Q | a-zofinequality

Quantitative easing

What is QE?

Quantitative easing (QE) is a form of unconventional monetary policy which involves the central bank creating money to purchase assets from private owners in an effort to push down market interest rates, inflate asset prices, and generally stimulate investment and spending with the overall goal of meeting mandated inflation (and sometimes employment) targets.

The first major economy to undertake QE was Japan which first utilised the policy in 2001 when, after a “lost decade” of economic stagnation and deflation combined with high debt levels, the bursting of the dot com bubble threatened a further recession and financial instability at a time when the Bank of Japan had already exhausted its orthodox policy options. QE was more widely adopted by most of the world’s advanced economies in the wake of the 2007-08 financial crisis and the subsequent recession [1].

The Bank of England (BoE), the UK’s central bank first enacted QE in November 2009 by purchasing £200 billion in government bonds (gilts). The BoE made a second round of QE purchases in July 2012 as the economic recovery slowed and the threat of a “double-dip” recession loomed, and a third in August 2016 after the UK’s vote to leave the European Union spooked investors; this third round included corporate bond purchases for the first time. The Covid-19 shock provoked the largest wave of purchases yet with three rounds of bond buying in quick succession doubling the BoE’s holdings by November 2020. Unlike some other central banks such as the United States’ Federal Reserve the BoE has never found it opportune to engage in quantitative tightening – reversing QE by selling assets back to the market – as of yet, so the total stock of assets purchased to date remains on the BoE’s books. Once the latest round is complete the BoE will hold £875 billion in gilts, more than 30% of government debt, and an additional £20 billion in corporate bonds [2].

Why?

The Bank of England is mandated to achieve an annual rate of 2% of consumer price inflation, to maintain the UK’s money supply and to regulate UK financial institutions [3]. While the BoE does not have a broader macroeconomic target unlike, for example, the Federal Reserve’s dual mandate of price stability and full employment [4], it is inevitable that in order to achieve its mandate the BoE must take the overall state of the economy into account.

The primary tool which the BoE uses to achieve its inflation target is the Bank Rate – also referred to as the “base rate” or even just “the interest rate” – which is the interest rate that the BoE pays to commercial banks on cash reserves held with the BoE [5]. While only banks can hold reserves and receive payments at the Bank Rate, changes in the Bank Rate tend to have a knock-on effect on interest rates across the whole economy. Raising it will discourage lending at the margin and put a dampener on economic activity, while lowering it will encourage more borrowing and spending, acting as a sort of stimulus.

In the wake of the financial crisis, credit crunch and recession the BoE responded in line with this usual logic, however, such was the severity of the crisis that the BoE quickly found itself running out of room to manoeuvre. As the deepest part of the downturn began in the autumn of 2008 the Bank Rate stood at 5%, within half a year it had been cut to 0.5% [6]. The BoE has since pushed closer to zero, cutting the Bank Rate to 0.25% in 2016 and to 0.1% in 2020 [7] and more recently asking the financial sector to evaluate their readiness for a negative Bank Rate, an option which has already been utilised by some other central banks [8]. After the recent rise in inflation, however, the Bank Rate has been progressively raised to 0.75% and is likely to increase further.

These cuts proved to be insufficient to revive economic conditions, both in the aftermath of the financial crisis and during the Covid crisis. The BoE decided that an alternative policy was needed which could approximately replicate the effects of further cuts to the Bank Rate and provide even more stimulus to lending and spending. Like many other central banks who were in the same boat, the BoE chose to implement quantitative easing.

How?

First, the Bank of England creates however much money it needs to make the desired amount of purchases. As the UK’s central bank the BoE has the authority to simply print money, though as QE involves digital money rather than physical cash it might be better to imagine it as making money by keystroke. Then the BoE goes out to the open market and uses its new money to buy assets from private investors. It does this through a “reverse auction” – the BoE declares how much it is going to spend and interested investors offer eligible assets. This has predominantly involved buying gilts, though since 2016 the BoE has also bought £20 billion of sterling-denominated non-financial investment-grade corporate bonds [9].

