The Bank of England has announced another round of quantitative easing. At its meeting on 9th February the Monetary Policy Committee voted to pump £50bn of extra stimulus into the economy. I thought it would be useful to take a closer look at quantitative easing at this point.
What is quantitative easing?
Normally when a central bank needs to raise the amount of lending and activity in the economy it will do this indirectly by cutting interest rates. This encourages people to spend rather than save.
When rates are too low to be cut any more, the central bank’s only option is to directly pump money into the economy. Although quantitative easing (QE) is often described as ‘printing money’, the bank does not actually do this, rather it basically credits its own bank account, thus expanding its balance sheet and monetary base.
It uses this money to buy assets, usually financial assets such as government and corporate bonds. The institutions selling the assets (commercial banks or other financial businesses) then have new money in their accounts, which boosts the money supply and should feed into the wider economy. Since these banks/institutions now have money available, they are more likely to lend to businesses and individuals.
When the bank buys bonds, it reduces the supply in the economy and so increases the demand for new bonds. This makes it cheaper for businesses to borrow money for longer-term investments, as long-term interest rates also get pushed down.
How much QE has the Bank of England done?
In March 2009 the BoE cut its interest rate down to the historic low of 0.5%, where it has remained ever since. At the same time it announced its first QE programme, starting with an initial £75bn of asset purchases. Later that year it expanded the programme to £200bn.
It announced a further £75bn of QE in October 2011. With its latest addition the total QE programme is £325bn. The latest round will take three months to complete. Some economists predict there is more QE to come.
Why this latest round?
The UK economy has been in danger of slipping back into recession, largely because of the Eurozone debt crisis. Banks have also been reluctant to lend to businesses and individuals because of concerns about the strength of their finances.
The Bank justified the move because of the backdrop of a weak economy, uncertain outlook for the Eurozone and falling UK inflation. The Monetary Policy Committee (MPC) statement said that further monetary stimulus was needed.
“The underlying pace of recovery slowed during 2011, with activity falling slightly during the final quarter.
“Some recent surveys have painted a more positive picture and asset prices have risen. But the pace of expansion in the main export markets has slowed and concerns remain about the indebtedness and competitiveness of some euro-area countries.”
The announcement was in line with market expectations. Analysts had originally predicted that this round of QE would be £75 billion, but then economic surveys indicated that the manufacturing and service sectors had performed better than expected in January.
The QE announcement was welcomed by business groups.
Does QE work?
The Bank believes it does. A BoE report found that the first round of QE had provided a “significant” benefit to growth and that gross domestic product had increased by between 1.5% and 2% as a result. This is the equivalent of cutting interest rates by between 1.5% and 3%.
While some analysts point out that lending to both businesses and individuals remains sluggish in spite of QE, others argue that it has helped the financial markets by keeping the interest rate on government bonds down.
While there is no way to quantify it, it is more than likely that the UK economy would have been in worse, perhaps much worse, shape without QE.
Does QE affect pensions and savings?
QE pushes down the yield on government bonds, and since annuity rates are based on these yields, new retirees will see their earnings reduced. Annuity holders have already seen rates plunge over recent years, and pensioners groups, like Saga, have reacted angrily to the announcement, accusing the government of making life difficult for many retirees.
It is not good news for savers either as it is proof that the BoE is nowhere near being in a position to raise the bank interest rate.
How does QE affect the UK’s international standing?
Ratings agency Fitch has approved the move, saying it has put the UK in a better budgetary position than France and even Germany. The £50bn of gilt purchases will “significantly reduce” the UK’s need to tap the private sector to fund its budget deficit.
It did however warn that QE was not a solution to the concerns about the structural deficit and growing public debt burden. “The most important factors regarding the UK’s overall creditworthiness are economic growth and its fiscal consolidation programme”, it said.
Fitch highlighted the fact the Britain’s economy benefited from being independent as opposed to being part of a monetary union, since it could take action as needed.
By Bill Blevins, Managing Director, Blevins Franks
13th February 2012