Deciding it was safe to come clean because banks are now on a more even keel and the worst of the credit crisis is behind us, the Bank of England has told the nation that at the height of the turmoil it secretly lent Royal Bank of Scotland and HBOS a colossal £62 billion, which is more than the entire British defence budget.

Both banks faced the imminent closure of high street cash machines and the curtailment of normal banking operations across the country.

The Bank said "this was a dire emergency" and Downing Street called the secret lending of taxpayers' money in the Autumn of 2008 "a powerful reminder of how close the banking system came to near collapse."

In Westminster, some MPs were flabbergasted, even though the loans have now been repaid.

"It is astonishing that this was kept secret for over a year," said Vince Cable, finance spokesman for the Liberal Democrats. "The government has treated taxpayers like children while expecting them to foot the bill."

John McFall, Treasury Committe chairman, said the sum caused "a little bit of an intake of breath thinking how many universities, how many colleges, how many jobs you could support with this."

"It's Enought to Make Anyone Feel Queasy," was Ian King's headline in The Times. "Any More £62 bn Loans You Haven't mentioned, Merv?" asked the Daily Mirror, addressing itself to Bank of England Governor Mervyn King.

"In exceptional circumstances ... the Bank acts as ‘lender of last resort’ to financial institutions in difficulty in order to prevent a loss of confidence spreading through the financial system," the Bank said in a statement. Lord Myners, the financial services minister, declined to say whether any other secret loans had been made.

HBOS shareholders would have been unaware of the Bank of England loans when they backed its takeover by Lloyds last December. "Shareholders in Shock after Banking Bombshell," said one Times healdine. The government said senior management at Lloyds knew about the loan.

“But is it a scandal that the emergency aid was kept under wraps?” asked Andrew Hill in the Financial Times’s Lombard column. “It is not. Picture the catastrophe — financial, social and political — that a press statement would have triggered. Guerrilla central banking has to be a last resort. But this was one clear occasion where a false market was better than no market at all.”

There has been pressure in the higher echelons of the Bank of England to dismantle banks that are too big to fail but in government this so far has had little resonance. But there is concern that these staggering bank bailouts erode the public’s confidence in the free market system by reinforcing the argument that there is one set of rules for the city and another rule for everyone else.

Should the Bank have secretly bailed out HBOS and the Royal Bank of Scotland? Do you believe there was an alternative? Are you concerned about other clandestine banking operations that taxpayers may be unaware of? What do such secret activities say about transparency and accountability in a democractic country?

Mervyn King, Governor of the Bank of England, sees a long, hard road back to the path we thought we were on before the financial crisis broke. Just how long is shown by  Chart 2 in Wednesday's Quarterly Inflation Report. The Bank's Monetary Policy Committee does not expect Britain's GDP to return to its peak, 2007, level until 2011, and there's an outside chance that even in 2012, the country's output will be no more than it was in 2006.

This "considerable period" of "sustained weakness of demand" is why the MPC's other fan chart, the "rivers of blood" projections of inflation, looks so benign. The best guess (sorry, "central projection") is plumb on the 2 percent target for the CPI in 2012. We all know, said the Governor, that inflation is going to jump in January, thanks to the combination of dearer fuel and rising VAT, but after that, it should slide gracefully back, wobbling around the target for the next three years.

Key to this projection is the belief that the UK economy could produce a lot more if the demand was there, and the report shows evidence of much effort to try and support this conclusion. Unemployment is one clear indicator of spare capacity, assuming some sort of match between the demands of consumers and the abilities of those without jobs.

More worrying, though, is the dramatic cutback in business investment, as companies have had to put survival ahead of expansion. Some have lost the battle, and others are sufficiently chastened to avoid becoming beholden to their lenders, even if it means passing up attractive opportunities.  The report points out that capital spending fell 10 percent in the second quarter, and the Bank expects it to fall further. Re-stocking should boost output, but it's hardly a sound basis for sustainable growth.

