QE inside out

Twitter can often be something of an intellectual cesspool in which people continue to shout across the cultural divide without ever hearing the views of the other side. It can, however, be a source of great enlightenment and I was very taken by a post (here) by Alfonso Peccatiello explaining why QE can never be inflationary. Having thought about it, there are many elements of this Twitter thread which are wrong. Nonetheless, it served a very useful purpose in forcing me to assess the nature of money and for that it is to be commended.

Inside versus outside money

At issue is the nature of “inside” versus “outside” money. Peccatiello argues that “inside money never reaches the real economy. Outside money does” and to the extent that he characterises QE as inside money, it cannot therefore impact on inflation. I suspect there is some confusion about definitions here and in order to get a better handle on this, we need to understand the concepts under discussion. The notion of inside versus outside money was introduced into economics by the seminal work of John Gurley and Edward Shaw, Money in a Theory of Finance, published in 1960. It was a very innovative work for its time and looked at the interaction between the real economy and monetary growth. As they put it, “real or “goods” aspects of development have been the center of attention in economic literature to the comparative neglect of financial aspects.”

Gurley and Shaw (G&S) define inside money as originating from within the private sector. Since one private agent’s liability is simultaneously another agent’s asset, inside money is in zero net supply within the private sector. Thus, funds held in bank accounts would be classed as inside money because they are an asset of private firms or households but a liability of private sector banks. Conversely, outside money derives from outside the private sector and is either fiat (unbacked) or backed by some asset that is not in zero net supply within the private sector. An increase in the stock of currency by the central bank would be classified as outside money, because although it is an asset of the private sector it is a liability of the public central bank.

The vexed question of money neutrality

Since outside and inside money represent different types of liquidity, they have differing effects on the wider economy. One implication of this is that the money stock is not homogenous – money is not just money as it is comprised of these two differing types. This calls into question the notion that money is neutral (i.e. it does not impact on real quantities in the long run and serves only to impact on prices). In light of the debate regarding the impact of liquidity creation by central banks and the recent surge in inflation, this may help us to shed some light on the monetary transmission process and the role of QE within it.

Without boring the reader with the details of the process, G&S demonstrate that in their general equilibrium framework inside money is neutral but outside money is not (the interested reader is referred here). How do we categorise QE?  In the sense that the central bank creates reserves to buy assets from the private sector (in this case, the non-bank private sector) but uses them to buy government bonds, they are merely swapping one type of outside money for another (cash for bonds). Consequently, the inside-outside composition of private sector assets remains unchanged. I thus agree with Peccatiello that QE can be categorised as inside money. If we accept the proposition of money neutrality, this implies that QE is unlikely to have any long-term impact on real activity. But this does not mean that it has no impact on prices. Indeed, classical monetary theory argues that if it does anything, QE will impact on price inflation.

Moreover, monetary neutrality relies on the absence of frictions but, as the work of Karl Brunner and Allan Meltzer has demonstrated, such frictions do exist and thereby allow monetary policy to have an impact on the real economy – perhaps only for a limited period of time. QE may not have had the impact on the economy that central banks hoped but there is in theory scope for it to boost activity. Analysis conducted by the BoE in 2011 suggested that the initial round of asset purchases boosted UK GDP by 1.5% to 2% compared to what would have happened in its absence.

Should central banks continue with asset purchases?

If we therefore accept that asset purchases do impact on inflation and prices, does it make sense for central banks to continue the programme, particularly in view of the surge in US inflation to 5.4% last month – the fastest rate since 2008? The short answer would appear to be no. Whilst it is true that the prices of used cars contributed a third of the monthly rise in the CPI in June, which is likely to be a temporary phenomenon, there is evidence that prices are rising rapidly across the board. Accordingly the Fed is widely expected to taper its asset purchases before too long with suggestions that the Fed will broach the subject at next month’s Jackson Hole symposium. Investors will recall the 2013 experience when the prospect of a slowdown in Fed asset purchases prompted the infamous taper tantrum which resulted in a spike in bond yields. However, with financial asset prices at red hot levels, taking some air out of the market may actually not be such a bad thing.

