John Hamilton, manager of the Jupiter Corporate Bond Fund, comments on the commencement of Quantitative Easing by the Bank of England.

In recent years, a substantial amount of funds for new lending came via the securitisation markets. Now, not only has this source of credit evaporated, banks have reined in lending too. With billions of pounds sucked out of the economy, it is not surprising the housing market has frozen and the slowdown seen in Q4 was so rapid. In order to maintain a reasonable level of demand and avert deflationary threats, something needs to replace this source of credit.

Just as a conjuror pulls a rabbit out of a hat, Mervyn 'the magician' King will now conjure money out of thin air. With today's half percent cut in interest rates the Bank of England has used up its conventional firepower in the fight against deflation and has now gone "unconventional". As a result of the credit crunch, the normal process of money creation via the commercial banks has stalled. The Bank of England has clearly recognised the need to supplement this by pumping extra money into the private sector.
 
Whereas investors used to judge the tightness/laxity of monetary policy by the level of interest rates, they will now also have to consider the effect of the additional quantity of money supplied by the Bank. This is uncharted territory. The Bank itself cannot know exactly how quickly and to what extent the effect of its action will spread through the economy.
 
Two days ago, the Bank received government authority to print up to £150bn. That is a big chunk of money. Once spent, it will boost broad money (i.e. deposits, notes and coins) by about 7.5%. Of that, £50bn is earmarked for purchase of private sector assets such as investment grade corporate bonds. The remaining two thirds is to be used to buy medium and long-dated gilts.

Today, the Bank announced its intention to spend £75bn of the £150bn, most probably by the end of May. By purchasing government and corporate bonds it hopes to improve liquidity in credit markets and reduce corporate borrowing costs. Companies which simply cannot afford to borrow at, say, 8% might be tempted to do so if they can issue debt at 6%. The Bank also hopes that the increased money balances held by the sellers of these assets will help boost overall spending within the economy.

By targeting medium and long-dated gilts, the Bank hopes the money will go to the non-bank sector, e.g. insurance companies and pension funds. The hope is that these institutions will sell their gilts and put the money raised on deposit with commercial banks. The banks might then lend it out with the usual multiplier effect as the money then circulates around the wider economy. Of course, the insurers may choose to spend the money by subscribing to new bond issues or rights issues. The Bank wants the money to be put to good use, not hoarded, and is agnostic about its precise route into the wider economy. That said, we would expect progress reports to appear in the monthly minutes of the Monetary Policy Committee.

Although it may seem like a conjuring trick, the effect on the economy should be real. It is positive for the gilt and corporate bond markets and should drive overall yields lower. It is central bank policy in emergency mode but this is justified by the exceptionally sharp slowdown in economic activity. The stance is designed to work against the deflationary pressures currently affecting the economy. It should not, therefore, give rise to worries about inflation especially at a time when growth in the money supply is slowing sharply.

Media fears that "printing money" will lead to hyperinflation are overdone. In this case, the aim is to create a powerful impact on the cost and availability of funds to the corporate sector. The Bank is not simply printing money willy-nilly. It will use quantitative easing within the framework of the inflation target. Indeed, quantitative easing might be quite slow to take effect. You can fill up the punchbowl to help the party get started but that doesn't mean people will rush to make merry.

It is true, however, that inflation worries may arise once all the various stimulus measures finally show signs of working and the Bank has to ensure that it tightens policy appropriately. But we are a very long way from having to consider that risk.

NOTE
Jupiter Unit Trust Managers Limited (JUTM) and Jupiter Asset Management Limited (JAM) are both authorised and regulated by the Financial Services Authority and their registered address is 1 Grosvenor Place London SW1X 7JJ. They are both subsidiaries of Jupiter Investment Management Group Limited and the group is collectively known as "Jupiter". The above commentary represents the views of the Fund Manager at the time of preparation and may be subject to change and this is particularly likely during periods of rapidly changing market circumstances. Their views are not necessarily those of Jupiter and should not be interpreted as investment advice. Every effort is made to ensure the accuracy of any information provided but no assurances or warranties are given.