The Bank effectively assumes that whoever's in charge at the other end of town will adminster the necessary fiscal medicine: "stabilising the ratio of public sector debt to GDP will require a combination of a reduction in government spending and a rise in taxation as a share of GDP." This will subdue consumer spending, which will help keep inflation down, but even so, the central projection in the report looks ambitious.

Last year's sterling weakness has probably worked through by now, but the pound does not look conspicuously cheap. Commodity prices are uncomfortably strong, and companies will surely rebuild profit margins before trying to expand sales. Looming over all this, unspoken, is the vast, chronic trade imbalance that the West has with the East. As the Governor did not say: We have not even begun down this particular long hard road.

When the Bank of England decided to expand its quantitative easing policy by 25 billion pounds to 200 billion on Thursday, it was essentially hedging its bets.

After Britain’s economy shrank unexpectedly in the third quarter, and with two thirds of the City expecting an expansion to the QE programme, simply shutting off the tap of government bond purchases would risk being more of a shock than the economy could bear.

On the other hand, the Bank clearly believes that the worst is over for the economy and that recovery will come soon — even if it’s going to be weak.

Thursday’s decision means the central bank will keep buying government debt until February, but at only half the pace of before. This still amounts to around 2 billion pounds a week, not including the much smaller sums of corporate debt that the Bank is buying.

What the decision means for a typical household is harder to calculate. The Bank says that its quantitative easing programme has raised the price of government and corporate
bonds, making borrowing cheaper.

But for average firms and consumers looking for a loan, the benefit is harder to spot.

There is little clear evidence that banks are much more willing to lend than a few months ago — though the Bank would argue that quantitative easing has been instrumental in avoiding the recession turning into a depression.

In the longer term, the big unknown is the impact that quantitative easing will have on inflation. Sterling’s weakness against the dollar and the euro will push inflation up in the short term, and going forward the Bank of England said it faced a balancing act.

While rising unemployment and half-full shops and factories will keep a lid on prices, policymakers know that quantitative easing could exert upward pressure on demand and prices for months if not years after it has stopped.

That’s why they took the decision today which could mark the gradual phasing out of this unprecedented policy of asset purchases.

That's the provocative question posed by Willem Buiter. His latest, characteristically lengthy, blog post tackles the regulatory vogue for forcing banks to hold much greater reserves of liquid assets - in practice, government bonds.

Buiter's missive follows new rules from Britain's Financial Services Authority, which will force banks to increase their reserves of government bonds by more than a third. The rules have been met with predictable bleating from the industry, which accuses the regulator of undermining Britain's competitiveness and promoting the fragmentation of the global financial system. Another concern is the FSA's handling of the transition.

Buiter's objections are more fundamental. He's not convinced banks should be preparing to deal with a seizure in the markets. That, he argues, is the job of central banks:

It may be possible for private banks to hold enough liquid assets (government debt, effectively) on their balance sheets to survive even a major liquidity crunch without recourse to the central bank.  But that would be socially inefficient.  Banks are meant to intermediate short liabilities into long-term assets, and frequently into long-term illiquid assets.  It’s what their raison d’être is.

By contrast, Buiter says: "Providing liquidity is what God made central banks for."

It's an argument which deserves to be explored further, though it does raise some practical concerns.

The first is whether central banks are able to prop up individual lenders without making matters worse. After all, the run on Northern Rock started after  the Bank of England announced it was providing support to the mortgage bank. The Bank of England has since installed a permanent discount window similar to the one used by the Federal Reserve. But it remains to be seen whether banks will dare use it once markets have returned to normal.

Then there is the question of collateral. The crisis has forced central banks to lend against a much wider range of assets than they previously accepted. Buiter appears to be suggesting that in future central banks should be willing to accept all kinds of illiquid assets, almost regardless of quality, as long as they apply an appropriate haircut.

Britain's embattled banks may welcome Buiter rallying to their cause. But they shouldn't get too carried away. The LSE professor prefaces his argument with a lengthy call for a global regime to shut down failing banks and seize their assets.

Only this, he claims, can "turn our financial sector back into something that belongs in and sustains a market economy instead of a form of communism for the rich and well-connected."

