The purpose and mechanism of quantitative easing

Quantitative easing (QE) serves as a tool for implementing loose monetary policy, particularly when interest rates are already very low or negative. It aims to stimulate aggregate demand or exert upward pressure on inflation by increasing the money supply.

How quantitative easing works

QE involves a central bank, such as the Bank of England, creating new money electronically. This new money is then used to purchase assets from financial institutions and other firms. The process encourages these institutions to either spend the money themselves or lend it to individuals and businesses, thereby boosting overall spending in the economy.

When quantitative easing is used

• Low aggregate demand - QE is often introduced during economic downturns, such as following a credit crunch where banks reduce lending, leading to decreased spending.
• Limited impact of interest rates - When rates are near zero, further reductions have little effect, making QE an alternative to inject liquidity directly into the economy.

Implementation of quantitative easing in the UK

QE was first introduced in the UK in 2009 as a response to the 2008 recession, which had caused a sharp decline in aggregate demand. At that time, interest rates were already at a low level of 0.5%, limiting traditional monetary policy options.

The UK's quantitative easing process

• Asset purchases - The Bank of England bought assets, such as government Treasury bills, from institutions including insurance companies and commercial banks.
• Initial challenges - Banks were initially reluctant to lend the new money due to caution following the credit crunch, instead using it to build up their reserves.
• Eventual outcomes - Over time, banks began lending to firms and individuals, who used the funds for activities like investing in machinery, starting new businesses, or purchasing homes.
• Economic effects - This increased spending helped to raise aggregate demand and contributed to a gradual increase in the inflation rate.

Benefits and risks of quantitative easing

QE offers several advantages for stimulating economic activity, but it also carries potential downsides that policymakers must manage carefully.

Benefits of quantitative easing

• Stimulation of spending - By increasing the money supply, QE enables more lending and borrowing, encouraging investment and consumption.
• Weakening of the currency - Unlike interest rate cuts, QE can keep the exchange rate low, making exports more competitive and supporting international trade.
• Boost to confidence - During recessions, QE signals active intervention by the central bank, which can reassure consumers and firms, potentially encouraging further economic activity.

Risks of quantitative easing

• Timing of lending - Financial institutions might hold onto the new money as reserves during downturns and only lend it when the economy improves, which could exacerbate demand-pull inflation if it coincides with rising prices.
• Inflation control challenges - Excessive money in circulation might lead to inflation becoming difficult to manage, although central banks can reverse QE by selling assets to reduce the money supply.

How the Bank of England considers the wider economy in monetary policy decisions

The primary goal of UK monetary policy is to maintain price stability, targeting an inflation rate of 2% with a tolerance of 1% above or below. However, decisions are not made in isolation and must account for broader economic conditions.

Balancing inflation control with economic support

• Response to high inflation - Normally, high inflation (e.g., above 4%) would prompt an interest rate increase to curb spending. Yet, between January 2010 and March 2012, inflation remained at 4% or higher, but rates stayed at 0.5% and QE continued.
• Influence of economic shocks - This period followed significant disruptions, including fears of a double-dip recession. The Bank anticipated that inflation would decrease naturally without rate hikes, and raising rates risked deepening the downturn.
• Support for government objectives - When inflation is managed, the Bank prioritises aiding wider goals like economic growth. Loose policy, including low rates and QE, was maintained to avoid further harming the economy during recovery.