In August, QE hit the economy

What are UK banks up to? Last month, their cash deposits at the Bank of England fell by 6 percent. In crude cash terms, banks withdrew almost ₤10 billion.

In the previous six months, banks had accumulated huge deposits. This was due to quantitative easing. The BoE was buying up bank holdings of Treasury paper. In return, it paid for this paper by increasing bank deposits held at the Bank of England. This was how the BoE were "printing cash"; it was generating big increases in reserve balances.

In principle, UK banks could have withdrawn that cash and used it to create new credit. However, during the first half of this year, banks preferred to park the money in the vaults of the Bank of England. That all changed in August, when for the first time since QE began, deposits shrank.

There is, of course, no explanation from the BoE about this recent development. The most likely story is that banks are beginning to lend again. The question, however, who are their new customers?

The most recent lending data, which goes up to June, shows that banks have a strong preference for mortgage lending. On a net basis, mortgage lending is still growing, although not at the levels seen during the recent bubble. Corporate lending, on the other hand, was shrinking rapidly. Meanwhile, unsecured consumer credit was rather flat.

Has QE unleashed a new housing bubble? It is early days, but the signs are really bad. The pick up in house prices since QE began has been remarkable. It is likely that house prices will record positive growth this year.

Since QE began, the BoE has pumped in breathtaking amounts of liquidity into the banks. In six short months, the BoE has created around 15 percent of GDP in new cash. That is a lot of spending power to throw into an economy with declining output. So far, that money has been held in the BoE. Now, banks are starting to pump it into the economy. It is highly doubtful that the economy can absorb such a massive increase in liquidity without sparking off a further round of asset inflation and a rising price level.

Can the BoE quickly withdraw this liquidity, should things get out of control? It is going to be really hard. There is only one mechanism; sell the government paper that they have accumulated. If they start to unwind, they are likely to cause a run on UK gilts, and interest rates will spike. This could, of course, push the UK straight back into recession.

So, the UK economy seems to be heading towards one of two extreme outcomes; another bubble or a double dip recession. Moreover, this mess was caused by one bad policy mistake being followed with another.

There are days, when I really wonder if the BoE know what they are doing. Today was one of those days.