On 13 July 2009, Charlie Bean, Deputy Governor for Monetary Policy, began a 7-day tour of Britain to explain the MPC's policy of injecting money directly into the economy alongside its decisions on interest rates.
The Deputy Governor made a number of visits to parts of England, Scotland and Wales. He met business groups and organisations and undertook media interviews.
To complement these visits, Charlie Bean invited your questions on quantitative easing. A large number of questions were received up to 24 July. Similar questions have been grouped together and our answers are provided below.
We would like to thank all those people who took time to submit questions and offer their own views. Individual replies will be sent shortly. Any further questions and enquiries can be put to the Bank through our public enquiries service:
by email at email@example.com;
by telephone on 020 7601 4878.
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- 1. Given inflation has only just fallen below the Government's 2% target, why is the Bank of England adopting such a large unconventional policy measure?
- The effects of monetary policy on prices and real activity only come through after long and somewhat variable lags. Consequently, the MPC has to focus on the medium term prospects for inflation when setting monetary policy, rather than the current level of inflation, which it can do very little about. Although inflation had been above the target for some time and has only recently fallen below it, the MPC judged that in the absence of a further monetary policy stimulus, the growing margin of spare capacity created by the recession would push inflation significantly below the target in the medium term. With Bank Rate already almost as low as it can go, the MPC therefore decided that a substantial stimulus through quantitative easing was warranted.
- 2. You say that the objective of quantitative easing is to increase money spending in the economy? Has the Bank of England's objective changed?
- No. The objective of the MPC remains to hit the Chancellor's 2% CPI inflation target. But the Bank is concerned with the growth of money spending in the economy because it is a primary determinant of inflation in the medium term. Inflation (deflation) occurs when the growth of money spending is high (low) relative to the rate of growth of the economy's supply capacity. In March 2009, the MPC judged that the prospects for money spending in the UK had deteriorated due to the financial crisis and demand would therefore be insufficiently strong to meet the inflation target in the medium term. Quantitative easing aims to increase money spending, and thereby to help achieve the inflation target in the medium term.
- 3. Quantitative easing isn't fair to savers who did nothing wrong in the lead up to the crisis and now get very little on their savings. Doesn't it simply reward the imprudent who borrowed too much?
- Monetary policy is a rather blunt instrument and unfortunately there will always be gainers and losers from any particular MPC decision. For instance, raising Bank Rate usually benefits savers and hurts borrowers. At the present juncture, many savers are suffering from particularly low interest rates on their savings, even though the financial crisis is not of their making. But by cutting Bank Rate sharply and undertaking quantitative easing now, the MPC is aiming to get the economy back on track sooner rather than later. And when that happens, interest rates for both savers and borrowers can return to more normal levels. If the MPC had not undertaken quantitative easing, interest rates would need to stay low for even longer to keep inflation on track to hit the target.
- 4. Won't quantitative easing just pump up house prices again and lead to more of the same problems?
- Monetary policy, including quantitative easing, seeks to stabilise inflation at the 2% target over the medium-term. The MPC does not target house prices, or any other asset prices for that matter, although it does take them into account when forming its judgement regarding the medium-term prospects for inflation. If quantitative easing ends up stimulating the housing market unduly then it is also likely to stimulate spending more generally and the MPC will in that case need to be tightening policy in order to hit its inflation target. But the experience of the past few years has shown that asset prices can rise rapidly even when the prices of goods and services are stable. So the FSA and the Bank will need to be on the lookout for evidence of unsustainable developments in housing and other asset markets.
- 5. Won't quantitative easing undermine trust in money? Won't it lead inevitably to high levels of inflation and a collapse in confidence in sterling? Aren't there limits to quantitative easing?
- Monetary policy in the UK is focused on maintaining trust in the currency by ensuring that inflation is continually on track to meet the Chancellor's 2% target in the medium term. At the beginning of 2009, the MPC's traditional instrument of Bank Rate was cut to nearly zero (0.5%), but the economy continued to weaken as a result of the financial crisis. That is why the MPC judged that inflation would undershoot the 2% target without an additional policy stimulus. Far from undermining trust in the currency, quantitative easing is designed to ensure that inflation is stable and in line with the 2% inflation target in the medium term. As the economy starts to improve, so the MPC will tighten monetary conditions by selling off the assets it has bought and/or by raising Bank Rate so as to keep inflation on track to meet the target.
- 6. Are you not simply monetising government debt? Is there any economic distinction between buying government debt in the secondary market from buying it directly from the Government?
