June 27, 2013 7:09 pm

Ignore the pessimists – central banks are helping

Evidence for the creation of a bubble born of QE is far from convincing, writes David Miles
Sterling banknotes©Dreamstime

Much of the most vocal and opinionated analysis of the impacts of central bank asset purchases – quantitative easing – strikes me as somewhat contradictory. But it is also important and may explain the recent reaction, quite probably an overreaction, to limited news from the Federal Reserve on asset purchases.

Some people seem to believe that large-scale asset purchases by central banks have created bubbles in many markets and that stopping such purchases (let alone reversing them) must cause big falls in prices. Others take the view that these central bank purchases are ineffective in stimulating demand in the wider economy. I think the evidence for either of these positions is weak. But some people believe both things – a position that I think is also contradictory as well as being profoundly pessimistic.

The first claim – that QE has artificially boosted prices to bubble levels – does not stand up. It is certainly true that in purchasing financial assets, central banks – certainly the Bank of England’s Monetary Policy Committee – has deliberately and consciously raised the demand for these assets and that will have supported their price.

Supporting asset prices helps to support growth. It means that many companies find it easier to raise funds, and that many household borrowers face lower longer-term interest rates. And by keeping the value of portfolios of wealth higher than it would have been, the spending of many of the people who own that wealth is supported. Does anyone doubt that many of the households that have seen the value of their savings accounts and other stocks and bonds rise over the past year or so would have been less inclined to spend had these instead fallen sharply in value?

One of the ways that financial crises can have drawn-out consequences is when debtors’ balance sheets deteriorate as the assets that they hold lose value. This runs the risk of a negative self-reinforcing spiral – a worsening economic situation pushing down on asset prices further depressing demand. By supporting asset prices, QE has helped to ensure that this sort of negative spiral has not happened in the UK.

If QE had created a bubble, there would be a big risk that values will soon crash. And asset prices have fallen sharply over recent weeks as people reassess the scale of purchases by the Fed. Yet the evidence for a general bubble in asset prices is not very convincing.

It is true that until the very recent sell-off the FTSE All-Share index was about back where it was in the summer of 2007 – having fallen by about 40 per cent between mid 2007 and early 2009. But in real (inflation-adjusted) terms, stocks were still down by about 20 per cent from the level they reached in 2007. Price to earnings ratios on those stocks do not look unusually high.

Average house prices in the UK are – according to some national measures – only 5-10 per cent lower than the levels at the peak of early 2008. But, in real terms, they are down by about 25 to 30 per cent. Yields on government debt – both in nominal and real terms – are unusually low.

Part of that reflects a belief that central banks are likely to keep short-term interest rates at low levels for some time yet. Part of it is likely to reflect a substantially higher perceived level of risk now relative to before the financial train wreck of 2007-8. That puts a premium on relatively safe assets – such as gilts. So there are good reasons why yields on less risky government debt should be low.

I think some people are far too quick to label this a bubble – which I would define as a level of prices far removed from what can be expected given the fundamental economic forces at work in the wider economy.

Finally what is one to make of the uniquely pessimistic – but increasingly widespread – view that central bank asset purchasing has both created multiple asset bubbles while having no impact in boosting demand in the economy? What I find implausible about this is the idea that a rise in the value of assets, and a fall in the likely future return on savings, could have no effect on stimulating someone’s spending. You would need to believe that the wealth effect – the positive impact on confidence and spending that higher wealth brings – does not work at all. There is good reason to think that many people, particularly older people, will spend more if their assets rise in value.

Furthermore, to think that asset purchases do nothing to support demand in the economy you would also have to believe that investment was not at all responsive to a greater availability of funding at lower interest rates. Is that plausible?

A rather less sensational view on the effects of QE is far more plausible. Central bank asset-buying has supported a wide range of prices and this has caused spending to be higher than it would otherwise have been.

The writer is an external member of the Bank of England’s Monetary Policy Committee. He writes in a personal capacity.

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Letters in response to this article:

BoE’s research tells a different story / From Dr John E. Woods

Creating more money to buy gilts risks turmoil / From Dr Ros Altmann

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