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Funds Insider
Funds Insider
08 Nov, 2010

Ask Citywire: Quantitative easing part II

The US has launched the second round of quantitative easing, or QEII, and the UK is still pondering whether it should follow suit. But what is it and how does it work?

While Bank of England's rate-setters have so far voted against a second round of ‘quantitative easing’ most commentators believe there is a strong possibility that the Bank will begin buying up more bonds in 2011 as the UK recovery is likely to slow.

What is quantitative easing?

Ben Bernanke, the chairman of the US Federal Reserve, is one of the world's leading supporters of quantitative easing. Back in 2002 he made a speech saying that central banks can always tackle deflation by printing money and likened that process to dropping dollars from a helicopter.

The process involves a central bank, in our case the Bank of England, buying assets from commercial banks or other financial institutions such as insurance groups and pension funds.  

Quantitative easing - often referrred to as printing money - was first introduced in Japan back in 2000 and was used again by the US, the UK and Japan in the wake of the 2008 financial crisis as a way to get money circulating again and to stimulate demand after markets froze up. 

Why are the central banks doing more quantitative easing?

The US has launched a second round of quantitative easing because unemployment remains just shy of 10% and data suggests the US is on the verge of deflation - an economic problem that is very difficult to tackle.

Japan has also begun pumping more money into its economy. The US said it will buy medium dated governemnt bonds to help bring interest rates lower while Japan has pledged to buy exchange traded funds and real estate investment trusts as well as corporate bonds. In the UK, the Bank of England has also mostly been buying governemnt

Banks in the UK remain reluctant to lend and demand remains in the doldrums with consumers and businesses still nervous about the pace of the recovery and the likely impact of government spending cuts.

Chancellor George Osborne has said that if its cuts have a larger than feared impact on growth, the Bank of England can launch a second round of quantitative easing. 

But inflation is a bigger worry in the UK than in other developed countries and recent economic data has been better than hoped, casting doubt on whether more stimulus is needed.

Is it working?

The extra money is meant to stimulate investment, consumption and other economic activity but the evidence so far has been mixed.

There has been one clear beneficiary: stock markets and other risky investments such as commodities have risen. 

Global stock markets have been boosted as low interest rates and the low yield on bonds means investors have been taking on more risk to guarantee a return on their cash.

Money has flooded into stock markets and into emerging markets as investors look for yield.

Bernanke (pictured) and Bank of England governor Mervyn King have said it is clear that quantitative easing has boosted stock markets. Both hope that will in turn improve confidence and boost demand. 

But emerging market governments have become worried that the flood of cash coming their way could destabilise their economies.

So will we have more quantitative easing in the UK?

Much depends on whether inflation continues to remain above the 2% target – which is increasingly likely given the VAT rise in january and the strength in commodity prices.

If growth remains strong and there are signs that demand is growing, the Bank of England may decide against doing more to stimulate the economy.

But one member of the Bank's rate-setting Monetary Policy Committee, Adam Posen, has already voted for more stimulus and other rate-setters including deputy Governor Paul Tucker say the case for  more stimulus is growing as the outlook for the UK is lacklustre.

Any more stimulus is unlikely before February, by which time the committee will have a better view of how the recovery is developing.

What could go wrong?

Most commentators agree that quantitative easing has little impact on the real economy and is largely a confidence game so data last week that showed consumer confidence has fallen back to lows last seen at the peak of the crisis in November 2008 is a worry.

The Bank of England's Charlie Bean has said it is vital that we spend our savings but some data suggests people are already raiding their piggy banks just to pay for the higher cost of living and that means they are reluctant or incapable of spending on any luxuries.

And with banks still nervous about whether they will be forced to hold more cash aside for a rainy day and reluctant to lend in this uncertain economic environment, it is possible that cash could remain in short supply and spending will remain muted.

Could anything else go wrong? 

The risks are hyperinflation and the collapse of sterling. In the days when governments actually printed more cash, this has traditionally been the end result of easing.

Sterling did fall back after the first bout of stimulus but has recovered much of the ground lost in recent months as the economic picture has improved and as it became clear the US would be first to do more quantitative easing.

But the currency could fall again if it looks like the UK will do more to stimulate the economy as that suggests interest rate rises are a dim and distant prospect, making sterling unattractive relative to the currencies in countries where rates are rising.

Most observers say the key is that government and the BoE stay alert to changing conditions and reverse the policy swiftly when needed.

The OECD has warned that withdrawing the stimlus poses a significat risk to global markets.

So why are we doing it again?

Because policymakers say there is no alternative way to stimulate the economy given the high levels of debt and because central banks fear deflation much more than they fear inflation.

King has repeatedly said it is easy to turn the tap off if it looks like inflation is getting out of hand. What that means in practice is that inflation will go unchallenged until the economy is clear stable again. At that point interest rates will be lifted to rein in price growth.

Read our guide to how QE2 will affect your investments. 

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