This process is intended to achieve the BoE’s objective of providing stimulus via three effects:

Added liquidity: QE injects a large volume of new cash into financial markets. This creates added liquidity which can be especially valuable during crisis periods when banks and investors find cash hard to come by. This allows for more transactions to take place and allows financial institutions to shore up their balance sheets with added reserves.

Portfolio rebalancing: in return for this new cash the BoE takes assets off the market. QE deliberately targets safe assets including gilts and investment-grade corporate bonds in order to push investors into adjusting their portfolios towards riskier assets which are likely to be more economically productive – entrepreneurial ventures or companies which need investment to stay afloat, for example – hopefully resulting in more employment and growth. This also tends to lower yields on the purchased assets as they are in greater demand and this tends to have a knock-on effect; much like lowering the Bank Rate transmits to lower interest rates offered by commercial banks, lowering the bond yields on safe assets like gilts pushes down bond yields across financial markets as they adjust in relation to safe returns [10]. This makes it cheaper for the government and corporations to borrow, spend, and invest.

Asset price inflation: QE makes the BoE a massive bond-buyer to the market with a large – and known – demand for safe assets while also increasing activity across asset markets thanks to the added liquidity, portfolio rebalancing, and cheaper credit. As demand for assets rises so does their price, so long as the supply does not keep up. QE therefore causes significant asset price inflation which produces a “wealth effect”: asset owners are enriched and so have more money to spend and invest [11]. This is essentially a kind of trickle-down effect: the wealthy get wealthier so, it is hoped, they deploy their new wealth in expansionary efforts which tend to increase the general level of employment and income.

Who benefited from QE? [12, 13]

A Bank of England research paper published in 2018 evaluated the distributional impact of the BoE’s loose monetary policy from 2008-2014. This took into account both the rapid cut of the Bank Rate to 0.5% and the first two rounds of QE. Their headline finding is that the BoE’s policies marginally reduced inequality compared to the counterfactual of tighter monetary policy (not cutting the Bank Rate and never doing QE) leading to a worse recession and recovery. However, drilling down further shows that the impact varied greatly across income, wealth and age distributions.

The paper found that QE did achieve a stimulus effect such that employment and wage levels were better (less bad, perhaps) than they would have otherwise been. This effect was disproportionately concentrated among higher income groups in both absolute and proportional terms with richer households gaining more from income support and the impact of monetary policy on interest rates. The poorest 10% were actually worse off than they would have otherwise been due to lower interest rates on savings costing them more than the very small gains from employment income and reduced interest costs benefited them. The very low Bank Rate and QE therefore tended to exacerbate income inequality. (Charts 13-14)

Reproduced from Philip Bunn, Alice Pugh and Chris Yeates (2018) “The distributional impact of monetary policy easing in the UK between 2008 and 2014" [14].

In terms of wealth inequality the picture is a bit more nuanced. In absolute terms the BoE’s policies clearly enriched the wealthy the most, with the wealthiest 10% of households benefiting by more than £350,000. In proportional terms the picture is broadly reversed: households with medium to low levels of wealth gained from asset price inflation primarily in the form of increased house prices which along with pensions account for the greatest part of most people’s wealth portfolio. The least wealthy 10% saw the biggest proportional gain thanks to the effect of higher inflation reducing the real value of deposits and debts. (Charts 15-16) However, these households tend to have the smallest balance sheets in terms of both assets and debts so for many even huge proportional impacts to their net wealth will not have translated into being substantially better off. The paper concludes that wealth inequality was reduced by the BoE’s loose monetary policy but this could be dismissed as a technicality; the practical effect in absolute terms is that the wealthy were massively enriched and the least wealthy were barely affected.

