Quantitative Easing and Inflation - Essay Example

? Quantitative easing and inflation Contents Introduction 3 Policy adopted by the Bank of England to minimise the inflation rate 4 Impact of quantitative easing in inflation 7 Revising quantitative easing 7 Inflation or deflation 8 Effect over the government 10 Conclusion 10 References 12 Introduction Inflation is a situation where the prices of goods and services are rising more than the general level and at the same time people are losing their purchasing power (Hart, 2009, p.15). In most of the times when a country suffers from inflation the central bank of that country takes several steps to stop severe inflation and tries to minimise the prices of the goods and services (Hudson, 1982, p.67). The central bank of United Kingdom is known as “The Bank of England”. In the year 1694, the bank was established and on 1st March 1946 it became nationalised (Sayers, 1976). It gained its operational significance in the year1997 and from then the bank can independently work on the implementation of monetary policies (Bank of england, 2013). From the year 1993 the bank started to publish its inflation report on a quarterly basis. It contains a detailed economic analysis with the inflation projections for the upcoming months (Tennant, 2009). By depending on this analysis, the monetary policy committee of the bank take several decisions based on the interest rate (Bank of England, 2013). Quantitative Easing is a strategy in monetary policy that has been adopted by several governments and central banks to ease the effect of inflation. It helps to increase the money supply by purchasing securities from government or other securities from the market (Fukasawa, 2000, p.65). As the financial institutions got flooded with capital it helps to increase the money supply which will subsequently promote to increase the lending and liquidity. Quantitative easing is used by the central banks when the interest rates have already been minimized to near 0% levels and unable to produce the desired effect (Kimura & Small, 2004, p.45). In the following research the researcher will try to understand how the “Bank of England” is trying to minimise the inflation rate and if the Quantitative Easing program will cause higher inflation in future or not (Rochon & Rochon, 2012, p.69). Policy adopted by the Bank of England to minimise the inflation rate In the month of March of the year 2013 the inflation rate of United Kingdom has been rated as 2.80. For the purpose of national statistics inflation rate has been reported to the UK office. From the past history it has been found that from the year 1989 until 2013 the average inflation rate of United Kingdom is 2.81%. In the year 1991 it has its highest point at 8.50 and the lowest was in the year 2000 rated 0.50 percentile. In this country the most important categories in the consumer price index are transport and housing, followed by water, electricity, gas and other fuels. The following chart shows the previous inflation rate in a bar chart format- The consumer price index grew by 2.8% in the current year. In spite of the large increase and decreases the CPI remain broadly flat. The central bank of UK introduced a monetary policy balloon which helps to set the interest rate to control the inflation. One needs to keep the balloon flying at a steady height of 200 meters. It is like the same as the bank’s monetary policy committee tries to make the inflation steady at 2%. The main objective of the bank’s monetary policy is to bring stability in the price, lower the inflation rate by supporting the objectives of the government for growth of the economy as well as employment. The targeted inflation rate is 2%. In the budget statement each year the Chancellor of the Exchequer announces the targeted inflation rate. The bank can change the interest rate; however in an extreme condition the government also can ask the central bank to change the inflation rate for a certain period. Depending on the consumer price index the inflation rate targeted as 2%. However it is not appreciable if the inflation rate gets lower than 2%. It will be the same harmful if it is above 2%. So the inflation objective is proportioned. As the target missed, and it is more than 1% of either side then the CPI inflation will be either more than 3% or by less than 1%. In this situation the governor of the bank is need to write a letter explaining the causes why the inflation rate is higher or lower. It also include the reforms that will taken by the bank to bring back the rate in its normal position. However it is also not considerable if the inflation rate sticks to 2%. The economy will change to a great extent with the change of interest rate. It is also not possible to stick the inflation rate at 2% in monthly basis. The main objective of the monetary policy committee is to set the interest rate in such a position, which will mobilize the growth of the economy. The monetary Policy committee consist of nine members, among them five is from Bank of England and four members is appointed by the Chancellor from outside. According to the inflation report which has been published by the Bank of England in the month of February of 2013, the monetary policy committee (MPC) considers a high rate of volatility in the growth of the quarterly output. Inflation rate still stayed high which is 2% above the target. However, subdued pay growth and weak productivity unable to minimise the domestic cost pressure. The MPC works on a primitive way which means they will try to reduce the pressure of the inflation before it arise (Bank of England, 2013). In the year 2009 the MPC announced that the bank rate will be reduced to 0.5%, as it is unable to reduce the bank rate below that level. For giving a next monetary charge to the economy, it makes a decision to purchase a series of assets. From March to November in the year 2009, MPC gets the authorisation to buy 200 billion Euro Worthing assets in terms of Government debts or “gilts”. Some further purchase was made in 2011 for 75 billion euro and in 2012, 50 Billion euro. However, at the end of the year 2012 the total assets valued at 375 Billion Euro. (Joyce et al., 2011) To boost the nominal demand money was directly injected in the economy by the above purchasing methods. The main objective of the monetary policy is to meet the inflation target which is 2% over the measurement of Consumer Price Index of the consumer prices. To undershoot the target, without any extra spending the MPC explained that the inflation will be more likely in the medium term (Bank of England, 2013). This policy