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Quantitative easing: What is it? And will it work?

Printing money, quantitative easing or extraordinary measures
– call it what you want but one thing is clear. The UK economy and the
Bank
of England
have entered uncharted waters.

On 5 March the Bank effectively abandoned the course it had steered for the
last 12 years and embarked on a novel double-header for monetary policy. It cut
interest rates to an historic low of 0.5% and unveiled plans to flood the
economy with up to £150bn of new money in a bid to unblock credit markets and
jumpstart an economic recovery.

Quantitative easing has no single, easy definition but the aim is to change
the quantity of money when one is so near to zero interest rates that it is
impossible to change its price. It often involves pumping cash into the economic
system by expanding the central bank’s balance sheet. In the UK case, it will
involve buying £100bn of gilts – government bonds – and £50bn of private sector
assets such as asset-backed securities and syndicated loans. The first tranche
of £75bn will arrive over the coming three months.

The reason for the radical action is that the money supply – the lifeblood of
an economy – has dried up. Annual growth in households’ money supply – cash,
deposits and loans – has slowed from 10% to 4.6% but for businesses it is
negative – falling by 4.6%.

Since the money supply constrains the (nominal) growth in the economy, the
Bank must arrest the decline in the quantity of cash, bank deposits and other
monetary components.

Meanwhile, yields on more risky corporate bonds – the price companies pay to
raise money – have soared n some cases to 32% from 8% before the crisis.

Quantitiative easing is meant to solve both problems and here is the (dismal)
science bit. The Bank buys assets from commercial banks and pays for them by
crediting the accounts those banks hold with it, creating new money just as if
it were printing new notes. Newly flush with cash, banks can use it to lend more
money, creating new credit through the so-called multiplier effect.

At the same time, buying private and public sector bonds pushes their prices
up, which in turn lowers the yield – a move that feeds through to lower market
interest rates.

But will it work? That’s the £150bn question. This is a large amount of money
– 10% of annual GDP and 12% of the money supply, so it is bound to have some
effect at some point.

Government bond yields did drop sharply after the news but it will take
months to see the impact on the money supply and on nominal demand in the
economy.

Meanwhile there are two things to worry about.

  • Firstly, banks may simply hoard the cash to restore their balance sheets.
  • Secondly, printing money can lead to inflation as too much money chases too
    few goods.

These are risks, but one the government is right to take. Even if some of the
cash is hoarded, banks are likely to on-lend some of it. And while inflation is
a medium-term threat, a deflationary trap such as the one Japan was mired in for
a decade is an immediate danger.

As Danny Gabay of Fathom Consulting and a former Bank of England economist
puts it, “Like a driver ascending a steep hill in an old banger, when traction
is low the only answer is to press the pedal to the floor.”

See our Shareholder Values blog:
Half
the rate, twice the work

Will ‘quantitative easing have the desired effect? Click on ‘Have
your say’ and tell us what you think.

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