Last word

Whilst there is general agreement that QE has been the primary driver of asset prices in recent years, there remains much debate about its impact on the wider economy. Whilst I have never been persuaded of some of the claims made for it by policymakers, I have never accepted that it has zero impact. Even if the effects are small, such has been the magnitude of asset purchases that even small spillovers will show up in GDP and inflation data. This 2016 paper by Martin Weale and Tomasz Wieladek offers evidence that in contrast to the claim made by Peccatiello, “US (UK) QE had a similar (much larger) effect on inflation and (than) GDP.” If asset purchases have helped the economy to avoid a slow post-pandemic recovery, they have done their job. But having done their job, it may now be time to think about scaling back.

What does it take?

There are certain central banking events which have gone down in history. Sometimes the event was only momentous in hindsight, as with Ben Bernanke’s 2002 speech setting out the guidelines of what would later become the QE doctrine. Occasionally, as with Alan Greenspan’s “irrational exuberance” comments in December 1996, it was obvious at the time that something truly memorable had just happened. Another such event took place five years ago when on this day in 2012, Mario Draghi made his famous speech in which he promised that “Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”

It was! Indeed Draghi deserves a lot of credit for keeping the show on the road against a backdrop which threatened to become utterly chaotic. His first act on taking over as ECB President in November 2011 had been to reverse the ECB’s misguided rate hikes earlier that year. But by summer 2012, the euro zone was experiencing an existential crisis with talk of Grexit high on the agenda. Draghi’s words helped calm a fragile market, and by subsequently stepping into the vacuum created by a lack of government clarity, the ECB did indeed do what was necessary. It pumped huge volumes of liquidity into the system and apart from a brief wobble in summer 2015, the euro zone has steadily moved forward. In the sense that Draghi’s goal was to prevent the euro zone from fragmenting, he very much did what was required. Indeed, today there is very much a sense of optimism surrounding the euro zone economy as sentiment continues to rise.

But the ECB still has its foot to the floor, buying huge quantities of government bonds as part of its QE programme and speculation is increasingly mounting as to when and how it will begin tapering its purchases. Meanwhile, the Federal Reserve has been through a tapering process culminating in a cessation of bond purchases, and has raised interest rates by a total of 100 bps since December 2015. Indeed, the Fed is actively discussing balance sheet reduction, so monetary policy normalisation is clearly underway in the US. Despite this, both the MOVE index of US Treasury market option volatility and the VIX index of equity option volatility have touched all-time lows on data back to 1988 and 1990, respectively (see chart). It may be summer, and trading vols have dwindled, but this does raise a question as to whether markets are too complacent. There again, what do markets have to fear?

Central banks have effectively anaesthetised bond markets in recent years and investors have piled into equities with impunity because (a) they don’t really have anywhere else to go and (b) they know that central banks will signal policy changes well in advance, providing them with enough time to get out. The ECB last week failed to give any hints at a policy change and is now effectively on holiday for the next month, and although there is a prospect that Draghi will try to steer market expectations at the Kansas City Fed’s Jackson Hole Symposium in late-August, the markets today seem to be in a mood to see action rather than words. Similarly, the Fed announced a steady-as-she-goes policy today, meaning that nothing will happen on the monetary policy front until September. The BoE may try to inject some volatility into the market following next week’s MPC meeting but it has limited scope to have a wider impact.

Do central banks now need to show that their bite is indeed as bad as their bark? The reason markets are idling along is an indication that they do not fear tighter policy. They should! Central bankers are aware of the dangers of allowing markets to become too complacent because the knee-jerk response in the event of an unanticipated shock will be all the more dramatic. This may explain why various BoE officials have tried to sound hawkish in a bid to jerk the markets into action. Markets may be able to live with the modest degree of tightening we have seen from the Fed so far. So long as interest rates remain low, a dividend discount model in which equity valuations are determined by the discounted value of future revenue streams, will continue to support current levels. But if the Fed starts to run down its balance sheet and put some upward pressure on global bond yields, the equity world may look different.

Unlike in 2012, words no longer appear to be enough. But my sense is that markets ought to take heed of the hints which central bankers are providing. Whatever some investors may think, central banks are not there simply to act as a backstop for market actions. If,  or when, the monetary policy cycle finally turns there is a risk that people might get hurt.

Central banks: A balancing act

One of the issues which central banks are going to have to face up to at some point in future is the question of whether and how to reduce their balance sheets, which have been swollen by the huge purchases of financial assets under the QE programme. The balance sheet of the US Federal Reserve, for example, now stands at $4.5 trillion, which is roughly 25% of GDP compared to a figure around 7% at the start of the financial crisis, with the expansion comprised primarily of Treasury and Mortgage Backed Securities (MBS).

