What is quantitative easing?
Money printer goes brr…
In response to the coronavirus spreading across the UK, the government has announced a range of measures to protect the economy. Figuring out what these actually are is something of a challenge.
The media is now publishing so much coronavirus content that wading through Twitter or Google News makes you feel like Hercules entering the Augean Stables.
Like that Greek hero of old, we’re here to try and help. Only we explain financial concepts and don’t clear up giant stables filled with poop.
One of the phrases you’ve probably heard floating around in the past couple of weeks is ‘quantitative easing.’
That’s because the Bank of England, the UK’s central bank, has promised to pursue it as a policy. Doing so could give a much-needed jolt to the UK economy but it may lead to inflation.
What is quantitative easing?
To fully understand what quantitative easing is, you need to know how the Bank of England’s actions affect the wider economy.
In simple terms, the Bank of England controls how much money is produced (physically and digitally) and plays a key role in determining the interest rates that banks pay. Producing more money and lowering interest rates for banks is more likely to lead to inflation.
That’s because printing more cash and encouraging lenders to loan money means there is more sterling floating around in the economy. And as we all know, the less scarce something is, the less valuable it is.
‘What does all of this have to do with quantitative easing?’ we hear you ask. Well, the Bank of England doesn’t just set interest rates and print money. It can also buy assets with the cash it produces.
Quantitative easing is when the Bank of England — or any central bank — creates new money and then uses it to buy securities in the financial markets. In the Bank of England’s case, the overwhelming majority of quantitative easing purchases have been UK government bonds, known as ‘gilts,’ though the central bank has bought some other assets in the past too.
How does quantitative easing affect the economy?
When the Bank of England buys government bonds, it doesn’t go straight to Her Majesty’s Government and hand them a load of money. Instead, it will buy bonds from investors that already hold them.
The knock-on effect of this is to introduce a huge sum of money into the economy. When the Bank of England buys bonds, the money that it gives to companies selling them is deposited with banks.
Those banks then have more money to lend to customers — whether it be businesses or individuals. Those loans should, in theory, stimulate economic activity.
That’s because the people and companies taking them out will have to spend them on stuff, which could be anything from buying a new car to starting a pizza delivery business.
As a double-whammy, the Bank of England has also cut interest rates to 0.1 per cent. This will make it even cheaper to borrow money and so people are, in theory, even more likely to take out loans.
Money printer goes brrr….
If all of this sounds like a last-ditch attempt to artificially keep the economy afloat with new money then….yea, that’s basically what it is. To paraphrase the now-famous meme making the rounds on Reddit, central banks are trying to save the economy by making their ‘money printers go brrrr…’
The efficacy of this policy continues to be a source of debate amongst economists and other finance geeks. Quantitative easing isn’t new. It was used by central banks, notably the US Federal Reserve, in the wake of the 2007–2008 financial crisis.
Some economists have argued that quantitative easing was responsible for sluggish growth that took place after that crisis. They also say that pumping vast sums of money into the economy leads to inflation.
Supporters of the policy have said it gave a much-needed boost to the economy by encouraging spending and boosting employment. It’s hard to say who is right.
Of course, no two crises are the same and one of the key differences between now and 2007 is interest rates. Prior to the 2007 crash, these stood at 5 per cent in the UK. Before the corona crash, they were only 0.25 per cent.
That means the Bank of England has cut rates from being very low to very, very low. That raises questions as to whether or not this reduction — and the accompanying purchase of gilts — will have any meaningful impact on the UK economy.
On top of that, the current lockdown essentially means almost all real-world economic activity has been suspended. So even if people can borrow more money, they are unlikely to use it to make any meaningful purchases or establish physical businesses — at least in the short term.
What does this mean for the stock market?
Predicting what impact all of this is going to have on the stock market is tricky. As is clear from the above, we aren’t in the same position that we were back in 2007.
In general, quantitative easing and low-interest rates are thought to drive up prices in the stock market. There are a couple of reasons for this.
First of all, if quantitative easing leads to greater inflation, the price of stocks could increase because the value of money is decreasing. This would be true, by the by, for all goods. If money becomes less valuable, you’ll need more of it to buy things.
Lower interest rates also mean that people don’t want to have their money sitting in a bank account. If you are only getting an annual return of 0.1 per cent on your money and inflation is at 1 per cent per annum, you are essentially losing money.
To prevent this from happening, people might want to put their money elsewhere and one of the ways people hope to increase its value is by putting it into the stock market. And when more and more people put their money into stocks, it tends to drive up the prices of those stocks.
There is a similar effect for companies. If they can borrow more cheaply, then they will generally be more willing to invest in new projects or ventures, and they have to pay less interest on the debt that they have.
The great unknown
As you can tell from the contradictory messages we are hearing about how long COVID-19 will last and how far it will spread, it’s really hard to say what quantitative easing is going to do to the economy or even how the economy as a whole is going to do.
Ultimately it looks as though we’ll be in for a bumpy ride. Monetary policy can’t make people less sick or stop a virus from spreading. It can help treat the economic symptoms of the virus causes and that’s about it.
For now, just expect lots of debate about whether the government has just saved us from a huge depression or is leading us down the road towards Zimbabwe-style hyperinflation.
This post was originally one of Freetrade’s Weekend Reads. Sign up here and you’ll get a fresh one delivered to your inbox every Saturday morning. They go well with coffee and OJ. ☕
This should not be read as personal investment advice and individual investors should make their own decisions or seek independent advice. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication.
When you invest, your capital is at risk. The value of your portfolio can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future results.
Freetrade is a trading name of Freetrade Limited, which is a member firm of the London Stock Exchange and is authorised and regulated by the Financial Conduct Authority. Registered in England and Wales (no. 09797821).
