Quantitative Easing in the UK: What is it and How Does it Work?
Updated: Sep 19, 2022
Quantitative easing refers to an unconventional monetary policy tool used by many central banks to stimulate an economy when short-term interest rates have already been lowered as far as they can go (typically zero percent).
This unconventional policy involves creating new money and using it to purchase financial assets such as stocks, bonds, or other types of debt instruments in order to reduce long-term interest rates and encourage borrowing, spending, and investing. Quantitative easing first began in Japan during the late 1990s and has since spread across the globe.
In the United Kingdom, it has been applied as recently as 2020.
How does quantitative easing work?
A form of monetary policy first used by Japan, quantitative easing, or QE, refers to buying government bonds to lower long-term interest rates. This leads to a stimulus for economic growth as higher levels of available credit allow more people to buy homes and cars.
Lowering long-term interest rates also stimulates lending because banks receive more profit from loans that are longer term. The end result is improved investment opportunities for businesses, which can lead to job creation.
Quantitative easing was often used following a financial crisis as the Bank of England sought an effective way to revive their economy while managing inflationary pressures during post-recession periods. The United Kingdom’s version of quantitative easing includes lowering interest rates, but they also bought some bonds and equities as part of their balance sheet expansion policy.
A Quantitative Easing History Lesson
In 2009, a post-recessionary recessionary period that many call The Great Recession reared its ugly head. The United Kingdom had responded to this difficult situation by raising interest rates, however this was not successful.
In 2010, the Bank of England began Quantitative Easing - which involves the purchase of more than £375 billion worth of government bonds - to buy up some of the newly released Treasury Bonds. This initiative was incredibly successful as financial stability was eventually restored.
What Happens When QE Ends?
Economists have been debating the usefulness of quantitative easing, including where rates should be when it ends. To put quantitative easing into perspective, we first need to know what happens when QE ends.
Quantitative easing has helped to keep interest rates low for quite some time but these ultra-low rates can't last forever. This was recently seen when central banks started raising their policy interest rates – also known as key lending rate or repo rate – after years of keeping them below zero percent.
As a result, bonds became more attractive as they offered higher yields with lower risk than before. More important though, by putting more money into circulation through QE, this helps to stimulate investment while simultaneously decreasing inflation risks by increasing consumer demand on goods and services.
When QE is taken away, there's less new money available for investors which causes an increase in bond prices because investors would rather invest their money in bonds that offer higher returns.
This means that at the end of QE, bond prices will fall and interest rates will rise. When this happens, government borrowing costs will go up which could lead to new austerity measures being introduced if debt levels are too high.
However, just like how a stimulus package can help increase GDP growth over time, so too could ending QE provide fiscal stimulus due to higher growth due to increased investor confidence.
Will There Be a QE4?
The term quantitative easing is a bit of a misnomer. It has nothing to do with giving money directly to individuals, but rather involves buying back government bonds from private investors, with the intention of lowering their interest rates.
This pumps more cash into the economy, which lowers interest rates. Theoretically this should encourage businesses to invest more money because they're getting better returns on their investments. However, when governments (and private entities) buy up large quantities of government bonds, this results in less supply available for private buyers so their costs rise - which discourages them from borrowing more funds from financial institutions at lower rates to expand or invest more.
Is Quantitative Easing Effective?
Quantitative easing is a monetary policy that raises liquidity in the banking system by increasing reserve requirements. This lowers interest rates and has an impact on credit availability.
Quantitative easing impacts lending markets, such as mortgages, by reducing risk premia charged to banks. Furthermore, quantitative easing increases aggregate demand through effects on equity prices, exchange rates, and commodity prices.
Quantitative easing can also have a positive effect on national GDP levels as lower borrowing costs make projects more profitable or cheaper to implement. However, there are risks associated with quantitative easing as well.
For example, if implemented too aggressively this could lead to currency depreciation that may damage exports while also leading to higher inflation via cost-push mechanisms within import reliant sectors of the economy.
Where Can I Learn More About Quantitative Easing?
QE was first practiced by Japan during a financial crisis of their own, with China and Europe following suit. The ultimate goal is to stimulate the economy by increasing liquidity in markets where demand has lagged.
In England, this includes buying up bonds from pension funds to free up funds for investments that are supposed to create jobs.
A more controversial use of QE includes propping up failing banks that are too big to fail. Critics of QE argue that not only does it not work, but it also increases inequality because wealthy investors benefit at the expense of lower-income individuals who depend on interest income.
A potential side effect of long-term quantitative easing is the risk of higher inflation, which is what we are seeing now.
Further reading on QE from the bank of england