From the outset, central banks were clear that it was the stock of assets held on the balance sheet which was important for the purpose of injecting additional liquidity, not the rate at which they were purchased. This was because the purchase of bonds has a counterpart on the liability side of the balance sheet in the form of a credit to the banking system (excess reserves), representing the transfer of funds from the central bank to the seller of the bond. To the extent that the banking system creates liquidity as a multiple of the deposits in the system, this rise in banking sector deposits held at the central bank is what ultimately determines the pace of liquidity creation in the wider economy. The Fed ceased buying assets in October 2014. But as existing bonds matured so they ceased to be an item on the asset side. In order to prevent an unintended decline in the balance sheet, it was forced to rollover maturing securities which means that it is still actively buying assets, albeit on a smaller scale than previously.

But the Fed has indicated that it will ultimately shrink its balance sheet, and thus impose an additional degree of monetary tightening, but not until “normalization of the level of the federal funds rate is well under way.” Whilst markets are concerned about when this is likely to happen, a more interesting question is how rapidly it is likely to proceed. It is widely anticipated that the Fed will allow its maturing bonds to simply disappear from the balance sheet – a form of passive (or less active) reduction compared to the alternative of actively selling bonds. Ben Bernanke (amongst others) has argued that the Fed should simply aim for a given size for the balance sheet and allow the maturing of existing bonds to continue until the desired level is reached.

It is pretty likely that wherever we do end up in the longer-term, the balance sheet will not go back to pre-2008 levels. With Fed estimates indicating that demand for currency is likely to reach $2.5 trillion over the next decade, compared to $1.5 trillion today (and $900bn before the crisis), it is evident that the absolute size of the balance sheet in the longer term will be far higher than it was 10 years ago. In one sense, this makes the Fed’s task easier because it will not have to run it down so far. Indeed, in a nice little blog piece in January, Ben Bernanke reckoned that the optimal size for the balance sheet over the next decade is likely to be in the region of $2.5 to $4 trillion. If indeed the optimal size is close to the upper end of the range, it implies that the degree of reduction will be very small indeed, and would have little impact on markets which fear that a rundown of the balance sheet will result in a sharp rise in interest rates.

This absence of a dramatic reduction would be in keeping with past historical evidence. Analysis by Ferguson, Schaab and Schularick which looks at central bank balance sheets over the twentieth century, argues that prior to the onset of the financial crisis balance sheets relative to GDP were very small relative to the size of the economy compared to longer-term historical experience. They also note that “outright nominal reductions of balance sheets are rare. Historically, reductions have typically been achieved by keeping the growth rate of assets below the growth rate of the economy.”

Perhaps what this all means is that we should stop worrying too much about the potential impact of big central bank balance sheet reductions. But it does mean that a more permanent change in the conduct of monetary policy is about to take hold. Prior to 2008, central banks controlled access to demand for banking sector liquidity by regulating its price via the overnight rate. Now that liquidity is plentiful, both the Fed and ECB operate a floor system by controlling the rate they pay banks on reserves held with the central bank. As recently as November 2016, the FOMC described the current floor system as “relatively simple and efficient to administer, relatively straightforward to communicate, and effective in enabling interest rate control across a wide range of circumstances.”

Such a policy requires the banking system to be saturated with reserves and implies that the balance sheet may be about to assume a more important role in the conduct of policy as it becomes the tool via which bank reserves are supplied. So maybe central bank watchers will spend less time worrying about the policy rate in future and we will go back to the old-fashioned job of trying to predict how much liquidity central banks are injecting into the market. Now that takes me back a bit …

The beatings will continue until morale improves

The ECB’s decision to extend its asset purchases beyond next March, albeit at a slower pace, is seen in some quarters as a tapering announcement and is viewed by others as a further round of monetary easing. To recap, the ECB announced that it will extend its asset purchases to December 2017, rather than end in March, but at a rate of €60bn per month rather than the current pace of €80bn. Technically, a reduced pace of asset purchases is a form of tapering. But let us not forget that when the ECB began its purchases last year, it was initially buying at a monthly rate of €60bn. I am inclined to view the announcement this week as continued monetary expansion rather than a precursor of tapering.

