The Impact of Quantitative Easing in the UK - Essay Example

The Impact of Quantitative Easing in the United Kingdom Under normal conditions, the BOE approach to monetary policy is always very simple. If BOE intends to stimulate a sluggish economy, it purchases government securities, thereby increasing the money supply and reducing the short-term interest rates. If its intention is to cool down an overheated economy, it must sell securities in order to increase the interest rates. In taking these actions, the BOE assumes that rational and self-interested actors will behave in predictable ways, borrowing money when rates are low and deferring purchases when rates are high. The conditions following the financial collapse were by no means normal, however, and the Bank of England had to innovate. As conventional monetary tools became virtually ineffectual, the BOE started pursuing Quantitative Easing (QE) monetary regime. Joyce et al. (2011) defines QE as a government’s policy of expanding the central banks balance sheet with an objective of increasing the level of central bank’s reserves. The main purpose of the BOE in introducing the program was to expand the balance sheet. QE policy includes purchasing of assets from the financial market with an objective of imparting additional liquidity. Secondly, it seeks to affect the term structure of interest rates by influencing markets expectations on future interest rates. BOE’s decision to open asset purchase window marked the transition of BOE policies from a conventional regime to an unconventional QE regime. In early 2009, the Bank of England (BoE) introduced a large-scale asset purchase (LSAP) programme called quantitative easing (QE). When the intensity of global financial crisis was high following the collapse of Lehman Brothers in 2008, most governments and central banks around the globe introduced a variety of ways meant at stabilising financial conditions and supporting aggregate demand (Joyce et al., 2011). The main focus of BOE was to purchase large amounts of UK government bonds (gilts) from non-financial institutions. The BOE finished the LSAP program in early 2010, but it restarted it in October 2011. The main intention of the BOE in engaging in QE program was to boost liquidity in UK financial markets and help in restoring stability in credit and bond markets. The BOE was responding to continued deterioration in world economic growth, excessive market volatility and persistent problems in international credit markets. In response, the BOE revised the official bank rate to the downside and reduced them by 0.5% to 1.5% in January 2009, prior to the introduction of the LSAP programme. The economic environment continued to show no signs of improvement, prompting the BOE to reduce the rates further to 1.0% in February and 0.5% in March (Ciro, 2013). . When interest rates hit such a low, standard monetary policy tools become ineffective. Thus, the BOE had to consider an alternative strategy: quantitative easing (QE). This strategy required the BOE to engage in massive purchases of bonds and other assets, essentially expanding its balance sheet while pumping liquidity into the economy. The bank appointed a Monetary Policy Committee, which engaged in various extraordinary measures which included purchasing both public and private sector assets using central banks reserves. The bank continued to purchase assets until the assets purchased totaled £200 billion (Ciro, 2013). These measures largely achieved the aim of QE program because the Bank’s balance sheet was expanded. On the basis of nominal GDP, the balance sheet expanded to three times its level compared to its level during the onset of the global financial crisis in 2007 (Joyce et al., 2011). As the authors also observed, this level of the balance sheet was also the highest in a period of two centuries, equaling 14 percent of nominal GDP. An event analysis on March 5, 2009 suggested that the purchases of assets had depressed yields by up to 125 basis points (IMF, 2010). IMF judged the trend in a two-day event window around the key announcement dates. It found out that the gilt yield curve had shifted downward by between 20 and 125 basis points, with the largest drop recorded for long maturities. These measures had an impact on various sectors including the financial markets. The sector where the greatest impact was expected was in financial markets because they were bound to react in a certain way. Though other areas have been considered, the impact on financial markets is the one that can provide the most timely and clearest picture of the effectiveness of the program and how it might be feeding through to the other areas of the economy. In 2010, an assessment by the IMF (2010) found out that lower long-term interest rates had broadly supported recovery in financial markets since March 2009. IMF established a link between QE and the financial markets recovery. The launch of QE in the UK coincided with the turn-around in UK and global equities. Quantitative easing also boosted confidence among key financial players, created positive wealth effects and improved the supply of credit to corporate. The improved supply of credit to corporate was influenced by small-scale BOE purchases of commercial paper and corporate bonds. That positive outcome was also largely influenced by the fact that large-scale gilt purchases made investors shift their funds into assetssuch as corporate bonds. The ultimate impact of QE on demand and inflation is not easily quantifiable. However, by far and large, QE largely influenced the recovery. As IMF (2010) observes QE enabled economic recovery, stabilised unemployment, and improved the health of the financial sector. Most of the asset purchases by the BOE were made up of gilts. Several studies have explored different ways of measuring the impact of QE on the markets (IMF, 