- David Kuo is director at The Motley Fool. The opinions expressed are his own.-

What is the collective name for a crossing of fingers?

Because that seems to be what the Bank of England’s Monetary Policy Committee members are doing. They are collectively crossing their digits in the hope that they have done enough to steer the UK economy out of recession.

They have pumped billions into the UK economy and it doesn’t seem to be having much effect – yet. That is unless you are a banker looking to bolster your balance sheet with freshly minted notes. Banks are happy to swap their assets for the Bank of England’s cash but remain unwilling to lend. Additionally, there is still uncertaintyabout the ability of the economy to grow unaided if the central bank should stop printing money.

And just when you think that things could not get any worse, it just did. It seems another problem has crawled out of the woodwork is inflation. The Bank believes inflation will be extremely volatile. It may fall in September but near-term inflation may exceed initial forecasts. But because it believes the rise in inflation will be temporary, the suggestion is that interest rates can be maintained at around current record low levels for some time.

However, low interest rates, low growth and low prospects of an economic recovery are spooking foreign investors. Sterling recently sunk to levels not seen for five months against the euro. It has dropped from 1.30 euro a year ago to 1.07 euro, though it has since recovered to 1.11 euro.
UK exporters will undoubtedly welcome the favourable exchange rate against our European trading partners. But the fly in the ointment will be more expensive imports from European.

German cars, French wines, Italian luxury goods, Spanish holidays, Irish butter and Dutch Edam cheese will all cost more.

Inflation is the unspoken effect of Quantitative Easing. It is something we need to guard against if we are to ensure that our nest eggs and investments are not eroded over time. Leaving any money you have in savings accounts may seem like a sensible and safe thing to do now. But over the long term, cash has a terrible record at beating inflation. Consequently, it is better to invest in assets that have a proven track record against rising prices.

If you have a mortgage on a property, now is a good time to pay down as much of the loan you can afford while interest rates are low. If you have money that you can afford to put away for five years or more then it should be invested in shares rather than allowed to idle in a savings account.

Crossing your fingers is not an option. Putting your money to work is because things just got a lot worse.

I've found the answer to the monetary puzzle de nos jours. The ritual of the UK Treasury's DMO issuing new government debt one day, only to have the Bank of England buy similar amounts of almost identical stock the next, has puzzled me ever since Quantatitive Easing began.

How much simpler it would be for the Treasury to borrow directly from the Bank - the modern equivalent of running the printing press faster - to pay the government's bills.

It turns out that the Maastricht treaty (Article 104(1)) expressly forbids European governments from borrowing directly from the central bank. The prohibition was drafted during a period when inflation seemed endemic, requiring strict controls to prevent monetary incontinence among European Union governments.

So QE is a mechanism to circumvent the rules. Perhaps you knew that already. The traders in gilt-edged stock, many of whom are not natural europhiles, should raise their Roederer Crystal to the treaty, as they laugh all the way to the (taxpayer-supported) bank.

- David Kuo is director at the Motley Fool. The opinions expressed are his own.-

If you are not confused you are not paying attention. Those sage words from management guru Tom Peters can be applied to a wide number of economic issues today, but none more so that to the latest inflation figures.

Question is: do we have inflation, deflation or some mixture of the two?

The answer lies in which index you are looking at?

Inflation as measure by the Consumer Prices Index (CPI) has held firm at 1.8 percent. But according to the Retail Prices Index (RPI), which excludes mortgage costs, inflation for July came in at minus 1.4 percent - that’s up from minus 1.6 percent in June.

So if you are a homeowner with a mortgage, then your cost of living is 1.4 percent lower in July than a year ago. But if you don’t have a mortgage, then the basket of goods that you regularly buy is 1.8 percent higher than a year ago.

The stickiness of the Consumer Prices Index, whilst the UK is in the midst of the worst recession for decades, poses an interesting problem for the Bank of England. In theory inflation should be lower as demand for goods and services are restrained by a fear of unemployment. Retailers, for instance, have been cutting prices to drive growth. Yet core inflation refuses to drop.