Looking more closely at the statement issued by the ECB (here) the presumption is that it will have to do more rather than less. Purchases will continue to December 2017 “or beyond, if necessary” and “if … the outlook becomes less favourable … the Governing Council intends to increase the programme in terms of size and/or duration.” Nowhere does it say that the central bank will scale back purchases if the outlook improves or if inflation picks up more quickly than anticipated. In that sense, it is an asymmetric commitment.

Increasingly, I get the sense that the ECB is out of step. It came late to the QE party, beginning asset purchases only in 2015 whereas the Fed and BoE started in 2009. The Fed has long since ended its asset purchase programme, and the BoE announced only a modest expansion in August in the wake of the EU referendum, having been on hold for much of the preceding four years. There is also clear evidence that the bang for the buck (or euro) diminishes the more QE is undertaken. Indeed, the BIS made precisely this point in its 2016 Annual Report (here, see p72). As it pointed out, “there are natural limits … to how far interest rates can be pushed into negative territory, central bank balance sheets expanded, spreads compressed and asset prices boosted. And there are limits to how far spending can be brought forward from the future. As these limits are approached, the marginal effect of policy tends to decline, and any side effects – whether strictly economic or of a political economy nature – tend to rise.”

The problem is not all of the ECB’s doing. Successive Presidents have been making the point since the ECB’s inception in 1999 that governments need to do more to reform their economies. And they simply have not done so. This mirrors comments by BoE Governor Carney who made a similar point regarding the UK (as I noted here). But the need for reform is far more acute in the euro zone. In a fixed exchange rate system, the burden of adjustment for economic problems falls squarely on the domestic labour market; No longer can countries rely on a weaker exchange rate to bail them out. Italy is a case in point, where the economy has barely grown in the last 16 years, and where politicians have been frustrated in their efforts to reform the domestic economy by groups with a vested interest in preserving the status quo (notably the unions). Whilst you have to feel a bit sorry for well-meaning politicians such as Matteo Renzi, it is hardly a surprise when electorates turn on their politicians as the Italians did last weekend in the constitutional reform referendum.

However, there is growing concern in Germany that the euro zone is morphing into a transfer union, as surplus countries continue to prop up the ailing southern peripherals. Technically, this is true. But this is also a necessary condition for the euro zone to survive. Not all countries can run external surpluses, and they certainly cannot all run surpluses against each other. In the absence of these transfers, the euro zone is just another fixed currency regime which will inevitably fall apart. Suggestions last week from German Finance Minister Wolfgang Schäuble that Greece must carry out structural reforms instead of receiving debt relief are to entirely miss the point about the nature of the problems which it faces. Greece is labouring under such a huge debt burden (182% of GDP) that unless part of it is written off, it will simply default. Period! And most people know it.

ECB President Draghi may be pilloried for running a policy which appears to benefit “profligate” southern European countries, but he is stepping into the void created by politicians who are not doing anything to support the economy via fiscal policy or structural reform. Without his efforts, the euro zone would be in an even sorrier state. But as the BIS analysis suggests, economies cannot live on monetary policy alone. And all this does raise genuine existential concerns for the future of the euro zone. We used to talk of Grexit long before we had even heard of Brexit but all the problems which the region has dealt with in the last seven years are still there. The beatings will continue until morale improves.

Boiled frogs and QE

For a long time central bankers told us that quantitative easing was the best thing since sliced bread. It would, so the conventional wisdom went, allow for a potentially limitless expansion of the central bank balance sheet which would flood the economy with liquidity and, at some point, eventually result in a recovery in demand.

Those who have been reading my material over the years will know that I have never been fully convinced of the merits of QE. Back in 2009, I pointed out that using QE to stimulate domestic recovery would be hampered by the weakness of the banking sector. I also suggested that “it is unclear whether a policy which acts to improve credit supply will help to stimulate activity when demand for credit remains limited.” In response to such criticisms, the BoE later held an impromptu session to explain to financial sector economists that the main channel through which QE worked was via the wealth effect. In this way, BoE purchases would drive down yields and force bond holders to switch into other assets. This in turn would boost household wealth and help support an economic upturn. In fairness, the BoE was correct in its assessment that investors would be forced to switch into higher yielding assets – the problem was (and is) that it is financial investors who have benefited rather than households.

