Quantitative Easing: The AnswersPosted on: 23 March 2009 by Gareth Hargreaves
Independent financial advisor Peter McGahan answers your questions on the government’s quantitative easing strategy.
Following last week's article on quantitative easing I had a number of questions which arose which I will endeavour to answer below.
How soon will quantitative easing take effect?
That’s an impossible question to respond to. Normal credit channels such as lowering interest rates take 6-9 months to have an impact and sometimes as long as 18 months to have the full impact.
Depending on what companies choose to do with their cash and lower borrowing rates, the effect could be quicker or slower.
Are there many instances when quantitative easing has worked and will it?
It worked in Japan, albeit after many years, but Japan's scenario was very different. Ultimately I suppose it has to work.
If you create money and keep pushing it into the system, it has to circulate and the Bank of England has the ability to do just that. The risk is that if you have to go too far that it’s a bit more difficult to unwind and slow the economy down.
My guess would be that there is an impact toward the end of six months from now.
Will it give rise to inflation?
Possibly, but lets remember we are in the middle of a global banking crisis, a subject I covered four weeks ago.
Rising unemployment, falling house prices, plummeting demand and record debt are not items that disappear overnight. They all stifle spending and as such will slow before they turn. It will be up to policy makers to use that and interest rates to slow the economy with the relevant measures.
But remember, a bit of inflation is a lot better than a bit of deflation.
Has quantitative easing had any initial impact?
Yes. The intention is to bring down the cost of borrowing. By buying lots of gilts from companies, this forces their yield down as the price rises. This, in turn means that companies could offer bonds at lower expected rates, reducing their borrowing costs.
In the first few days of quantitative easing the benchmark 10 year gilt yield declined by some 0.6% to 3.0%.
Is the UK familiar with quantitative easing?
Sure. In the 70's and 80's monetary targeting was seen in the UK and remember the bank buys and sells government securities anyway as part of its day to day operations.
In other countries they are considering a range of options such as quantitative easing in the U.S. although for the time being they are purchasing mortgage backed securities.
In Europe they are considering the purchase of corporate bonds and other financial instruments but the net aim is the same.
What are good signs to look for?
If banks used the extra liquidity they received to fund increased lending. We are constantly advised by government that they expect the money supply to ease up soon, but it doesn't! In today's difficult times banks may feel it more appropriate to sit and wait (and I think they will) until they feel a bit more of a floor under the economy.
Why do they want to lend in such a difficult time when it's hard to know how impacted the economy is likely to be?
This is probably why the purchasing of gilts has been aimed at the medium and long end of the market where the capital is invested by institutions. Banks tend to hold shorter dated gilts.
So follow this: The Bank of England buys its gilts from the investment company. That company deposits the new cash in its bank account. The key is what happens now. Sitting on it is no good. It is hoped that the bank will use this to lend or buy more assets in the market, thereby having a multiplying effect on liquidity.
That of course, is the theory. Prepare for the reality which may or may not be similar.
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