"The MPC's decision to extend QE from the current expenditure of £125bn to beyond the original £150bn remit by requesting and receiving permission for an additional £25bn over the next three months violated the conspiracy of incentives in financial markets, where investment banks have a powerful incentive to talk up the green shoots of recovery. This has prompted much negative commentary over the decision to extend quantitative easing. However, the Bank's actions are justified and serve as additional insurance against deflation.
"The Bank is aware from economic theory and history that in the initial stages of a recovery an economy can grow without credit as companies shift from reducing inventories to stability. This produces mathematical growth, but the economy is unable to sustain this growth without rising credit availability. Surveys show that credit has improved, but at a cost as the stimulus measures and government pressure increases the supply of credit in the economy. The Bank's additional QE is designed to drive down these funding costs by lowering the risk-free yield curve maintaining positive incentives for risk appetite.
"The Bank has probably done enough to avoid deflation in the UK; but we are a small island off the coast of Europe and the rest of the world is more hawkish, with the ECB adopting an ECB-style asymmetrical attitude to inflation, and the Fed likely to signal further contraction of its balance sheet at Wednesday's FOMC meeting as it celebrates the shift from inventory contraction to expansion. Gilts have further to run as the Bank continues its heavy purchase schedule; while the additional QE is likely to be damaging to Sterling in the short-run, it should be positive in the longer run."
