Alistair Darling paved the way on Thursday for Britain to start creating money to fight the recession – agreeing that the Bank of England should remain in the driving seat in any radical new phase of monetary policy.
Some City analysts believe that quantitative easing – a policy often described as “printing money” – could start within months, as the Bank exhausts its ability to cut interest rates to stimulate the economy.
The rate currently stands at 1.5 per cent.
In an exchange of letters on Thursday with Mervyn King, the Bank’s governor, the chancellor agreed a framework for the operation of such policy, under which the Bank would create money on its balance sheet to purchase assets.
Mr King has fought to ensure that in the event of the Bank having to create money, its monetary policy committee should maintain a high level of independence – even though the credit risk and fiscal implications of such a policy will fall on the taxpayer.
Mr Darling said on Thursday that it would be for the MPC to request the new powers to create money. Although he would retain a veto, his officials say that, in practice, it would never be exercised.
The chancellor said he would keep parliament informed and would tell MPs if he had agreed that the Bank could expand its fund for the purchase of assets.
The Conservatives argue that “printing money” is the ultimate expression of economic failure.
In his letter, Mr King gave the impression that he expected Mr Darling’s consent for quantitative easing to be forthcoming.
“I would inform you so that you could authorise the changes to the scale and operation of the facility that might be required,” he said.
Separately, the letter exchange set out the range of assets the Bank was expected to buy under a £50bn ($71bn) asset purchase scheme.
This programme to inject liquidity into the economy will not initially increase the money supply because it will be financed by the issuance of government bills.
Mr King made clear that the Bank would purchase a wide range of assets, including corporate bonds that were rated much lower than the top triple A rating but still qualified as investment grade.
This took some economists by surprise, as the Treasury had indicated that only assets of “high quality” would be purchased.
The Bank will publish details of the operation next week. However, it is expected that the facility will focus on the corporate sector and is unlikely to involve the purchase of securities backed by home mortgages.
Philip Shaw, an economist at Investec Securities, noted that the size of the asset purchase programme could have a significant effect on bond prices. He estimated that investment-grade sterling bonds totalled £325bn, allowing the Bank to purchase almost a fifth of all outstanding securities.