The importance of Quantitative Easing

Summary

  • Quantitative Easing (QE) is the practice of creating new money electronically and using it to buy financial securities back from banks and big corporations.
  • This money-creation mechanism, carried out by the Bank of England, should encourage lenders to give more credit to businesses and householders, and ultimately boost the economy
  • QE is not risk-free and pumping additional cash into the economy could indirectly lead to an inflation problem
  • A more synchronized monetary and fiscal policy is needed to make the recent BoE changes more effective in the long-term

Introduction

One of the central banks’ responsibilities is to keep the inflation at a target level (2% in the UK). Before the global financial crisis in 2008, central banks managed this task by adjusting the interest rate at which commercial banks borrow overnight. For example, cutting the rate if there were signs companies were slowing down their level of investment, thereby reducing their cost of borrowing and encouraging them to take more credit. On the other hand, if credit and business expenditure were increasing significantly, and inflation was seen to climb, then the central bank would increase the overnight rate.

But when interest rates are at almost zero, as they have been in the UK for the last few years, the central bank needs to adopt different tactics – such as pumping money directly into the financial system. This unconventional monetary policy tool is known as quantitative easing, or QE for short.

How QE works

The process is relatively simple. The Bank of England (BoE) creates new money electronically (so called ‘printed money’) to buy financial assets, like bonds, from investors. Like lowering interest rates, QE is supposed to stimulate the economy by increasing the overall amount of funds in the system, encouraging banks to make more loans. This money-creation mechanism should encourage banks and other financial institutions to give more credit to businesses and householders.

The general idea is that banks use the new money created to buy assets to replace the ones they have sold to the central bank. This raises stock prices and lowers interest rates, which in turn boosts investment, increases spending power and getting inflation back to the target.

The BoE said recently it would buy £60bn of UK government bonds and £10bn of corporate bonds, amid uncertainty over the Brexit process and worries about productivity and economic growth.

Is QE risk-free?

The process is relatively simple, but there are some drawbacks. The biggest fear is that pumping additional cash into the economy could indirectly lead to an inflation problem.

For instance, although CPI and RPI are relatively low in the UK, one area that has been affected by the impact of QE is the housing market. This has made property more expensive, forcing the majority of young buyers out of the housing market in London and the South East of England.

Others fear that the flood of cash may encourage injudicious and irrational financial behaviour, which negatively affects the overall economy.

Has QE really worked in the past?

The US Federal Reserve (FED) and the BoE adopted this unconventional monetary policy tool in the wake of the 2008 financial crisis. The FED carried out a bond purchase for $3.7trillion over the period 2008-2015 in an attempt to stimulate the economy.

The BoE started its QE program slightly after the FED, pumping £375bn ($550bn) of new money over the period 2009-2012.

The European Central Bank (ECB) adopted the same strategy, and since January 2015 has pumped almost $600bn of printed money into the system.

Evaluating and quantifying the efficacy of these QE programmes is not easy and it depends on the specific characteristics of each economy. In the last few years, the US economy has recovered slowly and its unemployment level has improved. There are other underlying factors to be considered, but the QE program is believed to have contributed to this recovery, at least in part.

Since 2009, the additional money printed by the BoE has contributed to increases in the availability of credit from banks and non-traditional lenders, and improved overall financial stability in the UK economy, despite the recent uncertainty post-Brexit.

As stated by the ECB governor in July 2015, the QE programme has “contributed to a broad-based easing in financial conditions, a recovery in inflation expectations and more favourable borrowing conditions for firms and households“.

The Avamore perspective

QE as a practice could be a double-edged sword. Rate cuts and QE are supposed to foster borrowing and discourage savings, it is also supposed to lead to higher asset prices, which in turn may encourage more borrowing and boost investments, at least in theory. By contrast, lower interest rates make it harder for traditional lenders to turn a profit, which may indirectly lower their appetite for lending.

From an investor perspective, QE could further reduce traditional investment yields, making them less attractive in comparison to property. Given this scenario, property, as an alternative asset class, would receive increased investor interest, offering both potential capital gain and rental income. Despite some post-Brexit uncertainty, with a large and fast growing privately rented sector, and a solid long-term track record of capital growth, it is likely that London will consolidate its primary position in the investor’s portfolio. This, combined with strong economic fundamentals and market transparency, should re-boost any investor’s appetite for UK property, contributing to the overall health of the UK economy.

About Avamore Capital:

Avamore Capital is a special situations lender that provides loans to property traders, property developers, property investors, and other property entrepreneurs. Loan sizes are between £0.5m and £5m with larger loans possible in conjunction with its partners. AvamoreCapital provides a flexible approach, quick feedback and very fast drawdown, subject to due diligence.

For further information please visit www.avamorecapital.com or contact Rocco Versace at rv@avamorecapital.com

Share:

Share on email
Share on twitter
Share on linkedin
Share on facebook