Looking at the distribution of impact by age group paints yet another picture. In terms of income, the paper finds that the incomes of younger people were supported the most thanks to higher levels of employment and debts being inflated away while the incomes of retirees were slightly reduced as the value and yield of their savings were eroded. In terms of wealthy the biggest gains were felt by broadly middle-aged people in the latter half of their working lives who benefited the most from asset price inflation through their pensions and homeownership. The youngest and oldest gained the least. (Charts 19-20)

In summary, the BoE’s monetary policy did achieve some degree of economic stimulus which boosted the incomes of the young and the well-paid. It also did boost asset prices substantially which was great for people with significant ownership in the form of houses and pension investment but which meant that those without missed out on the largest concrete gains. Young people may have been poorer without low interest rates and QE, but they also saw their prospects of one day buying their own home and investing in their retirement become less affordable [15]. This has also had a geographically unequal impact: house prices have remained at or even below 2007 levels across most of the UK with the big gains concentrated in or near major cities, especially London [16]. Overall, it is very difficult to dispute that the impact of QE has been exacerbated inequality in at least some aspects, only somewhat offset by the partial success of it as a stimulus measure (the recovery from 2008-09 nevertheless being especially slow and difficult).

Creating money at a keystroke.

As described above, quantitative easing involves the Bank of England creating new money and injecting it into asset markets. The creation of, by now, the best part of a trillion pounds with the stated intent of enriching particular institutions and individuals certainly seems egregious. However, it is worth remembering that vast amounts of money are created annually, mostly by commercial banks engaging in lending operations [17]. In a fiat currency system the total supply of money is effectively arbitrary and central banks, commercial banks, and governments themselves can create money more or less at will.

Of course, this is a power that must be used responsibly in order to avoid destabilising the monetary system. Fiat currency is a social contract which works so long as everyone agrees it works and money creation powers are not seen to be used to enrich particular interests at the expense of general welfare. Excessive money creation can lead to runaway inflation and even hyperinflation – usually defined as a monthly inflation rate of more than 50% (which works out at an annual rate of more than 10,000% due to exponential growth) – as seen in Weimar Germany in the 1920s [18] and more recently in Zimbabwe [19] and Venezuela [20], where the rapid and constant devaluation of the currency makes holding it undesirable and alternative stores of value are preferred, inevitably provoking general economic malaise.

The UK is certainly not experiencing hyperinflation, nor is any other country which has pursued QE, and defenders of the policy might argue that consumer price inflation – which many expected to spike as a result of QE – remained at relatively low levels, between 0-4% annually, from 2009 until 2021. This is arguably unsurprising and missing the point; QE involved injecting lots of money into asset markets in particular and it certainly helped push up asset prices, such as property and equity, which have enjoyed a far more buoyant decade than the consumer economy. The bursting of asset bubbles usually results in substantial asset price deflation and indeed during the financial crisis itself the housing and stock markets did fall sharply, but thanks in part to QE they rebounded much more rapidly than the rest of the economy.

QE exacerbates pre-existing trends and policies which produce a deeply unequal distribution of wealth and widen the gap between asset owners and the young and poor seeking to acquire even a small amount of wealth. The story of the post-financial crisis macroeconomy is one of vibrant asset markets and depressed consumer markets which is great if you own your home and have a portfolio of stocks and bonds, but for wage-earners seeking to buy their first home or save up for retirement it is a toxic combination [21]. If the wealthy can benefit in such an obvious fashion from money which is simply created out of thin air, why should those barely getting by listen to admonishments that there is no ‘magic money tree’ and accept governments speaking of tough choices and tightening belts when it comes to policies which would support them?

The real risk of QE, perhaps, is not that it is likely to cause a sudden catastrophic economic shock but that it will have a corrosive social impact over the long run. Money is a social contract; a pound sterling has no inherent value but is valuable because we as a society agree that it is. For this to continue people have to believe that the economic system is sufficiently legitimate and fair, rewarding hard work and productive investment. The monetary authority creating new money with the apparent effect of inflating asset prices, making the wealthy wealthier without having to do anything, and helping the government rack up debt as will be discussed subsequently risks undermining general confidence in the monetary system.

