QUANTATIVE EASING - HOW IT WORKS and the Bank of England.
THE TARGET - INFLATION AT 2%
- The Bank of Englands Monetary Policy Committee has been purchasing assets financed by new money that the Bank creates electronically. It buys assets such as government bonds, (loans to the government thought to be 100% safe), and to a smaller extent, corporate bonds, (loans to companies that have certain risks attached to them, such as default risk).
- Often known as "quantative easing" this policy is designed to inject money directly into the economy, due to the recession. This is in response to a sharp fall in demand as businesses and consumers reduced their spending. In short there is not really enough money in the economy, so things need a boost.
- The aim is to BOOST spending to keep inflation on track to meet the 2% inflation target seen above. Alongside its decisions on these asset purchases, the Monetary Policy Committee continue to set the bank rate each month at their monthly meetings as reported on the news.
* The Bank of England purchases assets from PRIVATE sector businesses, including, banks, insurance companies, and pension funds, and other non financial companies, trading on the stockmarket. In effect most of these assset purchases will be government bonds, but some corporate bonds as well. Substantial amount can be purchased very quickly, and large sums are involved.
- The banks injection of money into the general economy works through many different channels, creating a variety of potential effects. When the bank buys these assets they INCREASE in price, so thier YIELD (interest payments), reduce, so the overall return on those assets FALL.
- So now these sellers of the assets, (to the Bank of England), are encouraged to use that money to purchase OTHER ASSETS such as company shares and bonds, including corporate bonds, (lending money to companies rather than the government). As the purchase of these assets gains pace, their prices are expected to increase, which pushes down the YIELDS, (the interest paid), on those assets.
- LOWER YIELDS REDUCE THE COST OF BORROWING FOR HOUSEHOLDS, (MORTGAGES FOR EXAMPLE), AND BUSINESSES. This is supposed to lead to higher consumption as people have more money in their pockets etc, and more investment into businesses. However some people ought to pay down some of their debt!
- This can lead to some people being better off as assets prices can increase, (house prices for example), which provides extra spending on goods and services etc. For example new fitted kitchens, paving over the front garden!
- The government also buys up smaller amount of corporate debt called corporate bonds, (loans made to companies for expansion, other uses etc). This it is hoped will generally improve the conditions in the capital markets, so that these companies can more easily raise money for their day to day needs, and expansion needs etc.
- The other way of putting more money into the economy (by the Bank of England). Those companies selling these assets will have more money to put into their bank accounts, so commercial banks should have MORE MONEY TO LEND! (ha ha I hear you say). So more bank lending supports more spending in general.
- AS YOU KNOW THIS CHANNEL IS RATHER WEAK AS BANKS TRY TO REPAIR THEIR BALANCE SHEETS DUE TO THE ECONOMIC CRISIS, (they partly created). For that reason, the Bank of England tends to buy these assets from firms OTHER than banks.
- This extra money being injected into the economy by the Bank, should increase spending to keep inflation on target at 2%. However as you know inflation is well above that figure in 2010. Without the boost the amount of money in the economy would be TOO LOW, with possible weak spending, and inflation BELOW THE MAGIC 2%. As people see an improvement in the economy in general it is hoped that both business and private individuals will encouraged by this and spend accordingly. If people can see that the policy is working this will further increase spending. However one problem with this strategy is that it tends to increase inflation if you are not careful.
- EACH MONTH THE POLICY COMMITTEE MEET TO DISCUSS THE FUTURE OF INFLATION RELATIVE TO THE 2% TARGET. If they think inflation is set to RISE above the 2%, IT COULD RAISE BANK RATES. It would then SELL assets to remove the money from the economy, so slowing down the economy to stop it "overheating".
Notes on bonds, prices and yields.
Bonds are issued at a nominal rate of £100. They pay an exact rate of interest for their whole term normally, say 5%pa, and this does not change.
As bonds can be sold on the markets, (means they are negotiable), the price of the bond changes constantly from the original price of £100. If a bond goes up in value to say £120, then to work out the "running yield" (interest rate), and given that the bond will stil be paying 5%pa, the calculation would be:-
_5_ _ times 100 = 4.17% running yield.
120
So you can see from the above, AS THE PRICE OF THE BOND RISES, THE YIELD (interest receive from it), REDUCES, (if you were to purchase it at £120 on the market), so your interest rate would go down to 4.17% on a purchase price of £120.
If of course you just kept the bond for the whole of its life you would just receive the 5%pa, and at the end of the period you get your money back of £100. This means that bonds held to maturity do not go up in value at maturity, only if sold on the open market before.
The Bank of England - Founding and development
* Before the Bank of England the business of banking in this country was in the hands of the goldsmiths who loaned money to merchants and to the Crown. People deposited coin and gold, and were given recipts which were freely circulated, and were the first types of banknotes.
* In 1694 the Scottish merchant, William Paterson proposed the terms under which the Bank of England was created. The original charter was granted by William lll in 1694, with a capitalisation of £1,200,000.
* During the first 40 years of the Bank's life it traded in Grocer's Hall in London, and had fierce competition from The South Sea Company.
* During the 18th Century its private business flourished, developing mainly as a Government bank and managing the country's increasing national debt, (sounds familier), with customers like George Washington.
* From the period 1793 to 1815 Britain was at war with France, with the Bank helping to finance the war. Due to the expense the Bank's gold reserves fell heavily and in 1797 it was forced to restrict payment of its bank notes in gold. This was called "The Restriction Period", and went on till 1821.
* This restriction period started endless debates on monetary disipline with the then Prime Minister William Pitt the Younger. In 1826 the Bank was allowed for the first time to open branches throughout the country, which meant that the circulation of its bank notes increased. By 1997 all the Bank's branches had closed, leaving 12 agencies throughout the UK who liase with local businesses.
* The gold standard was adopted in Great Britain in 1816, linking the pound sterling to a quantity of gold, and the introduction of the gold soverign. This helped to control inflation, and international trade. It was abandoned in 1931.
* The Bank Volunteer Corps was recruited from the Bank staff in 1798 to defend the Bank in the event of a French invasion. The directors of the Bank were the officers, and the clerks became the rank and file!
* The author of Wind in the Willows, Kenneth Graeme was secretary of the Bank from 1898 - 1908.
* During the reign of Queen Victoria the Bank rapidly developed as an industrial power, and reinforced itself as our national Bank, and also with international financial power. On the domestic side staff welfare became very important, and was one of the first institutions in the City of London to employ women!
* During the First World War the national debt jumped from just under £1 billion to over £7billion. As with the war with the French, the Bank's main function was to manage the governments borrowing. The old gold soverign coin then rapidly disappeared, to be replaced by Bank notes of £1 and 10 shillings.
* Between the two world wars the Bank developed into a central bank as we know today, formulating monetary policy, (not fiscal policy), and managing the countries gold and foreign currency reserves, with regular contacts with other central banks throughout the world. As the staff increased many fold during the First World War they had to rebuild the Bank! The Bank you see today was completed in 1939.
* During the Second World War the Bank's main function was the management of the Governments borrowing, and the administration of the Exhange Control. Due to the possibility of attack, from the air and also the ground the printing works were moved to Hampshire. In 1946 the Bank was nationalised by the Labour government. This was just after the 250th anniversary of the Bank. This did not change the operation of the Bank very much, and it continued as normal.
* The Bank today has a Monetary Policy Commitee created in 1997, when the Bank was given independence to set official interest rates. The Bank's job is to maintain monetary policy, and to promote financial stability.
Well there we are then. If you would like more information then you can visit the Bank of England Museum which is very popular, and rather interesting, and particulary so as it is FREE.