MARKETS

Quantitative easing

Quantitative easing 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. Quantitative easing (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 an advanced economy.

Reducing short-term interest rates to encourage spending has 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 Euro-area, and the UK, and indeed in many regions 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 UK (QE1 was started in March 2009, and QE2 in October 2011).

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:

1. The Bank of England purchases existing corporate and government bonds held by banks and corporations with an injection of electronic money.

2. These funds are credited to the investors (banks) accounts, which, initially improves their liquidity.

3. The most immediate effect of the asset purchase is that prices of these 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.

4.  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:

1. Bank lending starts to flow again, leading to increased household and corporate spending.

2. Aggregate demand increases and the economy moves out of recession.