Is QE debt monetisation?

Quantitative easing does not function like normal government spending; it is more accurately described as an asset swap. When the Bank of England engages with the market as part of QE it does not just hand out its money but uses it to buy assets in return. For example, the BoE may pay a pension fund £1 million in exchange for £1 million worth of gilts; doing so does not directly make the pension fund any wealthier, it just exchanges one kind of asset for a different sort. No individual transaction that the BoE makes results in anyone becoming wealthier, rather it is the overall impact of the whole scheme which tends to stimulate markets and increase asset prices.

If new money is being created but private sector balance sheets remain the same size, enrichment coming from increased market activity rather than a direct transfer of wealth from the BoE, where is the monetary expansion taking place? The answer, of course, is in the public sector and specifically on the BoE’s balance sheet. Engaging in QE means the BoE acquires new assets – government and corporate bonds – but also increases its liabilities as the money it creates ultimately takes the form of reserves on which it pays interest.

This ends up being a significant boon to the government. The vast majority of bonds bought via QE are gilts and as a result the BoE is now the single largest owner of UK government debt. The Treasury still makes yield payments on any gilts held by the BoE and principal repayments on any gilts that mature on the BoE’s books, but this is really just an intra-government transfer and after covering its own costs the BoE remits its profits straight back to the Treasury [22]. The real cost to the public sector of servicing gilts owned by the BoE is not their nominal yield but rather the Bank Rate, the cost of paying interest on the reserves which fund the operation [23]. QE, therefore, lowers the real cost of government borrowing and arguably shrinks the stock of government debt, since public debt owed to another public institution isn’t really public debt at all, just a convoluted piece of accounting.

This has raised concerns that QE is ultimately a form of debt monetisation – printing (or typing out) money to pay off government debt – just with a few extra steps. Whether QE technically fits the definition of debt monetisation depends on whether or not it ends up being a permanent feature of policy [24]. The rationale of QE is that the BoE holds a certain stock of safe assets off the market until the economy returns to something like normality and they can be sold off. The US Federal Reserve was able to do this to a small extent prior to the Covid-19 crisis [25]. The risks are that either it turns out this is the new normal – it has already been 11 years and the BoE’s stock of bonds has only expanded – or that when something like a pre-2008 macroeconomic environment eventually returns the temptation to write down the national debt rather than engage in the painful process of selling the BoE’s gilt holdings and driving up yields will be too strong.

Unwinding QE.

If quantitative easing and the impacts it has on the economy and society are not to become a permanent feature it will have to be unwound eventually. This involves doing the opposite of QE: quantitative tightening. Tightening means offloading the Bank of England’s asset holdings, contracting its balance sheet, and can be expected to have roughly the opposite impact to QE: it will decrease liquidity as the BoE takes cash from private investors in return for assets, it will increase the supply of safe assets on the market which is likely to raise interest rates across the board and push asset prices downwards, and it is overall likely to discourage borrowing, spending and investment at the margin, putting a constraint on the economy.

This is in many ways a painful prospect which will have to be timed and managed effectively. While a buoyant economy would be able to absorb these impacts without too much trouble, engaging in quantitative tightening during a period of relative stagnation and fragility would be an unwelcome additional shock. In 2013 the US Federal Reserve merely announced that it would begin to taper off the rate of its bond purchases in the future, causing a market panic and a spike in yields referred to as the “taper tantrum”.