of assets purchasing is also known as “Quantitative Easing”. It does not require printing more bank notes. Moreover this is not a concept of giving money to the banks. This system is designed to beat the banking system. Under this method, the Bank of England creates electronic money to purchase the guilt from the private investors. These investors are mostly from pension funds and insurance companies. As holding money will yield low return these companies are not willing to hold the money. As a result they will purchase other assets like corporate bonds and shares. This minimises the long-term borrowing costs and boost to issue new equities and bonds (Bank of England, 2013). Impact of quantitative easing in inflation Quantitative Easing is a modern method of monetary policy. The main objective of this method is in the following ways- Bank liquidity will increase as the commercial banks will sell bonds to the Bank of England to increase their cash reserve. This indulges them to take loan from the businesses (Bank of England, 2013). As the banks purchase the government bonds the market price of this bond will rise up, as a result long term interest rates will get reduced. It improves better economic activity in the economy. After issuing the bonds when the central bank does not have the intention to buy more securities, the money supply will increase. Now the banks will start to lend cash from its previous savings. Revising quantitative easing At a certain time the Central bank of U.K. will reverse the policy of Quantitative Easing; this involves the selling of government bonds will be on hold in the open market. As a result the following situation can happen- 1. As the supply increased in the market, the price of the bonds will fall. 2. The bond yield will increase as the price of the bond fall and the interest rate will also become high. 3. Cash reserve in the banks will decrease if they purchase the government bonds. It will result in a fall in the money supply which may lead to deflation. Inflation or deflation As the quantitative Easing ends it becomes crucial to understand the following two scenarios. If the Bank of England extends a huge amount of extra money, the money will circulate within the economy during the period of strong recovery. As a result the economy will suffer from inflation. Again if the central bank reverse the method of quantitative easing in an early stage, when the economy still continuing with the liquidity trap and stagnant growth, the economy will get stagnant further. However if the Q.E. (Quantitative Easing) is processed, in the situation when the economy is still weak then the economy can witness deflationary pressures. So the timing of Q.E. is very crucial. On a positive note it is considered that the method of Q.E. can be gradually reversed during the sustained recovery of the economy. It is true that suddenly, the banks are unable to flood the market with 350 Billion euro of the government gilts. However it will be possible, if they sell 20 Billion euro in every couple of months. As the growth of the economy is strong, it will help to make a reduction in the supply of money and the higher interest rate can be easily absorbed. On the other hand as the Q.E. method has a great impact over the stimulation of the economy, so it is hard to understand the after effects of Q.E. method. In the past years it can be seen that the central bank of England is increasing its investment in government bonds (gilts) more than 350 Billion Euro. However M4 lending has been restricted the impact. As a result, in the year 2012, the augmentation in M4 lending has become negative, against the extra securities which cost around 350 billion euro. So it gets a real cause, when we can see that the recession would become deeper without the monetary stimulations of Q.E. Effect over the government The Q.E. method makes it easy for the government to borrow; as a result the central bank of England has become the main buyer of the government debts. At the time of Q.E. ends there will be no one such central bank to buy the bonds, however when the Q.E. method will revise, bonds will be sold in the market. It will make an assumptions that the selling of the bonds may create “bond bubble”, which may burst. This will hike the interest rate and the bond price will fall. So the government now has to suffer for the expensive borrowings to finance. The recovery also may get delayed due to the higher rates of interest. The annual debt interest payment is become very low, it charged about 45billion euro. However the interest payment will rise with the rise of the interest rates. This may not be wanted but causes due to the revising of Quantitative Easing (Pettinger, 2013). Conclusion The interest rate became higher at the end of Q.E. method with a positive thought that the economy will return to its normal position. It is nothing more wanted than the normalisation of the economy with the growth level of 2.5%. However it is really very difficult to make a judgement about the after effects of the Q.E. method. It should only be revised at the time when an economy is showing strong growth. It will also help to reduce the debt burden of the government. Moreover it can be asserted that when the economy will recover the interest rates of Q.E. will be surely increased. References Bank of england, 2013. About the Bank. [Online]. Available at: http://www.bankofengland.co.uk/Pages/home.aspx. [Accessed 30 April 2013]. Bank of England, 2013. Inflation Report :February 2013. General. London: Bank of England Bank Of England. Bank of England, 2013. Monetary Policy. [Online] Available at: http://www.bankofengland.co.uk/monetary policy/Pages/default.aspx. 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The United Kingdom's quantative easing policy: design, operation and impact. General. London: Bank of England Bank of England. Kimura, T. & Small, D.H., 2004. Quantitative monetary easing and risk in financial asset markets. 2nd ed. U.S.A.: Divisions of Research & Statistics and Monetary Affairs. Pettinger, T., 2013. What happens when quantitative easing ends and is reversed? [Online]. Available at: http://www.economicshelp.org/blog/6916/economics/what-happens-when-quantitative-easing-ends/. [Accessed 30 April 2013]. Rochon, L.-P. & Rochon, L.-P., 2012. Monetary Policy and Central Banking: New Directions in Post-Keynesian Thought. U.S.A.: Edward Elgar Publishing. Sayers, R.S., 1976. The Bank of England, 1891-1944: Vol.1. 1st ed. London: CUP Archive. Tennant, C., 2009. The Bank of England: And the Organisation of Credit in England. 1st ed. London: Tennant, Charles. Read More