction in more than 50 years, markets had widely expected the central bank to increase its asset purchases by 25 billion pounds.

Traders fretted that its decision to leave the target unchanged meant the Bank's unprecedented scheme to buy assets, over 90 percent of which have been gilts, may soon be brought to an end.

Ian Kernohan, an economist at Royal London Asset Management, said the knee-jerk rise in gilt yields gave some indication of the size of the QE premium in gilt prices.

"The problem will be how to exit the QE strategy without causing a significant back up in yields and the cost of funding the government's deficit," he said.

The September gilt future settled 1.45 points lower, sharply underperforming the equivalent Bund future which fell just 24 ticks.

The key part of this article is that the fall was not as a result of the Bank of England stopping QE, but as a result of no announcement of an increase in the QE programme. As some of the analysts described it, it appears that there was a belief that it was just a delay in the announcement of an extension of the programme:

Some analysts saw this as a hint an extension to the programme had merely been delayed until next month, when it will be able to explain its actions more fully.

"This probably does not sound the death knell for QE," said Philip Shaw, chief economist at Investec. "Rather we expect an increase next month, when the monetary policy committee will have the benefit of a fresh set of inflation projections," he added. The Bank indicated that it would slow the pace of its gilt purchases, buying just 4.5 billion pounds of gilts next week. Since April, the central bank has been buying gilts at a rate of 6.5 billion pounds a week - roughly double the rate at which the government has been issuing them.

It is apparent that even a hint towards an ending of QE is enough to set the markets on edge. The result is that Charles Bean of the Bank of England has since needed to offer hope to the markets by saying the following:

"We haven't paused on QE. We are committed to buying 125 billion pounds of assets that will take us through to August," he was quoted as saying.

"We decided last week there was no need to make a firm decision. and we could afford to wait. August is when we publish papers on the economy and it's a natural point at which to take stock."

It is apparent that the state of the gilts market is now largely being determined by Bank of England purchases, and this really is the monetization of debt that I have long considered to be the result of the QE policy. The fragility of the gilt market, and the necessity for QE to support the market have been revealed.

One of my regular readers has identified that Charles Bean is taking questions on the policy of QE and suggested that I ask him some questions about QE. At this stage, this seems the best way of seeing how the Bank of England might justify the policy. As such, I have sent the following questions.

1. Reuters has reported on the 9th July that, following no announcement of an extension of the policy of QE by the Bank of England, bond yields rose sharply. Bearing in mind that just the possibility of an end to the policy caused this reaction, does this not suggest to you that QE is propping up the Bond Market?

2. The CPI has finally dipped below the 2% target that the Bank of England uses in setting monetary policy, but is still not far enough off target to require a letter of explanation. I believe that the Governor of the Bank of England has identified QE as an untried unconventional policy with uncertain outcomes. Bearing in mind that, during all but the last week, CPI has not fallen below target, how can such an untested policy be justified? In particular, with monetary stability as a key aim, how can such an unconventional policy be justified?

3. With regards to exit strategies for QE, the Bank of England Quarterly Bulletin for 2009 Q2 states that 'Alternatively, the supply of reserves could be reduced without asset sales, through the issuance of short-term Bank of England bills.' Is this policy? If so, can you confirm exactly when and under what circumstances you will finally sell the gilts that have been purchased?

4. A secondary question as a follow on to question 3. If the purpose of QE is not to monetize government debt, then why would you not sell gilts at the end of QE policy? Do you have concerns that the existing expansion of gilt issuance would preclude the sale as the sale might destabilise the gilt market? Is this not recognition that the gilt market can not support the current level of issuance?

I do not know whether I will get answers, but it is certainly worth asking the questions. I will update you on any reply that is made. In the meantime, it is apparent that the Bank of England is locked into QE if it does not want a collapse in the gilt market. They are faced with the tough choice of supporting government irresponsibility, or seeing a gilt market collapse and the resultant fallout for the £GB. On the other hand, if they continue, the situation can only get worse, as the economy slides further down, and government borrowing continues to climb.

It is a tough position to be in. However, I hope that they might conclude that it is better to face the problem now rather than later, at which point it can only be far worse.