What the hell is 'Quantitative Easing'?

Having tried and failed to stabilise the economy by lowering interest rates, the Bank of England has turned to so called 'quantitative easing' as the supposed answer to our prayers. Here, Tony Harris explains what quantitative easing actually is and how it is hoped it might help the economy in our hour of need.

When the economy is in trouble, the Bank of England normally tries to stimulate spending by lowering interest rates. This encourages people to spend rather than save which in turn creates a demand for businesses and helps to get money moving again.

Sadly the authorities have been a little too successful in encouraging spending as opposed to saving in recent years and as a country we now have very little scope to boost the economy by blowing non-existent nest eggs on consumer goods.

With so little economic activity price inflation has gone into reverse and the spectre of deflation looms.

Quantitative easing is used when interest rates have been lowered as far as they can go and the economy is still stagnated. It involves the process of putting money into the economy by way of the central bank buying assets such as government bonds that may be being held by financial institutions.

Buying the assets with newly created cash gives the institutions that have sold the bonds money to play with, the idea being that if they have money to spend then they will begin lending again and this in turn will encourage consumers and businesses to spend again.

A risky strategy

Quantitative easing carries a high risk. If the Bank of England fails to push enough money into the economy then there is the risk that banks will still not feel willing to lend and there will be no resolution to the current problems we face as a country. This was the error that Japan made in the 1990s.

However, if there is too much money pushed through the system then we run the risk of seeing inflation soar and this could have a detrimental effect on the long term stability of the UK economy as was seen in pre-Hitler Germany.

The fact that the central bank is employing this strategy in response to expected deflation however, should mean that the risk of hyper-inflation happening is thankfully minimised. Germany and in more recent times Zimbabwe were printing money solely to pay for government expenditure and as such they debased the entire currency.

This is only seen as a temporary measure and the Bank of England expects to sell back its bonds to institutions once the economy is healthy again. This coupled with the fact that they are only buying from institutions and not directly from the Government should also help to minimise the risk of hyperinflation.

How will we know if quantitative easing has worked?

We should see the banks start to re-introduce lending as credit picks up and this will help businesses and consumers to borrow money again. Slowly this should have a knock on effect as consumer confidence will begin to grow again and people will start spending money which will help to ease the lack of activity in the economy. The Bank of England will aim to bring inflation back to 2% which is its target figure.

What do I need to do to protect myself?

At the risk of getting shouted down for suggesting equity investment when the markets are so depressed, ironically equities may represent the best way to protect yourself in the event that either quantitative easing works or turns a bad situation even worse.

If successful then shares will rebound on the back of an improving economy. If the Bank of England stokes up inflation then the spending power of cash and the value of bonds will reduce and again equities are likely to increase in value to reflect this inflationary environment.

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