The interest rate see-saw

This whole experiment of cutting the Official Base Rate to 0.5% (as close to zero as they will probably get) and 'quantitative easing' i.e. printing money, lead me to ponder on lots of different financial/economic phenomena:

1. They can only increase the money supply if they overpay for assets, and it is quite likely that they will, as evidenced by the fact that the price of ten-year UK government bonds jumped by four per cent in value between Thursday morning and Friday afternoon. Think about it, if the Bank of England merely offered to buy assets at exactly their market value, why would more people be likely to sell them? If a holder of whatever asset really needed cash, he can sell the assets for cash at market value anyway. TFB and others hotly dispute this, but it is still true.

2. Although psychology plays a rôle, as a general rule, the BoE can only influence short-term rates. All things being equal, a lower short term rate leads to inflation fears, hence long term rates go up. Higher short term rates reduce the likelihood of inflation, therefore they reduce long term interest rates, which I shall refer to as the 'interest rate see-saw'. So the government can only influence long term interest rates indirectly.

3. The UK government has now made it clear it will buy up a lot of longer term UK gilts (five to twenty-five years maturity). Although this is a large and very liquid market, there are rules that UK pension funds have to hold X% of their assets in gilts (thanks to DRC for reminding me of that), so the amount available for sale is not that large, possibly in the order of £75 billion to £150 billion. The UK government also came up with the ludicrous idea that commercial banks who have been bailed out should hold more gilts, which is nonsense of course - the government lends the banks money which the banks then have to lend back to the government.

4. QE aka printing money will cause modest price inflation and/or reduce price deflation, but I'm not sure it will change people's behaviour much. People with debts will use the extra money to pay them off and people with savings will just save the extra, so all the money will end up with banks, who aren't lending any out right now, because they themselves are desperately trying to pay off their own creditors (including the government who bailed them out in the first place).

5. So both QE and a near-zero Official Base Rate promote inflation, which increases the interest rate on long term gilts, i.e. depresses their price; meanwhile the BoE is charging round like a drunken sailor overpaying for long term gilts to increase their price, which reduces the interest rate on long term gilts.

6. Government borrowing is government borrowing, however they dress it up. Bank notes are just non-interest bearing government securities, so printing bank notes increases the nominal stock of government debts (although inflation erodes the value of that stock, provided the interest rate it is paying is lower than inflation). The same applies to 'electronic balances with the BoE' - if the BoE said to anybody 'we've created an electronic balance of £1 million for you, feel free to spend it any way you please' and you spent it, sooner or later, one of the recipients of that money would ask the government to redeem it, for example by netting it off with their tax bill.

7. Let's bung in Ricardian Equivalence for good measure, i.e. in the long run, it doesn't make any difference whether the government pays for spending with borrowing to be repaid out of future higher taxes, or funds it from higher taxes today. On a cash basis, this is exactly the same thing - under the former, people hand over money in exchange for gilts and then repay themselves those gilts out of taxes they pay in future. Under the latter, people just hand over the money, full stop.

8. To sum up, all these effects pull in equal and opposite directions, or indeed cancel themselves out. Notwithstanding the stupidity and/or corruption at the heart of government, they are trying to achieve opposites - they print money to push up long term interest rates and buy back long term gilts (with the money they just printed) to push down long term interest rates. Something's got to give, somewhere, it'll be interesting to see what.