- The key point is that the Bank is not being forced to create money in order to cover the gap between the government's tax income and its spending commitments. If it were carried out to finance the budget deficit, it would be a violation of Article 123 of the Treaty on the Functioning of the European Union. Rather, the Bank is undertaking quantitative easing in order to meet the inflation target and will sell the government debt back to the private sector once the economy recovers, thus unwinding the original increase in the money supply.
Central banks routinely buy and sell government debt in the secondary market as part of their normal operations in the money markets and such operations are not deemed to amount to monetary financing under the Treaty on the Functioning of the European Union. The only thing that distinguishes quantitative easing from normal operations is their scale and the length of time for which the assets are likely to be held.
- 7. Didn't this happen in the Weimar Republic and in Zimbabwe? Why will it be different this time? Aren't you taking an enormous risk with our economy?
- In the Weimar Republic and Zimbabwe, the central bank printed money to finance government expenditure. This vastly increased the money supply, and hence prices rose rapidly. This is not happening in the United Kingdom. Here, the Bank is buying assets from the private sector to stimulate the wider economy, because otherwise we risk undershooting, rather than overshooting, the inflation target. Quantitative easing is not carried out to help the government meet its financing needs. When the economy recovers, most of the purchased assets will be sold back to investors, reducing the money supply.
- 8. What is the difference between reserve balances and printing money?
- Reserve balances are, in effect, electronic money held only by commercial banks and can only be used to settle transactions between them and with the Bank of England. The Bank issues paper currency in response to the demand for banknotes from the public. But reserves and notes both represent claims on the Bank of England ('central bank money') and the banks can exchange the reserves for notes, although as they receive Bank Rate on their reserves they will only do this if the notes are needed to meet, for instance, withdrawals of deposits. When the Bank buys assets under its quantitative easing programme, the bank account of the seller goes up by the value of the sale and their bank simultaneously acquires an equal quantity of reserves.
- 9. If banks are unwilling to lend because of capital constraints, won't this make quantitative easing ineffective?
- Quantitative easing operates through a variety of channels, only some of which actively involve commercial banks. When the Bank purchases government debt (gilts), it depresses gilt yields and the yields on a range of similar assets. The sellers are then likely to buy other assets, including equities and corporate bonds, putting further downward pressure on yields and making it easier and cheaper for businesses to raise finance through the capital markets.
As a counterpart to the asset purchases, quantitative easing also generates extra reserves. These reserves represent a claim on the Bank of England and can only be held by banks; the Bank pays interest at Bank Rate on these reserves. If a bank wants, they can also be converted on demand into banknotes. Reserves thus constitute a highly liquid and riskless asset but one which pays a low return. Banks finding themselves holding more of these highly liquid, riskless but low-yielding, assets may therefore be tempted to use the extra reserves in ways that generate higher returns, including extending more loans. That could be especially helpful to small businesses that are presently finding it hard to get credit.
But banks may not expand their lending if they are worried about prospective losses on their existing loans and the adequacy of their capital to absorb losses; that was what happened in Japan earlier this decade. Even so, quantitative easing will still have a beneficial effect through the channels mentioned earlier, although it will be less powerful than it would otherwise be.
- 10. Quantitative easing was tried in Japan but didn't work. What lessons have you drawn from this? Why do you think it will work here?
- There are three main lessons to be learned from the Japanese experience in regard to quantitative easing. First, policy needs to act early and decisively. The Bank of Japan cut its policy rate to 0.5% in September 1995, but it did not start quantitative easing until March 2001. In the United Kingdom, quantitative easing started in March, the same month as the MPC cut Bank Rate to 0.5%.
Second, policy should not focus on a single transmission channel. The Bank of Japan sought to increase the banking sector's money holdings by buying assets principally from the banks. This meant that there was no direct effect of the Bank of Japan's actions on broad money - the money holdings of the non-bank private sector. So the Bank of Japan, in order to have an effect on broad money, was entirely reliant on the banks reacting to the extra reserves by expanding their lending. But the banks simply hoarded the reserves and did not expand lending. The Bank of England has taken a different approach, which aims to have a direct effect on broad money, and works through a wider range of channels to stimulate spending. In particular, it has focused on purchasing assets from the non-bank private sector in order to increase directly the money holdings of private individuals and companies who are more likely to spend this extra money. Of course this may then be reinforced if the banks choose to expand lending as well.
Third, the Bank of Japan bought only government debt until mid-2002. Though small in terms of the quantity of actual purchases, the Bank of England's willingness to purchase corporate assets is an important part of our strategy. That willingness to purchase private sector assets has helped to ease credit conditions directly for those firms using these markets to raise funds.
- 11. Will quantitative easing be unwound (assets sold back into the market) before interest rates increase again?
