Quantitative easing is an unorthodox monetary policy aimed at stimulating economic growth and preventing a fall in the money supply. Just to recap, Q.E. involves:
- Central Bank creating money electronically.
- Using this extra money to purchase government bonds (and other securities) from banks and financial institutions.
Q.E aims to:
- Increase bank liquidity. When commercial banks sell bonds to the Central Bank, they have an increase in their cash reserves. This increase in cash deposits should, in theory, encourage commercial banks to lend to businesses.
- Reduce interest rates. Through buying government bonds, the market price of bonds rises, leading to a reduction in long-term interest rates. Lower interest rates should, in theory, encourage greater economic activity in the economy.
What happens when quantitative easing ends?
There will come the point when increased economic activity means the Central Bank no longer feels the need to buy more securities. At this stage, the increased money supply from quantitative easing may be inflationary because, with increased confidence, the banks now start to lend the cash that they have previously been hoarding (saving). (though there is no sign of this occurring yet)
Reversing Quantitative Easing
At some point, the Bank of England will reverse the policy of quantitative easing. This involves selling the government bonds it holds on the open market. This will cause:
- A fall in the price of bonds, due to increased supply on the market.
- As bond prices fall, the bond yield will increase. Therefore, we will see rising interest rates.
- A decrease in cash reserves in banks. If banks buy government bonds, they will have a fall in their cash reserves; this could lead to a fall in the money supply, lower growth and possibly even deflation.
So will we get inflation or deflation when quantitative easing ends?
We don’t really know.
- If the Central Bank extends too much extra money and allows this extra money to stay in the economy during a strong recovery, then it is likely to contribute to inflation.
- If the Central Bank reverse quantitative easing too early – if they reverse quantitative easing when the economy is still in a liquidity trap / stagnant growth, then it could cause the economy to stagnate further. If quantitative easing is reversed when the economy is still weak, we could see deflationary pressures.
Therefore, the timing of quantitative easing becomes important. The hope is that the process of quantitative easing can be gradually reversed during a sustained economic recovery. Obviously, the Bank will not want 10-year. But, if it can sell £20bn every couple of months, the policy may be reversed without causing too much impact on the macroeconomy. If the economy is growing strongly, then the reduction in money supply and higher interest rates from Q.E, will be absorbed.
The other reason why it is hard to know what happens when quantitative easing ends is that it’s hard to know if quantitative easing has had much impact on stimulating the economy in the first place.