So what is Quantitative Easing?

Posted on: 06 March 2009 by Gareth Hargreaves

The Bank of England is set to take a further drastic step in its bid to revive the economy - embarking on a policy of so-called "quantitative easing" to ease conditions in credit markets.

As the name implies, QE aims to increase the amount of money in the economy through the creation of central bank money to buy up assets such as government gilts and commercial paper - which is like a corporate bond, or an IOU used by companies to raise funds.

Why is the Bank doing this?

Since the onset of the credit crunch, banks worried about the strength of their finances have tightened up lending dramatically.

The Bank of England has previously relied on interest rate changes - controlling the cost of money - to act as a spur or brake on the economy.

Despite official rates being cut to an all-time low of 0.5% by the Bank's Monetary Policy Committee (MPC), many banks are still refusing to lend to any great degree, meaning further action is required.

Isn't QE just printing money?

In effect it is, although the BoE 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.

What else will QE do?

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.

How much more money will the bank create?

Nobody knows for certain until the Bank unveils details of its plans, although reports have suggested up to £150 billion could be created. Capital Economics' chief European economist Jonathan Loynes said the actual number depends on "uncertain and variable" links between the banks' reserves, the money supply and economic activity.

The MPC is also likely to progress cautiously with its new-found power.

"Our best guess is that it is likely to be closer to £100 billion than £10 billion... it seems likely that the MPC will build up to that level only gradually," said Mr Loynes.

So now banks should go out and lend more money?

This is the 64,000-dollar question. In principle, QE should boost the money supply, but these are times of unprecedented turmoil for the banking sector and it could simply decide to sit on the money.

Investec economist David Page says: "The big unknown for us and the MPC is how much of the additional base money commercial banks would lend on and how much they will hoard."

Will it work?

In reality, we don't know. As Mr Page says, this is "very much unknown territory" in terms of UK policy and it depends on how much banks hold on to the new money.

The most recent example of the tactic was in Japan during 2001 as the government attempted to pull out of a decade-long deflationary spiral, but economists are divided over whether the move was successful.

Mr Page adds: "Were there to be little or no hoarding, relatively small increases in base money would generate large increases in broad money.

"If hoarding is high, the (money) multiplier falls until at the limit QE is ineffective as a policy tool."

He added: "Japan's experience with QE was more towards the latter and this is one reason why simultaneous recapitalisation of the banking system is seen as critical."

What are the risks?

Aside from the possibility that the bank 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.

But this assumes an increase in demand and - given the current state of the UK and global economy - this seems unlikely in the immediate future at least.

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.

How will we know whether it is working?

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 easing 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.

Should the Bank of England create extra money? What should be done to help stimulate struggling economies? Do you think quantitative easing is a good solution?

Let us know your thoughts by leaving a comment in the box below or share your thoughts with other readers in the 50connect forums.

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