Friday, March 6, 2009

Quantitative Easing Explained

Looking in my favourite economics textbook, (J.Sloman) there is no mention of quantitative easing. There are lots of policies for reducing inflation. But, in the post war period, when it comes to fighting deflation and depression there is very little experience. Interestingly, the Bank of England has been in close negotiation with the Bank of Japan and the Federal Reserve - perhaps to gain advice on how to implement quantitative easing.

The decision to inject £75bn into the economy (could be upto £150bn or 10% of economy) is a radical step for the Bank of England and the economy. The decision to pursue quantitative easing has been taken because of:
  • The extent of the economic downturn
  • The fact lower interest rates have not helped the economy recover
  • The fact interest rates cannot effectively be cut further (0.5% today)
  • The fact inflation is predicted to fall below target of 2% risking prospect of deflation.

What is Quantitative Easing?

  • The Central bank undertakes to buy various assets - commercial and government bonds from banks. To buy these bonds the Central Bank issues Central Bank reserves. This is effectively creating money through electronic means
  • Banks gain an increase in liquidity because they sell assets for cash. This increase in banks balance sheets should hopefully encourage them to lend more.
  • By buying assets and government bonds. The price of bonds rises causing interest rates on bonds to fall. These lower rates should help boost spending
  • Bank of England £75bn Asset purchase scheme at B of E website

Possible Problems of Quantitative Easing

  • Inflation. When economy recovers it might be difficult to take out the excess money supply causing uncontrollable inflation.
  • Investors could lose confidence in economy due to risk of inflation
  • Danger of 'bond bubble'. Bonds and gilts will rise in price encouraging investors to buy and interest rates to fall. This could cause a bubble in the price of gilts which could collapse at a later stage causing long term interest rates to rise at an early stage in the business cycle.
  • Could cause lower value of Pound - Pound slumps on QE fears

2 comments:

supernova said...

I quote the post:
"Banks gain an increase in liquidity because they sell assets for cash. This increase in banks balance sheets should hopefully encourage them to lend more."

Globalization is an issue in this. If banks do lend more, it is likely to be in other countries with higher interest rates. So the local currency will tend to devalue against foreign ones. On the medium term, this may result in increased competitiveness and larger outputs.

So if quantitative easing is introduced too early, it may more beneficial abroad rather than locally especially on the short term.

A global simultaneous coordinated cash injection would have perhaps been safer...

An early overreaction into quantitative easing by the UK may be quite perverse as it may signal that investment should go elsewhere and that UK plc is in much worse troubles than elsewhere...

Bill Rollo said...

The 'banks' supposedly went bust in 2008. Where do they get these'government bonds' from? How do government by government bonds from a bank it doesn't own? Why do we have to buy these 'assets' when we could have insisted on them for our 'bail-out'? How will QE help, if the banks don't lend it out?