Quantitative easing

What is Quantitative Easing?

Quantitative easing is a process occasionally used by central banks to invigorate a sluggish economy when all the usual methods have failed.

Ordinarily a central bank (such as the Bank of England) will lower interest rates in order to encourage greater lending and spending and keep inflation on track. However, if interest rates have been cut as low as possible and economic activity has still not improved, then the central bank may inject a 'quantity' of money directly into the wider economy to boost the money supply and 'ease' the situation - i.e. 'quantitative easing'.

The central bank does this by firstly creating a batch of new money, not by printing actual bank notes, but by simply crediting its own bank account electronically with an amount of virtual new money. It then uses this new money to buy assets, such as government bonds, from private sector businesses including high street banks, pension funds and insurance companies.

When the central bank buys up assets, their price rises and the yield (return or interest) on those assets falls. The sellers of those assets are then likely to use their new money to buy other assets such as equities and corporate bonds, which depresses yields further. Reduced yields means the cost of borrowing is reduced for businesses and individuals and as a consequence lending, spending and investment should all increase.

Also those banks which have increased funds in their account from the sale of assets should in theory be more inclined to provide loans, which again will lead to increased spending and investment.

When the economy recovers, the central bank can then sell the assets it has bought and remove the cash it receives for those assets from the economy, so that in the long term no new money has been created.

Background

Quantitative easing was first used in the UK in 2009. The collapse of US banking giant Lehman Brothers in September 2008 precipitated a worldwide financial crisis which by 2009 had developed into a serious global economic downturn. World GDP was forecast to fall to its lowest rate since World War II and in the UK GDP was down 2.4% in the first quarter of 2009.

The Bank of England's Monetary Policy Committee had already set the bank rate as low as possible at 0.5%, but decided that in order to meet the inflation target of 2% further action was needed. The MPC announced in March 2009 that it would begin to inject money directly into the economy - the process known as quantitative easing.

The Governor of the Bank of England, Mervyn King, said at the time: "It's fair to say that in the Bank's 300 year history we have not seen measures of this kind enacted on this scale, but remember we haven't either seen the scale of the problems to which we've had to respond."

The then Chancellor, Alistair Darling, had authorised the Bank in January of that year to set up an Asset Purchase Facility (APF) which would provide a framework for the MPC to use asset purchases for monetary policy purposes should that prove necessary. In February the Governor of the Bank of England wrote to the Chancellor requesting authorisation to use the facility and in March authorisation was given.

Initially the Bank announced that it would purchase £75 billion of assets using new money it had created. The Governor said it was "hard to judge" whether that would be enough, but that the situation would be monitored to see whether it was necessary "to do more or less". In May 2009 the Bank decided it would need to purchase another £50 billion of assets bringing the total figure to £125 billion. In August that total figure was increased to £175 billion and in November to £200 billion.

Most of the assets purchased have been UK government securities (gilts), but the Bank has also purchased small quantities of high-quality private sector assets in order to support the flow of corporate credit.

The MPC decides at its regular monthly meetings whether or not more assets need to be purchased and in February 2010 the Committee voted to maintain the stock of asset purchases at £200 billion, but added that further purchases would be made if the outlook warranted them.

On 6 October 2011, the MPC increased the limit of the current purchase programme to £275 billion and on 9 February 2012 to £325 billion, with a further increase of £50 billion to a total of £375 billion on 5 July 2012.

Controversies

One of the main concerns about quantitative easing is that if too much new money is created, this can lead to hyperinflation, as was seen in the German Weimar Republic after World War 1 and latterly in Zimbabwe, where increasing numbers of banknotes were printed of ever higher denominations until they became virtually worthless.

But the Governor of the Bank of England has rejected the comparison, pointing out that the Bank is not printing vast amounts of new bank notes and insisting that the amount of new money being electronically created is not big enough to generate "anything remotely like" that kind of situation.

However, Japan also embarked on a process of quantitative easing between 2001 and 2006 similar to that of the UK, buying up government bonds when rock bottom interest rates failed to stimulate the economy, and the process was judged to be less than successful with Japan still facing problems of low growth and falling prices.

