Quantitative Easing (QE): Policy Analysis - Essay Example

Quantitative Easing (QE Policy Analysis Introduction Like much of the world, the UK economy has been dreadfully affected the by global recession 2008-09. This financial crisis can be attributed to the UK’s budget deficit and declining employment rate. This situation forced the UK government to increase its public sector spending which in turn caused the national debt to mount every year. A weaker employment sector was identified to be a major growth impediment to the UK economy. Joyce et al (2011) points out a series of corporate failures in UK that can be attributed to the global recession 2008-09. In response to this situation, the Bank of England, together with other central banks, liberalised the nation’s economic policy using both conventional and unconventional monetary measures (ibid). The UK mainly used an unconventional economic policy called quantitative easing (QE) to respond to the economic turmoil. The main idea of this policy is that the central bank purchases financial assets to pump a prefixed quantity of money into the economy so as to stimulate national economic growth (ibid). As part of this new economic policy, the UK’s Central Bank purchased £200 billion of assets, representing nearly 14 percent of the country’s annual GDP (ibid). This paper will analyse the United Kingdom’s quantitative easing policy. Context of the economic policy The failure of Lehman Brothers in September 2008 caused investors’ confidence in the global economy to drop. As a result, dysfunctional international financial markets and tightened credit functions caused a decline in global financial transactions (Joyce et al 2011). In response to this situation, most central banks took measures to liberalise their monetary policy and thereby promote demand. In the UK, the Bank of England’s Monetary Policy Committee (MPC) trimmed down interest rates significantly as a way to loosen the nation’s monetary policy (ibid). During the 2008 quarter 4, the MPC cut down 3% points; an additional 1.5% points was trimmed down in the early 2009. The Bank rate was further decreased to 0.5% in the early March 2009. However, regulators observed that these monetary measures were not adequate to curb the financial crisis. The MPC stated that nominal spending may not be able to meet 2% CPI inflation target for the medium term unless additional measures are taken (ibid). Hence, the MPC announced an extensive quantitative easing programme for promoting the country’s economic growth. UK’s quantitative easing The quantitative easing can be simply referred to unconventional monetary economic policy deployed by central banks to fuel an economy’s growth when conventional monetary policies fail to stabilise sustainable economic development. Quantitative easing is defined as the process of “buying financial assets to stimulate the economy when the central bank target interest rate is near or at zero and the interest rate cannot be lowered further” (Boyes & Melvin, 2012, p. 298). It must be noted that the practice of quantitative easing is entirely different from the conventional approach of buying and selling government bonds to keep a suitable market interest rate. It is interesting to notice that a central bank uses new electronically made money for purchasing financial assets under this monetary economic policy. This practice may be helpful for the UK economy to improve amount of bank reserves which in turn would lower yields. By executing this policy, the UK economy ultimately aims to trim down long term interest rates and thereby foster country’s economic activities. For this purpose, UK monetary authorities purchase longer maturity financial assets so as to reduce long term interest rates on the yield curve. The quantitative easing would be the best tool available for the UK economy to ensure that inflation rate does not go below the targeted level. In the view of Elliot (2009), economic theories suggest that the unconventional quantitative easing policy may assist banks to keep excess reserves with them and therefore extend credit facilities to businesses and individual borrowers largely. In turn, businesses could use these funds to promote their productive activities including R&D and infrastructure development (ibid). This system will make sure effective money circulation throughout the economy. Hence, these enhanced economic activities would probably aid the UK economy to come out of stagnation and fuel its economic growth. Since the tool of quantitative easing is capable of keeping the inflation at moderate level, it assists UK regulatory bodies to prevent the economy from falling into deflationary pressures. Is is reported that reports that some developed nations including the United States and Japan are also very much interested in quantitative easing policies as a way to promote growth (Business Wire, 2011). The author points out that US was the first country deploying quantitative easing as a tool to address recessionary conditions. According to an International Monetary Fund report, major developed countries that practiced quantitative easing technique since the advent of the 21st century were less impacted by global recession 2008-09 while compared to other developed economies (ibid). It has been observed that the quantitative easing policy strengthened financial markets by adding liquidity during the recent global recession. A weaker currency enhancing export demand can be considered as one of the potential positive effects of UK’s quantitative easing policy. Evidences indicate that this policy has the ability to improve employment rate to a certain extent. Even though the quantitative easing may be a potential tool for the UK economy to spur its economic activities, it will cause many negative effects once the theoretical assumptions go unmet. According to Harrison (2011), this monetary economic policy may result in high inflation if excess amount of money is created due to overestimation of easing amount. In addition, banks are likely to use financial surpluses to make investments in emerging markets or to seize other overseas opportunities instead of allowing credit to local businesses. Some economists opine that low interest rates in UK could possibly lead to the creation of asset bubbles in other economies. While fuelling money supply under the quantitative easing policy, this situation may negatively impact the UK’s currency exchange rates. Often, this monetary economic policy may hurt the interests of creditors and other currency holders since their holdings’ real value is diminished considerably. The currency devaluation may also raise potential challenges to importers because this process causes to inflate the cost of imported goods. From the view point of Hermansson (2010), although quantitative easing is an effective strategy to confront with peak stage of a crisis, it has only a little role to play when the economy is recovering. According to David Miles, a member of the Bank’s