The Bank of England is pursuing a policy of quantitative easing by buying assets (both corporate bonds and gilts) from non-bank financial institutions. The sellers receive bank deposits in exchange for their assets, thereby increasing the amount of money in the economy. In this way the Bank hopes to offset the deflationary pressures created by the collapse in bank lending.
At some point in the future, bank lending will recover and the velocity of money will increase. The Bank will then wish to reverse the quantitative easing process in order to mop up excess liquidity and avoid high inflation. It can do so by selling the bonds it holds back to non-bank financial institutions, thereby reducing their bank deposits.
But selling these assets will be far more difficult if the market for gilts is already saturated as a result of very high levels of government borrowing. The government is likely to have to raise in excess of £150 billion a year in the medium term. A key question is whether it will be possible for the Bank to sell its assets on top of this, without bond yields rising significantly. If investors are not reassured that quantitative easing is being reversed quickly enough then they may also demand higher yields in the form of an inflation risk premium.
Given high levels of debt, such a rise in bond yields will, of course, damage the prospects of economic recovery – perhaps causing a double-dip recession – and put further strains on the banking sector. It could also prove difficult for the government to service its own repayments. This is the reality of the government massively increasing its borrowing. One way or another, life must be made more difficult for the private sector – in the medium term if not sooner. Indeed, all these pressures may lead to the government inflating away its debts – thus justifying the market’s fears of higher inflation.
Given these horrific risks, the government needs to act quickly. It needs to reassure the markets by slashing its borrowing. This means large spending cuts in the forthcoming Budget. Fiscal policy is set to run against the grain of monetary policy if government spending is not reined in.