It is this kind of thinking which has prompted much of the recent criticism of central bank policy, particularly by politicians. But as BoE Governor Carney noted yesterday in parliamentary testimony “an excessive focus on monetary policy in many respects is a massive blame deflection exercise.” He is certainly right on that, as those of us who believe there is an expanded role for fiscal policy in the current conjuncture would attest. However, the BoE should not be allowed to get off scot-free. Some five years ago I recall having a conversation with one BoE official who, in response to my question of why QE should be expanded given that its marginal impact had cleared waned, replied in effect that “more QE does no harm, so it cannot hurt to do too much rather than too little.”

Being charitable, I guess that no policymakers thought that monetary policy would have to remain in post-crisis expansionary mode as long as it subsequently has done. And it probably seemed reasonable to central bankers in 2011 that a further dose of bond purchases would probably not do much harm. After all, there were not that many suggestions at the time that QE was overly harmful. However, I did point out as long ago as 2009 that “the impact of quantitative easing in lowering bond yields will pose real problems for pension funds.” We might have been able to wear that for a year or two, but few if any would have expected that both the BoE and ECB would still be buying assets in 2016 which in part suggests that it is the duration of the monetary easing phase, rather than the easing per se, which is the problem. Indeed, as Carney’s quote suggests, it is the government’s failure to step in to provide additional policy support which has thrown the onus onto central banks.

One of the great ironies of QE is that rather than making life easier for the banking system by providing it with a huge liquidity injection, things have got a lot tougher. Action to cut short rates to zero, or into negative territory, has increased the cost to banks of holding excess reserves whilst the QE policy has flattened the yield curve, which in turn has reduced the spread which banks need in order to make money. In many ways, the side effects of QE are akin to the frog-boiling syndrome. If you put a frog in a pan of boiling water it will immediately jump out, but if you put it in a pan of cold water and gradually turn up the heat, it will not realise that it is being boiled alive. Banks in particular are now waking up to the prospect of being boiled alive, and the ECB may even turn up the heat still further if it announces an extension of its QE programme in December.

Some respite may be afforded by the recent Trump-induced rise in bond yields, which if sustained could alleviate some of the margin pressure. But we are all now increasingly alert to the dangers of relying on more QE. This is not to say that it should necessarily be reversed but without more thought to the mix between monetary and fiscal policy, electorates in other countries might be tempted to follow the example set by the US and UK, and jump right out of the pan.

All the way with the BoJ

The Bank of Japan is nothing if not innovative. After all, it was the BoJ which first attempted a policy of quantitative easing in 2001, which involved buying large amounts of securities in order to flood the economy with liquidity in a bid to stimulate inflation. Central bankers in the west treated Japanese QE as an interesting intellectual exercise but never really believed that they would ever have to implement it. But some eight years later the Fed and BoE were doing exactly that.

Meanwhile the BoJ has tried everything it knows to raise inflation to 2%, which was a key element in the Abenomics strategy unveiled in early 2013. The BoJ has bought huge quantities of securities and in the process has raised the central bank balance sheet to around 90% of GDP, which is more than three times that of the Fed, ECB or BoE. But buying ever more financial assets is simply not working as inflation remains stuck at extremely low rates.

So the BoJ opted this week for a different tack: Its two-pronged approach seeks to control the yield curve by holding 10-year yields at zero and allowing inflation to overshoot the 2% target. Such an approach differs from the standard QE policy in as much as it fixes the long end of the curve, rather than driving it down. Using the standard levers to control the short end allows the BoJ to steepen the yield curve, and reduce fears that driving down short rates will hurt the banking system. The idea is that the BoJ, which already has a long track record of asset purchases, only needs to tell the market that it has a 0% target and investors will fall into line without the need for a huge rise in central bank purchases. In essence, it will be a cheaper way for the BoJ to hold interest rates down, and if it is successful in stimulating inflation, will push down real interest rates and thereby give real activity a lift. The idea of overshooting the inflation target relies on the argument that more inflation tolerance will be necessary in order to move expectations to be consistent with achieving the 2% target in the first place.