Monetary Policy Committee, quantitative easing is a best technique to boost asset prices. Similarly, the IMF also supports the UK’s quantitative easing policy. The IMF suggests that UK must consider another round of quantitative easing to promote its economic recovery process. Objectives of the policy The major objective of the UK’s quantitative easing policy is to pump money into the economy so as to enhance nominal spending and thereby achieve the 2% CPI inflation target. Through the implementation of this policy, the UK government attempts to do several things. Firstly, the government tries to make adequate funds available for banks to enable them to loan money at fairly low interest rates. The government believes that low interest rates would enhance the volume of financial transactions and better circulation of finance may promote overall economic growth of the nation. Another objective of this economic policy is to increase the velocity of money circulation. Ultimately, this policy is aimed at promoting the UK’s sustainable economic development. The proposed economic policy increasingly focused on purchasing huge amount of UK government bonds. The country’s assets purchases between the period March 2009 and January 2010 mainly represented medium and long dated gilts. Reports indicate that these asset purchases correspond to approximately 30% of the gilts outstanding held by private sector at that time. The asset purchases added to the size of the Bank’s balance sheet with the help of earlier liquidity support policies to the banking sector. However, the UK’s quantitative easing policy was not capable of meeting the government’s 2% CPI inflation target. Despite the quantitative easing measures taken, the UK’s inflation rate still continues above 2%. Recently, the country’s inflation rate reached 3% in April 2012 by falling 0.5% down from 3.5% in March 2012. The UK’s historic inflation rate for the last ten years is illustrated in the following graph. (Trading Economics, 2012). Alternative policies While framing responsive policies to a recession, economies should not give much emphasis to short term bailouts of stimulus packages. Rather, they have to concentrate on policies that are likely to stabilise the country’s future growth. In case of the United Kingdom, active labour market policies and marginal or payroll tax cutting policies could be alternatively used to defend the recessionary conditions. Active labour market policies are government intervention programmes developed to help unemployed people find job. This policy could assist the UK economy to improve its employment landscape. Similarly, marginal or payroll tax cuts may benefit the UK government to increase its public sector spending and fuel money circulation throughout the economy. However, these policies are not potential as much as quantitative easing since their applications are restricted to some specific areas. Quantitative easing on UK pension service It has been identified that the quantitative easing policy has many adverse effects on UK pension scheme services. Currently, the UK’s quantitative easing programme stands £325 billion. According to the National Association of Pension Funds (NAPF), the UK’s quantitative easing policy “has knocked a further £90 billion off the value of final salary pension funds” (cited in Investment Sense, 2012). One of the notable impacts of quantitative easing is that it leads to a rise in the value of government funds (gilts) while causing the income they product to drop. This situation raised significant troubles to final salary pension funds that are big gilt buyers since they had forced to spend more money for purchasing gilts for a comparatively lower return. As per The NAPF reports, this price rises and yield falls has increased the final salary pension scheme deficits by £90 billion over the last six months. According to a report by the Pension Protection Fund (PPF), the United Kingdom had collective surplus of £22 billion in 2010 for it 6,533 final salary pensions and this surplus turned to a deficit of £255 billion by the end of 2011. In the words of the NAPF’s Chief Executive Joanne Segars; “businesses running final salary pensions are being clouted by quantitative easing” (cited in Investment Sense, 2012). Pointing to these adverse effects, economists argue that the Bank of England’s decision for increasing its QE programme by £50 billion is most likely to cause negative impacts on the value of pension scheme investments. Quantitative easing on UK voluntary sector (special constables) In the voluntary sector, the QE policy has made some noticeable positive effects. To illustrate, The UK witnessed an increase in the number of voluntary constables over the last few years. According to a news report, the total number of voluntary constables in UK was recently increased by 15% and reached 16,772. At the same time, it must be noted that number of police officers in UK have dropped by over 2,500 in the past year. This fall in number can be attributed to suspension of recruitment activities after the economic downturn. Hence, it can be concluded that this economic approach has mixed effects on public sector and policing. Conclusion From the above discussion, it is clear that the UK’s quantitative easing policy failed to meet its major objective of achieving the 2% CPI inflation target. However, this policy has assisted the economy to manage its economic recovery process effectively. The most advantageous feature of this economic policy is that it promotes effective circulation of the money throughout the economy. Economists like Hermansson argue that this tool is not much effective when the recovery is in progress. Active labour market policies and marginal or payroll tax cuts are some alternatives to quantitative easing in promoting economic recovery. It seems that QE approach has adversely affected the country’s pension scheme services whereas it had a mixed impact on policing. References Boyes, W & Melvin, W., 2012. Economics, USA: Cengage Learning. Business Wire., 2011. RK Investment advisors speculators portfolio up 142% in Q3, [Online] Available at: Elliott, L., 05 November 2009. Bank of England extends quantitative easing to £200bn, The Guardian, [Online] Available at: [Accessed 24 May 2012]. Harrison, E., 2011. The federal reserve’s quantitative easing is raising inflation expectations, Credit Writedowns, [Online] Available at: [Accessed 24 May 2012]. Hermansson, C., 2010. Central banks face difficult choices, Sweed Bank: To the Point, pp. 1-7, [Online] Available at: [Accessed 24 May 2012]. Investment Scence., 2012. Pensions: Quantitative easing hits pension funds for £90 billion, [Online] Available at Joyce, M, Tong, M & Woods, R., 2011. The United Kingdom’s quantitative easing policy: Design, operation and impact, Quarterly Bulletin, pp. 200-212, [Online] Available at: [Accessed 24 May 2012]. Trading Economics., 2012. UnitedKingdom inflation rate, [Online] Available at: [Accessed 24 May 2012]. Read More