The Bank of England has embarked on a policy of quantitative easing. What is it and will it work?

What is quantitative easing (QE)?

QE aims to increase the amount of money in the economy through the creation of central bank money to buy up assets such as Government gilts and commercial paper – which is like a corporate bond, or an IOU used by companies to raise funds.

Why is the Bank of England (BoE) doing this?

Since the onset of the credit crunch, banks worried about the strength of their finances have tightened up lending. The Bank of England (BoE) has previously relied on interest rate changes – controlling the cost of money – to act as a spur or brake on the economy. Despite official rates being cut to an all-time low of 0.5 per cent yesterday – by the BoE’s Monetary Policy Committee (MPC) – many banks are still refusing to lend to any great degree, meaning further action is required.

Isn’t QE just printing money?

In effect it is, although the BoE does not literally turn on the printing presses to send a huge flurry of notes into the economy. What will happen is that it will create the money to buy the assets and credit the reserves of various banks and financial institutions with the new money. Economists call this “high-powered” money because the increase in their reserves should, in theory, allow the banks to go out and lend much more under the “money multiplier”

principle. Politicians will be keen to distinguish QE from central bank funding of Government deficits – also known as “monetising the debt” – which is more akin to the idea of printing money in the popular imagination.

This is outlawed under the Maastricht Treaty and can lead to the kind of hyperinflation experienced by Zimbabwe.

What else will QE do?

All things being equal, as well as creating more money, the BoE’s actions should create more liquidity in commercial paper, helping to get capital markets moving more easily again. On a technical level, if the BoE buys up Government bonds from banks, the cost of the bonds will go up and their yield – or return – will go down. This fall in the yield will help lower long-term interest rates.

How much more money will the bank create?

The first tranche of QE will see the BoE spend £75bn on corporate and Government bonds over the next three months. It has permission from Chancellor Alistair Darling to buy up to £150bn in assets if necessary, with about £50bn of that spent on private sector assets to support the flow of corporate credit.

How will the process work?

Members of the MPC will now vote on what quantity of assets to buy alongside their usual monthly decision on the level of official interest rates.

So now banks should lend more money?

In principle, QE should boost the money supply, but these are times of unprecedented turmoil for the banking sector and it could simply decide to sit on the money.

Will it work?

In reality, people don’t know.

The most recent example of the tactic was in Japan during 2001 as the government attempted to pull out of a decade-long deflationary spiral, but economists are divided over whether the move was successful.

What are the risks involved?

The expansion in the money supply as well as the impact of interest rates at record lows could give the BoE a severe inflation headache in years to come. But this assumes an increase in demand and, given the state of the UK and global economy, this seems unlikely in the immediate future at least.

How will we know whether it is working?

Experts will look at a variety of factors to assess the impact of the policy.

Economists will keep an eye on the BoE’s credit conditions survey to detect signs of easing lending markets. The BoE’s measures of “broad money”

in the economy may offer some clues, as well as its balance sheet. If, over time, banks’ reserve balances are higher, this may suggest banks are hoarding the extra cash.