an introduction to quantitative easing

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An Introduction to Quantitative Easing

Bank of England by Adrian Pingstone on Wikipedia

Part 1 - When Its Used

Since the dawn of the financial crisis in 2008 - a crisis that continues to affect

the health of our economy, and therefore the prosperity of each one of us today -

there has been much discussion as to the best ways to minimise government debt

whilst, at the same time, encouraging as much growth in the economy as possible.

One tactic that has been used in a few countries including the UK and US is that

of quantitative easing.

Typical Monetary Policy

A central banks primary and most effective tool when influencing or controlling the

speed at which the economy is growing is the base interest rate. In the UK the

central bank, the Bank of England (BoE), defines this rate as the rate at which

they will lend to other banks. In short, by lowering this base rate, other banks are

able to borrow at a lower rate and consequently offer lower interest rates in turn

on both loans and savings accounts to their customers. These customers

therefore have access to more affordable (due to the lower loan repayments)

money with which to grow their businesses or to spend on goods and services.

Meanwhile, the lower interest rates on savings accounts reduce these potential

returns and so there are less incentives for customers to deposit their money as

savings. All these factors make investment opportunities more attractive and

spending more likely; thus increasing the flow of money through the economy.

When Quantitative Easing Is Used

This system works well as long as the base rate has room to be lowered. However,when it is too low to be reduced any further the central bank must look to other

solutions to encourage further spending and investment. Whats more, when a

base rate is lowered in response to a lack of liquidity and growth in the economy,

there is a point at which banks can become more reluctant to lend. This is caused

by the twin effects of lower yields for the bank on their loans, due to the

tendency for the interest rates across the market to be lower, and the increased

uncertainty surrounding whether individuals and businesses will be able to make

their repayments. All of which reduces the money reaching invdividuals and

businesses and subsequently their spend and investment on goods and services

within the economy, slowing down growth.

When the central bank encounters a situation such as this, as has been the case

in a number of economies in the last few years, they can utilise a secondary tactic

of quantitative easing. The basic principle behind quantitative easing is to

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introduce more money (i.e., more liquidity) into the economy to spur spending and

growth, by using newly created money (colloquially referred to as newly printed

although in truth it is all done electronically). This new money is injected by the

central bank when they purchase government bonds (i.e., government debt) from

private companies, as explained further in the second installment of this article,

with the aim of there being a trickle down effect throughout economic markets to

other businesses and individuals.

Managing Growth

The level of spending in the economy can be intimated by the inflation rate - the

percentage rate at which the value of goods and services are changing, usually

increasing, in price. A high inflation rate reflects the fact that there is high demand

for these goods and services within the economy, although the higher it becomes,

the greater the chances of a rebound effect that then reduces demand and slows

spending - high inflation means high prices and these prices can reduce the

affordability of goods and/or money will start to lose its value (particularly in the

case of hyperinflation such as was seen in Germany in the inter-war period).

Therefore, countries tend to aim towards a stable rate of inflation which reflects

growth with a sustainable momentum.

In the UK, a committee within the Bank of England called the Monetary Policy

Committee (MPC) has the remit of attempting to maintain a stable rate of inflation

at 2%. To that end the committee is responsible for a number of monetary

policies. including setting the base interest rate and overseeing the BoEs

quantitative easing policy.

The second installment of this article looks at how quantitative works and

achieves this aim.

Sea of Money by Rareclass on Flickr

Part 2 - How It Works

In the preceding part of this article, the concept of quantitative easing was

introduced in the context of the wider subject of monetary policies, with reference

in particular to the circumstances in which it may be utilised by central banks. The

second installment looks further into how the policy works and how it therefore

achieves its aim of stimulating economic growth and maintaining inflation rates.

As explained in the previous installment, quantitative easing provides central

banks, the Bank of England (BoE) in the UK, with a method of introducing newly

printed money into the economy, increasing its liquidity so that individuals

ultimately have more to spend and businesses earn more and invest more; thus

lubricated the whole economic cycle.

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How It Works

The mechanism that a central bank uses to inject these new funds into the

economy when quantitative easing is to buy up assets like government bonds

(government debt) from private companies which include pension funds and

insurance funds etc. The process has a number of consequences which are

designed to pass on the liquidity to companies and individuals both directly and

indirectly.

Firstly the companies from which the assets are purchased increase their cash

deposits whilst being discouraged from re-investing that money in the same

government bond market by the fact that the increased competition posed from

the central banks activities increases the price of such assets and reduces their

yield. The private companies are then more inclined to invest in alternative asset

types which can have a number of further impacts. The trickle down effect of

increasing competition and demand repeats in further asset markets down the

chain and ultimately encourages more money to be retained on deposit, in banks.

The more money held on deposit in banks by business customers, the more they

will be able and inclined to lend back out into the economy, and as mentioned

before, that stimulates spending and growth. Additionally, if private companies areinvesting in alternative asset markets such as stocks and shares the resultant

competition and higher prices of assets, increases the wealth of others in the

market so that individuals have more money to spend, and businesses more to

invest and grow.

Whats more as companies look to alternative investment opportunities with higher

yields they are more likely to invest in vehicles such as corporate bonds which

directly raise capital for the businesses which issue them - allowing them to invest

further in their operations and growth.

In the end a visibly successful quantitative easing policy leads to perceived

confidence and trust in the economy and the likelihood of people spending more

rather hoarding in case the money runs out; it therefore creates a cycle of spending which drives economy forward. As mentioned in the previous installment,

this is where inflation can be a useful tool in illustrating the price rises which occur

in response to greater demand for goods and services. However, quantitative

easing is only ever intended to maintain a stable inflation rate rather than drive it

up and so it always tempered by the risk of causing excessive inflation.

As a footnote, in the UK the BoE aims to have introduced 375bn by end of 2012,

with the first tranche of that already in place (known as QE1) totalling 200bn.

The final total is likely to account for a third of all government debt coming into

the possession of the BoE.

To find out more about investing in global economies you can visit this globalequities investment trust site.

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