More quantitative easing

News of the current state of the economy came thick and fast this week, with talk of ‘the most serious financial crisis since the 1930s’ – and that’s just from Bank of England Governor,  and MPC Chairman, Mervyn King.  This, in a week that started with Mr Osborne’s speech hinting at credit easing, continued with the announcement of a further £75 billion of quantitative easing (not to be confused with credit easing), and concluded with the downgrading of 12 UK banks and two European countries’ credit rating (Italy and Spain, if you are interested).  Oh, and UK growth was downgraded from 0.2% in the second quarter, to an official 0.1%. So, for the record, what exactly is quantitative easing?

Quantitative easing (QE) is a process whereby a Central Bank, such as the Bank of England, purchases existing government bonds (gilts) in order to pump money directly into the financial system. QE is regarded as a last resort to stimulate spending in an economy when interest rates fail to work. This was the situation that faced the Bank of Japan in 2001, when it embarked upon its QE programme – regarded as the first major QE programme by a modern economy.

Reducing short-term interest rates to encourage spending has, of course, long been the favoured policy option of Central Banks when dealing with the threat of deflation and recession. However, if aggregate demand fails to respond to ever-lower rates, another policy must eventually be sought. This is because nominal interest rates cannot fall below zero.  As in Japan seven years earlier, by late 2008 nominal rates were heading towards zero in the USA, the Eurozone-17, and the UK, and indeed across much of the global economy.  Near-zero rates, together with cash hoarding by individuals, corporations and commercial banks, resulted in liquidity being trapped in the banking system, and contributed to the financial crisis.

To help unlock liquidity (when a liquidity trap exists) and encourage banks to lend, rounds of QE were embarked upon in the US (QE1 was started in December 2008, and QE2 in June 2011) and the UK (QE1 was started in March 2009, with QE2 launched this very week.)

How does QE work?

Essentially, QE works by raising asset prices, starting with government bonds, and then spreading out through the wider economy – this gives a boost to bank assets and current bank lending and creates a positive wealth effect for asset holders.

Although regarded widely as printing money, purists argue that printing money is more associated with funding government debt, rather than QE, which is directly pumping money into the financial system to stimulate spending.

Quantitative easing by the Bank of England involves the following steps, and results in a number of interconnected effects. The Bank of England purchases existing corporate and government bonds held by banks and corporations with an injection of electronic money. These funds are credited to the investors’ accounts, which immediately improve their liquidity.

However, the most significant effect of the asset purchase is that prices of existing assets (gilts) increase, while yields – effectively, the interest on them – are pushed down. This encourages banks and other investors to look to rebalance their portfolios by investing in other assets with a higher yield, such as corporate bonds and equities. As new investment occurs, the new liquidity is re-directed towards sellers of bonds and equities. This creates a wealth effect, with holders of assets experiencing an increase in their wealth, raising confidence and stimulating spending, which can spread out to the real economy.

The hope is that Bank lending starts to flow again, stimulating corporate and household spending and business investment, and enabling the economy to return to growth. The Japanese experience tells us that its own QE was too little and too late, and led to its ‘lost decade’.  All eyes will be now be on Cannes – the venue for next month’s G20 summit.