What is Quantitative Easing (QE)? Specifically, it’s when the central bank purchases assets from financial institutions using money created electronically. In other words, it’s when digital money is created and is used to buy government debt in the form of bonds – with the simple aim of boosting spending and investment within the economy. With the financial crisis of 2008 causing it to be used as an emergency measure, 12 years later it seems to still be a large part of the UK’s monetary policy. With the current global pandemic, we’ve seen a huge shift in the use of quantitative easing around the world and possibly an opening into its true effectiveness.
For those who don’t know, bonds are a form of borrowing by firms or government. Money is borrowed which will be repaid at a fixed point in the future (the maturity date) and at regular interest (coupon) payments annually. Before maturity, the bond can also be bought and sold second hand on bond markets. They have two interest rates, the coupon rate and the yield. The yield is the interest rate that a buyer would get from the investment. For example, if a company issued a £1000 bond at a coupon rate of 6%, the bond would pay £60 annually. However, if the market rate increases to 9%, then this bond would lose value since there is no reason to buy an old bond paying £60 annually when a new one would pay £90 annually. Hence if you wanted to sell that bond, it would have to be at a lower price e.g. £600 since the yield increases from 6% to 10% which is over the market rate. The general rule is that the higher the market rate of interest, the lower the market price of bonds that have already been issued and vice versa.
During the global recession in 2008, the Bank of England lowered the bank rate from 5% to 0.5% in order to support the UK’s economic recovery (the cost of borrowing fell, encouraging firms to increase investment/spending). However, since there’s a limit as to how low interest rates can go, QE was introduced for the first time within the UK.
But how does it work? There are two main ways to look at this. Firstly, in terms of interest rates. QE has the effect of lowering interest rates further and therefore encouraging borrowing. This is because the Bank of England has effectively increased the demand for bonds issued by government which drives down the interest rates on those bonds. For example, if the government issued £1000 bonds at a coupon rate of 2%, interest payments would be £20 annually. QE will mean that the central bank will try to buy the bond (increasing demand) pushing the price of it up to perhaps £1100. Since the interest payments would still be £20 annually, yields will have fallen from 2% to 1.8%. The sellers of these government bonds are then likely to use their new money to buy other assets such as equities and corporate bonds depressing yields further (due to the increase in demand pushing prices up and therefore reducing yields). Firms who want to raise money for capital spending often do so via bonds. Since bond prices are now higher and yields are lower, they can borrow more and offer a lower coupon rate. Consequently, spending, investment and lending should all increase.
Secondly, QE can stimulate the economy by boosting a wide range of financial asset prices. For example, by buying £1 million worth of government bonds from an insurance company, it will now have £1 million in money. Rather than hold on to this, they might invest it into riskier financial assets (since bonds are considered low risk) therefore increasing demand for them. This raises the prices of these assets making businesses/households (the owners) wealthier and therefore encouraging spending. In addition, commercial banks can offer low interest deals to customers because the Bank of England provides them with more cash to lend out (rise in the money supply). This is because commercial banks will now hold fewer bonds/loans and more money once the Bank of England purchases the bonds off them.
During the global pandemic, QE in the UK has been vital throughout. After the second quarter the UK was in recession after witnessing a record fall of GDP by 20.4%. With fears of mass unemployment and COVID-19 itself, QE has helped fund the fight against the virus. Measures such as the furlough scheme, support for business and extra funding for NHS all required higher government spending funded by QE. With QE, the Bank of England increased demand for bonds and thus raising the price and lowering interest rates on the bonds making borrowing a lot cheaper for the government.
As of November 2020, the purchases of UK government bonds will total £875 billion. Additionally, £20 billion of corporate bonds have been purchased. In total, £895 billion of QE has occurred. This is a significant increase in comparison to the original £200 billion during the financial crisis.
It’s evident that QE (as unconventional as it may be) is becoming a vital part of monetary policy and has had a rather large impact. However, it’s important to remember that it was only brought in as an emergency measure during the financial crisis and so there are many downsides that are being recognised during the pandemic. The most significant being rising inequality. During the pandemic, we’ve seen the rich become richer and QE’s partly to blame. Think of those wealthier members in society who own a multitude of assets (e.g. government bonds). QE has essentially increased demand for these assets and has therefore pushed their prices up. The asset owners then sell these assets to the central bank to make a profit and now have cash to spend on riskier assets with greater return. The rich get richer. But it doesn’t end there! Since several asset owners now all demand financial assets all at the same time with their new-found money, assets get even more expensive. As you can imagine, as the prices of assets increase, as an investor your projected profit will also fall. This in turn forces investors to seek out riskier investments such as small start-ups/businesses. From an investor’s perspective, although it can be very profitable indeed, it is extremely dangerous as the prices of equities can be volatile and a lot of money can be lost. However, this is also arguably a positive effect of QE as it encourages entrepreneurial activity and supports small firms. This is why we may have seen riskier investments throughout the pandemic. QE in general can be beneficial but it has limits and cannot continue on forever. One reason being that it would distort markets. Since the central bank with essentially unlimited financial capacity can intervene without worrying about asset prices, risk assets will no longer be valued at their ‘fair’ value. In addition, QE seems to be a very short term solution, for once a crisis passes, it is hard to stop without potentially destabilising markets.
Regardless of QE’s adverse effects, most research suggests that QE has helped to keep economic growth stronger, wages higher and unemployment lower. It’s also speculated that QE may reduce the long-term interest rate of the UK as it once did in Japan. Lower long term interest rates may keep business confidence higher and may have an overall positive effect on the UK’s economy. On the other hand, it will reduce the reward for saving and in turn could discourage saving. As seen from the diagram, interest rates have fallen to 0.1% as of 2021.
The pandemic quantitative easing in the UK has been useful but may not be over just yet. Ever since the furlough scheme was extended to the end of March 2021, a new round of QE may be needed, possibly influenced by additional factors such as a very low inflation rate of 0.8% (Office for National Statistics – CPI). Such a low rate imposes the threat of deflation hence why QE is seen as a precautionary measure to avoid a decline in consumer spending and rise in interest rates.
But what of the future? With the expectation of inflation to remain low for the foreseeable future, more rounds of QE can only be expected. In a post-pandemic world, more government borrowing will be expected in order to support the economy. We cannot know if QE has been successful until we count the cost after the end of the pandemic. We can only hope that we can avoid a substantial rise in unemployment and COVID-19 dissipates as soon as possible. Only time will tell…