But central banks have long avoided trying to control the longer end of the yield curve, arguing that it is difficult to do so and introduces distortions into asset markets as they seek to fix the benchmark risk-free rate. Indeed, if the market decides to test the BoJ’s resolve, it may end up having to buy a lot more paper than under the current QE policy (which, by the way, will continue to run in parallel). There are other serious flaws in the strategy: The commitment to fixing the 10-year yield means that in the event of a bond market sell-off which prompts a global rise in yields, the BoJ is required to continue expanding its (already large) balance sheet indefinitely. Some analysts have pointed out that the BoJ is relinquishing control of real interest rates whilst policy becomes highly pro-cyclical. For example, if there is a negative demand shock that raises demand for JGBs (i.e. yields fall) and depresses inflation expectations, the BoJ will reduce the amount of JGBs it buys whilst falling inflation expectations put upward pressure on real rates. All in all, given the BoJ’s failure to achieve its policy objectives over the past 20 years, scepticism remains high that this policy will be no more successful than the others.

We also now run the risk of straying into the area of debt monetisation. Balance sheet expansion of the form implied by QE is meant to involve a temporary expansion of the central bank’s asset holdings. The theory is that they are run down over time, otherwise the central bank merely holds assets until such times as they mature and hands the proceeds back to the government. Nowhere are central banks talking about running down balance sheets. In theory, if the BoJ is forced to sell bonds in order to hold nominal yields at zero, this could be one side effect, but the presumption is that balance sheets should rise rather than fall. Continued balance sheet expansion creates all sorts of problems because (a) it raises governmental moral hazard risks and (b) in theory could unleash much more serious inflationary pressures than central banks are aiming for.

Whilst the BoJ’s QE policy in 2001 was an experiment which was copied by other central banks some years later, I seriously hope this is one lesson we don’t copy in Europe (for one thing debt monetisation is prohibited in the euro zone). It looks like a policy of desperation: if flooding markets with liquidity cannot stimulate inflation, I cannot see how yield curve control will. Boosting liquidity leads to higher inflation when it is transformed into the purchase of goods and services. In an ageing society like Japan, where people are content to sit on their money balances, greater liquidity provision will not prove to be the inflation stimulant which the BoJ seeks. I have long maintained that efforts to get Japanese inflation back to 2% without some help from global conditions will not work and I remain sceptical that these measures will do the trick either.

An un-save-ry business

The Bank of England’s action yesterday to ease monetary policy by driving interest rates deeper into all-time low territory has both positive and negative aspects. On the plus side, the fact that the central bank has acted pre-emptively illustrates that it is aware of the potential economic consequences of the Brexit vote. Another welcome innovation was the Term Funding Scheme, which is designed to ensure that banks can obtain funding at a cost “close to Bank Rate” which in turn means that they can pass on a significant chunk of the lower interest rates to their customers. As the BoE pointed out, the all-in cost of funding in the wholesale market is close to 100 bps and the TFS will ensure that banks can access funding at between 25 and 50 bps, depending on their lending volume. In this way, banks will be able to avoid the margin compression which is such a problem in a low rate environment, and hopefully will prevent many of the distortions which have been such a feature of the euro zone in recent months.

Two other elements of the package were an additional £60bn of gilt purchases and up to £10bn of corporate bond purchases, both of which were designed to further reduce yields, thereby giving additional monetary stimulus, and triggering portfolio balancing by forcing investors out of bonds and into other assets. Perhaps the most impressive part of the package was that it demonstrated a degree of joined-up thinking. The distortionary effect of low interest rates on banks’ business models is a well-known problem and the BoE clearly went some way towards addressing this crucial issue in a way which the ECB has not.

But it is not all good news. Driving interest rates ever lower is placing a serious burden on savers and is most certainly having an adverse effect on our retirement incomes. When pressed on this during the press conference, Governor Carney basically suggested that it is a choice between sacrificing savers and putting lots of people out of work. I think this is a false choice. For one thing, the Brexit fallout represents an uncertainty shock which is not readily amenable to monetary solutions. Lower borrowing costs will not determine whether Nissan decides to continue investing in its British operations. Indeed, if the Brexit negotiations go awry, Nissan could put lots of people out of work AND savers retirement incomes will still be under pressure.

What is more pernicious is that many policymakers, past and present, argue that more monetary easing does no harm so why not just do it. But that is also false. As noted above, low rates hurt savers. And there is another problem: By national accounting definition the current account deficit represents the difference between domestic saving and investment. If we reduce the incentive so save, so the economy can only invest by borrowing from the rest of the world – and the UK just happens to have one of the biggest current account deficits in the OECD (exceeded only by Colombia). So you still think that low rates are a good idea?

