Quantitative easing explained
Thursday 06 October 2011
The Bank of England has followed in the footsteps of its US counterparts and boosted its "quantitative easing" programme - but what does QE actually mean?
Q: What is quantitative easing?
A: Simply put, quantitative easing, or QE, is an emergency measure used by policymakers to boost economic growth.
This is something the Bank of England would usually try to achieve by slashing interest rates, as lower rates encourage people to spend and not save.
But when rates cannot go any lower - as is nearly the case in Britain, where they are at a record low of 0.5% - the Bank will pump cash directly into the economy to encourage lending and activity. This is QE.
Specifically, the Bank will do this by buying assets - such as Government and corporate bonds - with money that is effectively created out of thin air.
The companies selling the assets - usually commercial banks or other financial businesses such as insurance companies - will then have new money in their accounts, which in turn should feed into the wider economy.
Q: Hasn't the Bank done this before?
A: Yes, the Bank started to inject more money into the economy in March 2009. Before today's decision, the level of QE issued by the Bank stood at £200 billion.
Q: So why has the Bank increased QE again?
A: Banks are worried about the strength of their finances and since the onset of the credit crunch have tightened up lending dramatically.
Lending to businesses and individuals is still at low levels, despite attempts by the Government to improve the climate, such as the so-called Project Merlin agreement with the banks.
The Bank warned strains on the banks - such as the eurozone debt crisis and volatile financial markets - meant the credit supply would continue to be limited.
Elsewhere, the Bank said the squeeze on household incomes and the Government's tough package of spending cuts and tax reforms would also stifle spending.
The move comes after figures revealed the UK economy effectively stood still in the nine months to June and as debt woes in the eurozone - the UK's biggest trading partner - worsen.
As rates have been held at 0.5% for more than two-and-a-half years, the Bank is left with few options.
Q: Isn't QE just printing money?
A: In effect it is, although the Bank does not literally turn on the printing presses to send a huge flurry of new notes into the economy.
What will happen is that the Bank will create the money to buy the assets and credit the reserves of various banks and financial institutions with the new money.
Economists call this "high-powered" money because the increase in their reserves should - in theory - allow the banks to go out and lend much more under the "money multiplier" principle.
Politicians and the Bank will be keen to distinguish QE from central bank funding of Government deficits - also known as "monetising the debt" - which is more akin to the idea of printing money in the popular imagination.
This is outlawed under the Maastricht Treaty and can lead to the kind of hyper-inflation experienced by Zimbabwe and the Weimar Republic in Germany.
Q: What else can QE do?
A: All things being equal, as well as creating more money, the Bank's actions should create more liquidity in commercial paper, helping to get capital markets moving more easily again.
On a technical level, if the Bank buys up Government bonds from banks, the cost of the bonds will go up and their yield - or return - will go down. This fall in the yield will help lower long-term interest rates.
Q: How much more money has the Bank said it will create?
A: The Bank said it will inject a further £75 billion into the economy, bringing the total level of QE to £275 billion.
Adam Posen, a member of the Bank's Monetary Policy Committee, which votes on interest rate and QE levels at its monthly meetings, has voted in favour of a £50 billion boost to QE for several months - so today's larger figure will come as a surprise to some.
Q: So now banks should go out and lend more money?
A: This is the 64,000-dollar question. In principle, QE should boost the money supply, but fears of debt contagion from Europe and major changes to regulation in the UK still mean banks are being cautious with their balance sheets.
Q: Will it work?
A: A report from the Bank - its first to measure the effect of QE on the economy - found the stimulus measure provided a "significant" benefit to growth and helped GDP increase by around 1.5% and 2%.
This was equivalent to dropping interest rates by between 1.5% and 3%, the Bank found.
Q: What are the risks?
A: Aside from the possibility that the banks could refuse to pass on the extra money, the expansion in the money supply as well as the impact of interest rates at record lows could give the Bank of England a severe inflation headache in years to come.
The Bank's study on the effects of the last round of QE found the consumer prices index rate of inflation increased by between 0.75% and 1.5% following the move.
However, inflation, which currently stands at 4.5%, will only rise if demand also increases, which given the current state of the UK and global economy seems unlikely in the immediate future at least.
The Bank said the deteriorating outlook meant it was now more likely that it would undershoot that 2% target in the medium term.
Sir Terry Leahy, the former boss of supermarket Tesco, last month linked the surging cost of oil, which was in turn squeezing household incomes, to QE.
"QE created an awful lot of liquidity intended for the real economy but found a home in markets and speculators looking for quick returns," he said.
The Bank of England is also keen to emphasise that QE was being considered only to the extent necessary to meet its 2% inflation target.
Q: How will we know whether it is working?
A: Experts will look at a variety of factors to assess the impact of the policy. Economists will keep an eye on the Bank's credit conditions survey to detect signs of softer lending markets. The Bank of England's measures of "broad money" in the economy may offer some clues as well as the Bank's balance sheet.
If over time banks' reserve balances are higher this may suggest banks are hoarding the extra cash.
Q: What options, if any, does the Bank have left?
A: The Bank has ruled out cutting interest rates below 0.5% - but at its meeting in September, minutes revealed policymakers had given the idea some consideration.
Another option is to continue increasing quantitative easing levels. James Knightley, economist at ING Bank, said he would not be surprised to see the total asset purchase spend rise to £500 billion, while IHS Global Insight economist Howard Archer suspects further QE will be revealed in the first quarter of 2012.
But business leaders have called for more "radical methods" from the Bank to boost confidence.
The British Chambers of Commerce (BCC) called for the Bank to impose negative interest rates on deposits held by commercial banks at the Bank of England, which could help to boost the availability of credit.
The BCC also called for the Bank to guarantee that rates will not rise until the end of 2012, as the US Federal Reserve has effectively done. Such reassurance would boost confidence and encourage banks to lend and businesses and individuals to borrow.
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