- When the MPC wanted to loosen monetary policy to support the economy at the start of the recession, it began by cutting Bank Rate aggressively. But once Bank Rate had reached its effective floor - Bank Rate is currently 0.5% - it was necessary to stimulate money spending in other ways. That is what quantitative easing is supposed to achieve.
When it comes to tightening policy, the MPC will have two instruments available: raising Bank Rate; and selling back assets. Removing money from circulation can be achieved by selling the assets back to the private sector. The MPC will be likely to use a combination of raising Bank Rate and selling back assets, although the precise sequencing and the relative importance of the two instruments will be considered month by month at each MPC meeting. The Bank will seek to sell the assets it owns in an orderly fashion in order not to disrupt the market for government debt.
- 12. Won't quantitative easing inevitably lead to higher interest rates on government debt when you come to sell the assets back?
- It is possible that gilt prices will fall, thus raising the corresponding interest rates, when the Bank starts to sell its holdings. Subject to achieving the 2% inflation target in the medium term, any sales will be co-ordinated with the Debt Management Office so as to limit any adverse impact on the functioning of the gilt market. Moreover, at this point it is impossible to know whether long-term interest rates at the time of sale will be lower or higher than at present.
- 13. Is the suggestion that the Bank might issue short-term Bank of England bills to reduce reserves an indication that it will be difficult to sell the assets it has purchased back to the market?
- The market for UK government debt is one of the deepest and most liquid financial markets in the world. Nevertheless, buying and selling large quantities of assets quickly is likely to result in price distortions. If the MPC decides that it wants to reduce the quantity of reserve balances held by the banks, the easiest way to do it quickly would be to issue them with Bank of England bills in exchange for the reserves, rather than selling off the Bank's holdings of government debt back to the non-bank private sector. The assets could then be sold back in an orderly fashion over a longer time period. Whether the Bank issues extra bills in exchange for the reserves or not will ultimately be a technical decision that will be taken with a view to market conditions at the time.
- 14. Why not purchase more corporate bonds?
- Since March, the Bank of England has purchased government bonds, corporate bonds and commercial paper paid for by issuing additional central bank reserves. The vast majority of the Bank's purchases have been government bonds. The purchases work through two mechanisms - by increasing the amount of money circulating in the economy and by improving conditions in the corporate credit market. The quickest way to expand the money supply is to purchase government debt from the private sector because there is a large stock available for purchase; that is why the majority of purchases have been government bonds.
Large-scale purchases of corporate assets, for instance of corporate debt or equities, would involve the Bank taking a lot of risk onto its balance sheet, the burden of which would ultimately fall on the taxpayer. So any decision to purchase large-scale quantities of corporate assets really should be made by the Government, not by the MPC or the Bank.
The immediate purpose of buying corporate bonds is to improve the functioning of corporate credit markets. That would reduce the spreads on such assets - the difference between the yield on bonds and the yield on an equivalent maturity gilt - and stimulate issuance by making it known that the Bank is standing ready to act as a buyer. That in turn should support private sector demand for these assets by making the markets function better and so enable companies to get easier access to finance through these markets.
But it is not the intention to replace private demand altogether. Indeed, if the operations are successful, then it may not even be necessary for the Bank to buy many bonds in order to reduce spreads and improve issuance conditions. The very fact that it is widely known that the Bank is willing to operate in these markets may prompt spreads to fall and issuance to increase. And, as it happens, since the bond purchase facility was announced, the demand for corporate bonds by private investors has been very strong and bonds spreads have fallen significantly.
- 15. Why did you limit the maturity of government bonds that you will buy?
- As of 6 August 2009, the Bank will buy gilts of all maturities of three years and above. But our previous purchases were focused on the maturity range of five to 25 years. We did not buy ultra-long gilts because those are predominantly held by pension funds to hedge their pension liabilities and tend to be relatively lightly traded. And we did not purchase short gilts because they are held in greater quantity by the banks - we wanted to focus our purchases on buying from the non-bank private sector. However, given that the Bank now holds significant quantities of the maturities that it was purchasing, it was deemed sensible to expand the range of eligible maturities in order to avoid distorting the gilt market too much.
- 16. When you go into the market to buy gilts, which would you prefer to buy a small quantity which creates a disproportionate rise in prices, or to buy a lot as cheaply as possible?
- The primary purpose of buying gilts is to increase the money supply as rapidly as possible. Therefore the priority has been to buy in deep and liquid markets. We determine which gilts to buy by comparing the offered sale prices with the respective market prices. In order to ensure all market segments remain liquid, the Bank will cease purchasing a gilt of a particular maturity when it owns a significant proportion of the stock outstanding as the market for that particular gilt is then likely to become less liquid.