Another thing that concerns me is that central bankers have been loath to tighten monetary policy even once a recovery appears to be underway. There is thus a real risk that we get sucked into a world of low interest rates for far longer than is necessary, with all the attendant risks outlined above. And finally, there is general recognition that the Brexit problem is by no means as serious as the shock in the wake of the Lehman’s bust. So why then has the BoE implemented a monetary stance which is even more expansionary than we saw in 2009?

Maybe I am being a little too harsh. But the problem is that monetary policy remains the only game in town, given that the previous occupant of 11 Downing Street pursued an aggressive austerity policy which left no room for fiscal expansion. Many economists would welcome a change of policy on this front. And if over the course of the next year or two we do see a more activist fiscal approach, the BoE should be far less squeamish about raising interest rates. After all, savers could do with a break after seven years of squeeze.

The lowdown on interest rates

Over the course of the past seven years, monetary policy has been at its most expansionary setting in history, a point made by Andy Haldane in a speech last year. Indeed, we have become dangerously used to interest rates at near zero – and in some cases below.

It used to be thought that when interest rates get close to zero, there was very little else central banks could do. But in 2001, the Bank of Japan began the process of flooding financial markets with liquidity by buying huge quantities of financial assets in a bid to head off deflation (so-called quantitative easing). In 2002, Ben Bernanke argued, in what has gone down as one of the most influential speeches in modern central banking history, that a policy of central bank balance sheet expansion was guaranteed to reflate moribund economies and if it was failing in Japan, this was primarily a result of specific Japanese factors. Little did we know that western central banks would quickly exhaust all their conventional ammunition in the wake of the meltdown triggered by the Lehman’s bankruptcy, and that by 2009 the Fed and Bank of England would  be pumping huge amounts of liquidity into the financial system with the European Central Bank following suit in 2015.

We don’t have space to go into a detailed discussion of these unconventional monetary policies here, but suffice to say that although I was critical of the QE strategy in 2009, it did serve a purpose by preventing a market meltdown, and it probably did help to stabilise the real economy and set the stage for a recovery. The key point, however, is that it helped markets first and foremost. It did so by forcing investors to abandon the safe haven of government bonds, as central bank purchases drove down yields, and into riskier assets yielding higher returns. But with the ECB only starting to embrace QE last year, when global markets were a lot more stable than in 2009, this struck me as too little too late. It has had no discernible impact on generating a pickup in activity and although the ECB will doubtless argue that the situation would have been worse in its absence, that remains unproven.

What has become apparent is that central banks have become addicted to the provision of cheap liquidity. Indeed, in the euro zone the interest rate on cash deposits at the central bank is negative, as the ECB tries to force banks to lend rather than hold excess cash balances. There is little evidence that this policy is working.

In fact, lowering interest rates in the current environment is merely helping to magnify economic distortions. For one thing, they have forced investors to raise asset prices out of line with fundamentals by producing market bubbles which may well pop in future (at the very least, they raise market volatility by increasing the degree to which markets are dependent on central bank policy). For another, they distort the operation of the financial system, the main purpose of which is to match those with excess funds and those with insufficient funds. But in an environment of excess liquidity, banks are simply holding excess cash which – in the euro zone at least – is a drain on profitability because they have little option but to hold it at the central bank, which incurs a penal rate of interest. Then there is the problem of how savers can build up their balances in order to generate sufficient for their retirement. Today’s consumers may enjoy the dubious privilege of low rates today, but they will not thank central banks tomorrow when they see what their retirement funds are worth.

So it is against this backdrop that the BoE is widely expected to cut interest rates this week. But the truth is it will do little good. Whatever else the Brexit shock is, it is not a monetary shock to the system as we saw post-Lehmans when the global financial system seized up. At that point, radical monetary easing made sense. Lower interest rates today cannot compensate for any uncertainty shock which may cause companies to cut back on investment and employment. Nor is there any real need to expand QE – the BoE has already taken action to reduce banks’ countercyclical capital buffer which does much the same job.

The BoE will argue that the harm caused by inactivity outweighs the harm of further easing and the markets certainly will not take kindly to inaction. But the lesson of the past seven years is that once policy is eased, it has proven very difficult for central banks to consider unwinding it. We may not know the longer-term costs of cheap money for many years to come but it increasingly looks to me as though monetary policy is almost out of road and it is time for some heavy lifting from fiscal policy.