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). As the MPC of the Bank of England stated in 2009, their view was that once Bank Rate had reached 0.5% it '...could not practically be reduced below that level, and in order to give a further monetary stimulus to the economy, (the MPC) decided to undertake a series of asset purchases...'. (Source: Bank of England).
How does QE work?
QE can work in a number of ways, but essentially it 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, this is not the case. Printing money is more associated with funding government debt, rather than QE, which is directly pumping money into the economy 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 private businesses, including pension fund holders, insurance companies, private firms and high street banks. This is done through an injection of electronic money.
These funds are credited to the investors accounts, which, initially improves their liquidity.
The most immediate effect of the asset purchase is that prices of these existing assets (gilts) rise, while yields - effectively, the interest on them - adjust downwards. 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 shares (equities). As new investment occurs, the new liquidity is re-directed towards sellers of bonds and shares. In addition, lower yields push down borrowing costs for business, which can act as a stimulus to borrowing and spending.
The rise in the yields of other assets, such as shares, creates a wealth effect, with holders of assets experiencing an increase in their wealth, raising confidence and also stimulating spending. This positive effects of this may then spread out to the real economy.
The hope is that:
Bank lending starts to flow again, leading to increased household and corporate spending.
Confidence rises as lending and spending increase.
Aggregate demand increases and the economy moves out of recession.
The inflation target (2%) is achieved - rather than fall below target as might happen in a recession or periods of low growth and poor expectations.