This raises the question as to how quickly inflation may rise when the UK economy eventually emerges from recession. For instance, how soon will the rise in the price of oil this year start to seriously drive up the cost of goods?

Additionally, with signs of a nascent recovery in Asian economies, how quickly will increase in demand start to affect prices in the UK? It is naive to ignore the purchasing power of the Asian consumer, which can have a direct impact on the cost of raw materials, minerals and food on the West.

Another area of concern lies in the extent to which quantitative easing by the Bank of England is storing up price pressure in the future. The Bank of England has increased the amount of money it will pump into the UK economy by 50 billion pounds to 175 billion pounds. But the big question is whether the Bank of England can mop up the money quickly when the economy starts to grow.

It is easy to consider inflation as an irrelevance now. But it would be wrong not to guard against inflation in the future. For starters, VAT will be restored from 15 percent to 17.5 percent in January. This will immediately push up consumer prices. As a consequence, the Bank of England will be forced to take action by hiking rates.

So, enjoy low inflation while it lasts. If you have debts, try to pay them down quickly while interest rates are low. If you are debt free, then consider investing in inflation-beating assets. Historically, only two asset classes have successfully beaten inflation. These are property and shares. So, if you already own a house, then start investing in the stock market now.

-- John Kemp is a Reuters columnist. The views expressed are his own --

The Bank of England's decision to continue with its asset purchase programme, or quantitative easing (QE), at the rate of 50 billion pounds per quarter in Oct-Dec, unchanged from Jul-Sep, shows bank officials are more worried about ending support for the recovery too soon than about risking inflation by leaving it too late.

The problem with QE is that you have to keep buying the same amount of assets each month to maintain the same monetary stance. With interest rates, the Bank can cut them and they stay cut. If asset prices drop with QE, it represents a tightening of monetary policy.

The Bank initially bought 75 billion pounds in the first 3 months (Apr-Jun) and then tapered this to 50 billion in the second three months (Jul-Sep) as the crisis engulfing the banking system and the rest of the economy eased. A cautious approach might have tapered the QE programme again to 25 billion in the final three months of the year before ending it entirely at the start of 2010. But the Bank opted to stick at 50 billion.

Critics point out that the programme has not achieved its announced objective of increasing bank credit and the amount of money in circulation. The rate of growth in M4, the broadest money supply measure, has risen only marginally. But that ignores the counterfactual of what would have happened to M4 in the absence of the programme -- it might have fallen sharply.

Growth in the monetary aggregates is, in any event, mostly endogenous. It depends on demand for credit. In the current environment, where many households and businesses have little or no collateral, credit is impaired, and most are focused on paying down debt rather than adding to it, limited growth in M4 is not surprising. Trying to make it grow faster is like force feeding a duck to make foie gras -- possible but unnatural.

QE has always been as much about restoring confidence, dispelling fears about deflation and ensuring a ready market for the safer securities banks hold as much as growing the money supply. On most of these measures it must be considered a qualified, if expensive, success. A full judgement will only be possible when the Bank has proved it can withdraw the excess liquidity in a timely manner to prevent an upsurge in inflation.

In the end, the decision to press on is driven by fears about the fragility of the current recovery, and the risk that if QE ends too soon, effectively tightening policy, whatever green shoots have emerged over the summer will be killed off by an autumn frost.

All recoveries are fragile and weak early on. While the rebuilding of inventories along the supply chain, often provides the initial boost, this must eventually be replaced by a more sustained increase in household and business expenditure.

But with their new focus on the experience of the 1930s, central bank officials worldwide are more worried than normal about doing anything to stall the recovery.

Looming over the debate is the experience of 1937, when the Federal Reserve responded to concerns about the amount of "excess liquidity" in the banking system and sharp rises in the price of some commodities, especially steel, by doubling reserve requirements on banks in the space of nine months. It effectively converted previously "excess" reserves against which the banks could lend into "required" reserves against which they could not.

The four-year old recovery (1933-1937) promptly collapsed amid tightening bank credit, and the United States suffered the second deep recession in a decade, with output not fully recovering until the onset of war in 1940-41 (https://customers.reuters.com/d/graphics/DSTMIRROR.pdf).

