Alongside cutting the official rate by half a point, the Bank of England embarked on the bold experiment of quantitative easing...those two unwieldy words that simply mean the Bank will try to boost the money supply by buying corporate debt and Treasury bonds (gilts).
Today's announcement provided some welcome clarity on what the Bank will actually be doing over the coming months:
What are they doing?
The Bank has been given permission to expand the Asset Purchase Facility and redefine its purpose. The total pot is now £150 billion. £50 billion of that will still be used to buy commercial paper and corporate bonds. But on top of that, the Bank will use £75 billion of new money to pump into the economy by buying gilts. The old Asset Purchase Facility (which was only agreed in January) has been suspended.
£150 billion! That sounds like a lot of money?
It is a lot of money, about 10% of GDP...but that simply reflects the the degree to which the ailing banking system has made businesses and consumers cautious about spending money. With less credit and less money flowing through the economy, the concern is that inflation will become entrenched below its target level. The Bank wants to pump money into the markets to keep that from happening.
What are the risks?
The UK badly needs a boost, but as Stephanie Flanders at the BBC points out, the more the Bank does the greater the risks it runs.
The primary risk is that the Bank and the Treasury start using the extra money to finance government's debt. In that scenario, the credibility of UK economy could be undermined, undermining the pound and driving up interest rates. That's why Mervyn King and Alistair Darling were at pains to put a wide gap between what the Bank is doing and the Treasury. This operation is being run by the Bank to meet the inflation target.
There's also the risk that the Bank will be too good at boosting the money supply...that inflation will begin to run away once the economy recovers. King and Darling were less clear on the exit strategy. That's a slight concern for us. There's no real clear framework for understanding whether or not their efforts have been successful in boosting the money supply and what happens if, in three months time or whenever the billions are spent, the economy is still struggling.
The real risk, though, is doing nothing. Interest rate cuts have lost their effectiveness in terms of boosting economic activity. Though a bold step, quantitive easing is a next tool in the Bank's armoury.
Will it work?
David Smith provides a benchmark for sucess:
"These things can work, though the evidence will have to be assessed carefully. There is a lot of noise in the broad money (M4) figures and in the bank lending numbers, as a result of the amount of lending still being channelled in to the troubled financial sector. The big requirement is for a return of underlying lending to something like normal levels."
By buying corporate and government debt, the Bank will automatically increase the amount of credit flowing through the economy. But once that money works through the system (and given the state of financial markets, that's not guaranteed!) it'll be up to banks to start lending again and to businesses and ultimately households to start spending.
Despite the exchange of letters between King and Darling and the proliferation of pundits giving their views, there is still a degree of uncertainty about how the next few months will unfold. Today's move is absolutely welcome, and the Bank appears to have set out a fairly clear and simple framework of what it is doing, but less clear about measures of success and how this operation to boost the money supply will be wound down once the economy recovers.
We'll do our best to track how effective the Bank is at boosting the money supply, so keep checking back here for more details and updates.