A walk through the pros and cons of quantitative easing

Apart from reducing the base rate to 0.5% - the lowest level since the Bank of England was established in 1694 - governor Mervyn King has introduced a quantitative easing policy worth up to £275bn.

But what brought this situation about, what is quantitative easing and what will the likely impact be?

The Treasury has approved the Monetary Policy Committee to buy £275bn of bonds through the creation of Bank money. This represents around 18% of gross domestic product, 13.75% of broad money supply (M4), 22.55% of M4 by households and non-financial corporate and around 5.5% of the total assets of UK banks.

In the three months to February 2012, the Bank will have deployed £75bn in medium to long-term gilts with outstanding maturities of between five and 25 years.

The purpose of such a policy is to boost broad money supply and credit, raising the rate of growth in nominal spending to a level consistent with meeting the inflation target in the medium term. That is the theory, so how will this affect the market in practice?

Whether quantitative easing can revive economic growth depends on whether commercial banks are willing to lend the additional money they receive.

As the extra reserve increases commercial banks’ liquidity, they may return to lending to companies and households, which will boost spending and investment.

On the other hand they could hold the extra reserve as a buffer and earn interest instead. In this case, the quantitative easing only boosts reserves – the narrowest definition of money supply.

This is what is happening in the US. In a speech in the second half of 2011, US Federal Reserve chairman Ben Bernanke said the Fed’s lending has resulted in a large increase in bank reserves as they chose to leave their excess idle.

The Fed’s credit easing has produced $670bn of excess reserves at commercial banks and other financial institutions in the US, around 4.7% of the nation’s annualised gross domestic product.

If the central bank buys long-term assets, sellers, using the cash received, can buy commercial bonds and other long-term investments. So the Bank’s plan to use the initial £75bn to buy medium to long-term gilts is positive.

Another question is whether this money creation will lead to inflation. The Bank has said there is a risk that the government’s preferred measure of inflation, the consumer prices index, could undershoot the 2% target in the medium term. So it is assumed the MPC would like to use this £75bn to maintain inflation at 2%.

However, history suggests that it’s hard for countries to use quantitative easing to avoid deflation successfully without falling into high inflation. In Japan, for example, it is still uncertain whether quantitative easing has vanquished deflation.

For us, quantitative easing will lead to inflation only if the government increases expenditure, commercial banks greatly relax lending and the costs of mortgaging are lowered.

But we do not expect all this to be achieved with the current level of quantitative easing.

Sterling fell sharply against the dollar after the Bank’s October 2011 announcement of further quantitative easing as increasing money supply is generally bad for a currency.