2010; Joyce et al., 2011). These authors examine both the two-day window and one-day window. However, Joyce et al. (2011) has suggested that a three-day window could also be appropriate for robustness. These authors further observed that using a shorter window would not be appropriate in measuring the relative novelty of QE in the UK. QE made it easier for the UK government in its fiscal policy because it provided a ready buyer for government debt. Without QE, the UK government would be forced to contain further the degree of its fiscal initiative. Though there are no greater benefits of QE to UK, the solid evidence of the benefits of QE largely outweighs the weak evidence of costs. Though there are few costs of QE, they are not significant. During the global economic crisis, IMF advocated for greater international coordination, and as a part of its coordinated policy response, the IMF encouraged central banks to ease monetary policy and cut official interest rates. BOE adopted QE to avoid devastating effects of falling asset prices and deflation (Ciro, 2013). Private credit creation was viewed by IMF as an important component contributing to the overall health of global credit markets. It also felt that credit risk associated with credit intermediation should be minimised particularly because it relates to the central bank’s balance sheet and credit risk profile. The adoption of QE in UK helped in the restoration of liquidity to credit markets, which in turn helped stimulate consumer demand and business environment (Ciro, 2013). However, the purchasing of assets did not stop even with such an improvement. By July 2012, BOE had purchased additional assets making the total assets purchased amount to £375 billion. There are great uncertainty researches and literature studies about the effectiveness of QE in the UK. The major objective of QE in UK has been to affect the prices and yields of assets other than bonds. QE has generated considerable impacts on financial markets, assets markets and influenced changes in aggregate demand. As stated by Joyce et al. (2011), the transmission mechanisms and channels of QE affect output and inflation. For example, the policy signaling channel has the capability of affecting economic agents’ expectations about future policies. UK witnessed a substantial recovery in asset market prices in 2009 and 2010 due to the adoption of QE by BOE (Joyce et al., 2011). As observed by Lipsey and Chrystal (2015), the first wave of QE was the one that appeared to have a positive effect on the UK economy during 2009 and 2010. This progress stopped in 2011-2012 due to a rise in GDP. This prompted the MPC to initiate a second wave of QE. The second wave seriously affected the external environment, and the situation was worsened by the Eurozone debt crisis that dented the consumers’ confidence. Therefore, the second wave had less impact compared to the first wave. Currently, the UK economy still suffers from slow growth and excess capacity. For example, in 2013, the GDP was still 1 or 2 percent below potential (Lipsey and Chrystal, 2015). The interaction of QE and aggregate demand was the one that determined the gainers and losers. As discussed by Lipsey and Chrystal (2015), QE affects aggregate demand in various ways which include interest rates, money supply, asset prices and spending, and confidence. In buying a lot of government bonds, the UK policy intention was to affect the prices of these bonds and hence their yield. That is, even if the policy-makers did not lower short-term rates any further they did so to long-term rates. Lipsey and Chrystal (2015) observe that lower long-term rates make it cheaper for companies to borrow to finance investment spending. Finance investment spending is a major component of aggregate demand. Therefore, the major gainers, in this case, were companies. The direct purchases of bonds increased the supply of money. The sellers of bonds deposited their BOE’s cheques in the commercial banks. These deposits increased the sellers’ bank balances. The commercial banks presented these cheques to the BOE and got an increase in their reserve balances at the Bank. Both the sellers and commercial banks benefited form QE. Companies also benefited greatly from the purchases of corporate bonds because of raised prices and spending. Such purchases raise the price and lower the yield thus reducing the cost of capital for companies. QE in UK motivated the holders of shares and bonds because the value of their wealth rose. This in turn encouraged consumer spending. Lipsey and Chrystal (2015) positively relate consumption to household wealth. Fourthly, QE bolstered the confidence of companies and households. Largely, BOE has achieved most of its goals in adopting QE. However, the QE has not managed to affect money supply as BOE had anticipated. Currently, there are strains in the financial markets because many banks are concentrating on resolving their balance sheets. However, QE has managed to restore the health of financial markets. Without the intervention of QE in UK, the economic downturn could have intensified. However, though QE is the rightful policy of resolving current challenges in the UK, it is sometimes overstepping its boundaries and abusing its independence. References Ciro, T. 2013. The Global Financial Crisis: Triggers, Responses and Aftermath. London: Ashgate Publishing. IMF. 2010. United Kingdom: 2010 Article IV Consultation: Staff Report; Staff Supplement; Public Information Notice on the Executive Board Discussion; and Statement by the Executive Director for the United Kingdom. Washington: International Monetary Fund. Joyce et al. 2011. The Financial Market Impact of Quantitative Easing in the United Kingdom. International Journal of Central Banking, 7(3), pp. 113-161. Lipsey, R. and Chrystal, A. 2015. Economics. Oxford: Oxford University Press. Read More