Anxious to avoid a repeat, it is no wonder that the Bank of England is in no hurry to tighten policy. While this level of QE must eventually generate inflationary pressures, the Bank judges, probably correctly, that it still has some time before policy needs to move to a more restrictive setting.

– Margaret Doyle is a Reuters columnist. The opinions expressed are her own –

Chancellor Alastair Darling has ignored the first rule of holes: if you’re in one, stop digging. He could have produced a few motherhood-and-apple pie reforms of the banking system, to give the impression of activity. Instead, he has dug in, proposing an upgrade of Britain’s failed “tripartite” system of regulation.

No one expected him to admit as much, but the arrangement that split responsibility between the Treasury, the Bank of England and the Financial Services Authority (FSA), was doomed from the start.

Unfortunately, the Conservatives have already pledged to dismantle it and give more power to the Bank so, faced with political reality, Darling has plumped for reinforcing failure. His new “Council for Financial Stability” is effectively the tripartite authority on a statutory footing. It will be required to review the Bank’s and FSA’s publications on financial stability and to make public recommendations. The FSA is also given a “statutory objective” to strive for financial stability.

It’s hard to see how this will make any difference. The FSA and Bank are engaged in a turf war, while Mervyn King, the Bank’s governor, revealed recently that the Treasury had not shared this White Paper (policy document) with him.

At the retail level, Darling’s introduction of a new “national money guidance service”, to be funded by a levy on the financial services industry, looks like an attempt to grab the headlines. Banks and insurers undoubtedly sell complex products whose main purpose is to generate fees but the FSA already has a mandate to protect and to educate the consumer.

He has also accepted the recommendations from Adair Turner, chairman of the FSA, to oblige banks to have more capital and sufficient liquidity. However, he seems to have no more idea than anyone else quite how to do it.

He has resisted the temptation to split commercial banking from investment banking, instead requiring banks to “make a will” so that they are easier to wind up in the event of insolvency, thus limiting the damage to the rest of the economy. Again, much easier said than done.

Darling proposes to fix one flaw in Britain’s deposit protection scheme by pre-funding it. That looks like yet another demand on banks’ scarce capital. Better communication, coordination and transparency between regulators is needed to avoid another crisis. Unfortunately, as Turner has himself admitted, they were not competent to spot the last one, and all the transparency in the world will not equip them to spot the next. Perhaps these measures are just motherhood-and-apple-pie, after all.

(Edited by David Evans)

- Edward Menashy is chief economist at Charles Stanley. The opinions expressed are his own. -

The Monetary Policy Committee of the Bank of England has kept its key lending rate at a record low of 0.5 percent, last reduced in March 2009 when it indicated that conventional policy had reached its limit and unorthodox measures such as quantitative easing were to be used.

Recent economic statistics however have been strong with the UK service sector staging a surprise return to growth in May 2009 thus raising the prospect that the country’s recession may be about to end. Also the Nationwide survey of consumer confidence hit a six month high in May 2009.

Recently the CBI indicated that the banks would tighten credit less aggressively in the next three months.  The survey indicated that only 7 percent of firms expected to be offered tougher conditions for new lending, down from 36 percent from the March 2009 survey.

So against this backdrop all these factors have raised the prospect that policy might soon change.

Hence, if recessionary forces are decelerating and credit is becoming more available the prospect for rising interest rates has moved a step nearer.  Could this explain the strength of the pound and the weakness of the gilt market?

Not surprisingly, the Bank of England is expected to stick to its target of £125bn for Quantitative Easing. Interestingly the futures market foresees interest rates taking the following shape:

Month/Year     Base Rate %
Sept 2009        1.12
Dec 2009        1.31
March 2010    1.48
June 2010        1.81
Sept 2010        2.21
Dec 2010        2.66

Conditions remain very difficult for income seekers.  Record issuance, rising inflation, slow growth, downgrades in credit ratings have left investors bewildered yet, for capital protection we suggest looking at the 2.5 percent Treasury Index-Linked 2016.