But the Bank of England argues that lessons can be learned from the Japanese experience. Firstly that the Bank of Japan failed to act early enough or decisively enough when it cut its policy rate to 0.5% in September 1995 but did not begin quantitative easing until March 2001. The MPC cut the bank rate to 0.5% in March 2009 and began quantitative easing in the same month.

Secondly the BOJ bought assets principally from banks, so there was no direct effect on broad money, whereas the Bank of England is working through a wider range of channels, focusing on the non-bank private sector. Also, the BOJ bought only government debt until mid-2002, whereas the Bank of England will purchase corporate assets as part of its strategy.

Another concern is that quantitative easing will be ineffective if instead of using the new money to lend to small businesses and individuals, banks just sit on the cash in order to increase their capital reserves. But the Bank disputes this, pointing out that quantitative easing operates through a variety of channels, only some of which actively involve commercial banks.

On 9 November 2012, the Treasury announced that the Government had agreed with the Bank of England to transfer to the Exchequer the excess cash held in the Bank’s Quantitative Easing (QE) facility.

This move would align the cash management arrangements for the facility with normal government practice and with the approach followed by other countries undertaking QE.

The Treasury stated that with the purchases of the APF having reached £375 billion in July 2012, the Facility had now accumulated a large cash balance; and as the scale and likely duration of the scheme had increased significantly since its inception, “it makes sense to normalise the cash management arrangements for the APF.”

Also, as monetary conditions normalise, cash flows will need to be reversed and return payments from the Government to the APF may be necessary to meet shortfalls in the APF’s net income as the Bank Rate rises, or capital losses on its gilt holdings as the MPC unwinds QE.

The Treasury added that as the previous Government had agreed that any future losses incurred by the APF would be met in full by the Government, any net coupon income transferred from the APF to the Exchequer should be used solely to pay down government debt.
 

Statistics

Bank of England Asset Purchase Facility Fund Ltd.
Review of 2011/12

On 6 October 2011 the MPC increased the limit of the current purchase programme to £275 billion and then on 9 February 2012 to £325 billion.
The Company is authorised to purchase up to £10 billion of private sector assets.  These purchases can be financed either by the creation of central bank reserves or by Treasury bills and the Debt Management Office’s cash management operations. 

The limit on purchases of private sector assets was reduced from a maximum of £50 billion in 2010/11, following an exchange of letters between the Governor and the Chancellor on 29 November 2011.

Since the inception of the Company to the end of February 2012, total purchases net of sales and redemptions amounted to £287.1 billion (2011:  £199.6 billion).  Of which, gilts comprised £286.8 billion (2011:  £198.3 billion) and corporate bonds £0.3 billion (2011:  £1.3 billion).  No secured commercial paper was held at 29 February 2012 (2011:  less than £0.1 billion).

Source: Directors’ Report for the year ended 29 February 2012

 

On 9 November 2012 the Government agreed with the Bank of England to transfer to the Exchequer the excess cash held in the Bank’s Quantitative Easing (QE) facility.

If the APF’s gilt purchases remain at £375 billion, it is expected that around £35 billion of excess cash will have accumulated in the APF by the end of 2012-13.

In order to maintain the stability and predictability of the Exchequer’s cash management operations, the transfer of this cash to the Exchequer will be staggered across 2012-13 and 2013-14 as follows:
It is envisaged that the net coupon income earned by the APF during 2012-13, expected to be around £11 billion, will be transferred to the Exchequer during 2012-13. The excess cash that had accumulated in the APF up to the end of 2011-12 (£23.8 billion) will be drawn down over the course of 2013-14.
From 2013-14, the ongoing cash surplus will be transferred regularly on a quarterly basis thereafter.

Source: Treasury – November 2012
 

Quotes

“When this Government entered office, the UK’s cost of borrowing was the same as Spain’s and Italy’s. Today, their cost of borrowing is more than six per cent and ours is one and a half per cent.
“That market confidence and those ultra-low interest rates are precious assets – hard won and easily squandered.
“And it is precisely that market confidence and fiscal credibility that allows our independent monetary authority, the Bank of England, to operate a more active monetary policy:

"Expanding the Quantitative Easing programme.
"Launching with the Treasury the new Funding for Lending Scheme operational next week that will reduce bank funding costs to reduce loan rates and mortgage costs."

Chancellor George Osborne, from a speech at the Global Investment Conference – July 2012