29 Jun 2011 | Economy

Easing the Economy 

David Smith looks at whether quantitative easing
has worked. 

Had we know before the recent global financial crisis that central banks would be forced to turn to quantitative easing (QE), perhaps someone might have thought up a better name for it.  Still, clumsy though it sounds, QE explains the process well.

Normally central banks alter the price of money – interest rates – in an attempt to control the economy. Cutting rates boosts the money supply by stimulating credit growth, and thus the economy.

But what happens when rates are at rock bottom and that is still not enough to stimulate the economy? Central banks act directly by electronically creating and thereby increasing the quantity of money, hence the term quantitative easing. There are a few different ways to do this, but one of the most straightforward is that employed by the Bank of England from March 2009 until February last year, to the tune of £200bn. In order to ‘create’ money, the Bank bought assets, mainly gilts, from the private sector.

QE is a relatively untested policy. The Bank of Japan did it from 2001 to 2006 but with little obvious effect, perhaps because interest rates had already been close to zero for several years. However, this did not deter the world’s central banks resorting to QE in response to the worsening crisis. The US Federal Reserve went further by launching a second tranche – ‘QE2’– $600bn of additional easing last November, a programme that is due to end in June this year.

Has it worked? The Bank of England initially appeared to suggest that the consequences of QE would be realised mainly in additional bank lending, but later explained that the effects had been most felt in the impact on financial markets. Gilt purchases by the Bank pushed up their prices and so pushed down yields. This drop in yields was reflected in other markets, including corporate bonds and may have boosted the stock market. Thus, while QE did not help small firms, it did help larger firms to raise funds in capital markets.  Though it has not obviously improved money supply growth, it may have helped prevent a monetary collapse. The aim of the policy was to help the economy recover, and while it has been bumpy, it has done so. On balance, QE appears to have helped.

What about inflation? Consumer price inflation is roughly double the Bank’s 2 per cent target. Did QE cause that? The Bank does not mention it as a possible cause of inflationary factors, focusing instead on rising global commodity prices, higher VAT and rising import prices as a result of the earlier weakness of sterling. QE may however have helped to keep sterling down, not least by persuading the markets that the Bank was a long way from tightening monetary policy (by raising interest rates).

The effect of QE on inflation may have been felt in another way. When the Federal Reserve launched QE2 late in 2010, many ‘emerging economies’, including China, complained that the extra money was flooding out of America and into their economies, boosting commodity prices. Again the effects are difficult to disentangle but it is a fair rule of thumb that if central banks pump up the money supply, it will show up in inflation somewhere.

Perhaps the most important lesson is that QE should be used with caution. Few would dispute its use in dire emergency.  I, for one, would be uneasy if it came to be seen as something to be used in all circumstances. We don’t know enough about its effects to risk that.

Author: David Smith
David is economics editor and an assistant editor and policy advisor for The Sunday Times and a visiting professor at Cardiff University. His latest book is The Age of Instability: The Global Financial Crisis and What Comes Next.