Fortunately, the fact that the BoE has engaged in bond purchases provides a build-in method for gradually tightening while causing minimal disruption: simply allow the bonds it owns to expire. Currently, any bonds which mature on the BoE’s books are replaced with new bonds in order to maintain the overall stock of assets, so if the BoE just stops buying new bonds its holdings will eventually to fall to zero, though this process would take decades to complete [26]. More substantive tightening efforts, where large amounts of bonds are sold at once, could be deployed if the economy threatens to overheat. The timing and execution of quantitative tightening are sensitive matters which will have to be handled carefully, but on the whole it is a simple and achievable policy.

A crucial question is what, if anything, would replace QE. The underlying poor macroeconomic conditions which caused central banks across the world to run into the zero lower bound and reach for unorthodox policies are unlikely to disappear anytime soon. Even if they do, and QE can be unwounded relatively painlessly and with little controversy, they may subsequently return. If QE is unacceptable, an alternative approach ought to be put forward.

In terms of unconventional monetary policy QE is not the only game in town. Several central banks, included the European Central Bank and the Bank of Japan, have been willing to breach the zero lower bound and set a negative base rate, but the extent to which this would be transmitted across the economy is very limited as, for instance, savers could not be hit with negative rates or they would just withdraw their cash and stash it [27]. One route around this is to adopt dual interest rates, where the central banks sets one base rate for reserves and another, lower rate, at which it offers loans so that it can provide cheap credit without overly punishing savers. The European Central Bank already does this to a limited extend through its targeted lending operations [28]. However, these approaches could all be categorised as relatively minor tweaks to the fundamental problem of low interest rates proving insufficient to accelerate economic activity.

It might be possible to adapt the general idea of QE with more egalitarian principles. The notion of “helicopter money” was coined by the free-market economist Milton Friedman to refer to a stimulus where money is created and simply given out to the public [29]. This could take the form of government spending or tax cuts, or even a direct payment to every individual or household [30].

Perhaps the fundamental problem is that QE involves the central bank and monetary authority straying into territory where it does not really belong. Stimulus is more commonly the realm of government fiscal policy – taxing and spending – rather than monetary policy and the experience of QE arguably shows that central banks are not all that good at it. In some sense central banks deserve a little sympathy: macroeconomic conditions, both market trends and a whole range of policies and institutional structures, have made it virtually impossible for them to meet their legal mandates without some form or unconventional strategy. Firstly, to the extent that stimulus is necessary is should be the purview of governments and treasuries, not central banks. Secondly, returning the economy to a more dynamic state will require deeper and more controversial structural reforms which are beyond the remit of central banks and generally beyond the ambition of governments.

1https://www.federalreserve.gov/pubs/ifdp/2011/1018/ifdp1018.pdf

2https://www.bankofengland.co.uk/monetary-policy/quantitative-easing

3https://www.bankofengland.co.uk/about

4https://www.chicagofed.org/research/dual-mandate/dual-mandate

5https://www.bankofengland.co.uk/monetary-policy/the-interest-rate-bank-rate

6https://www.brookings.edu/blog/ben-bernanke/2017/04/12/how-big-a-problem-is-the-zero-lower-bound-on-interest-rates/

7https://www.bankofengland.co.uk/boeapps/database/Bank-Rate.asp

8https://www.bankofengland.co.uk/-/media/boe/files/prudential-regulation/letter/2020/info-request-operational-readiness-policy-rates.pdf?la=en&hash=E973B09B00A6EC1D2B5AB9B845BF20EB5EF7BBB6

9https://www.bankofengland.co.uk/markets/market-notices/2020/asset-purchase-facility-additional-corporate-bond-purchases

10https://www.bankofengland.co.uk/-/media/boe/files/working-paper/2018/the-impact-of-the-bank-of-englands-corporate-bond-purchase-scheme-on-yield-spreads.pdf?la=en&hash=6C4947C7C536F27A8ED86165C521F301C01EE9E6

11https://link.springer.com/article/10.1007/s11293-016-9511-9

12https://www.bankofengland.co.uk/working-paper/2018/the-distributional-impact-of-monetary-policy-easing-in-the-uk-between-2008-and-2014