What is quantitative easing?
Quantitative easing is a tool central banks can use to meet an inflation target.
We are the UK’s central bank and our job is to get the rate of inflation to our 2% target.
We do that by changing interest rates to influence what happens in the economy. We use two main tools to do this. The primary tool we use is Bank Rate. This is the interest rate we pay on deposits placed with us overnight by eligible firms such as commercial banks.
Additionally, we can buy bonds to bring down longer-term interest rates on savings and loans. This is sometimes called quantitative easing (QE). It is the Monetary Policy Committee (MPC) that decides on Bank Rate and QE.
When we need to reduce the rate of inflation, we raise interest rates. Higher interest rates mean borrowing costs more and saving gets a higher return. That leads to less spending in the economy, which brings down the rate of inflation.
When we need to support the economy by boosting spending, we lower interest rates. That also causes inflation to go up.
QE is one of two tools we can use to lower interest rates, particularly when Bank Rate is very low and there is limited scope to lower it further.
We first began using QE in March 2009 in response to the Global Financial Crisis. At that time Bank Rate was already very low. In fact, it couldn’t be lowered any further at that point. So we needed another way to lower interest rates, encourage spending in the economy, and meet our inflation target.
QE involves us buying bonds to push up their prices and bring down long-term interest rates. In turn, that increases how much people spend overall which puts upward pressure on the prices of goods and services.
In total, we bought £895 billion worth of bonds. Most of those (£875 billion) were UK government bonds. The remaining £20 billion were UK corporate bonds.
The last time we announced an increase in the amount of QE was in November 2020.
At the moment, inflation is above the 2% target, so we have raised interest rates to bring it back down again.
We have also been reducing the stock of bonds we bought during QE – a process sometimes called ‘quantitative tightening’ (QT). The MPC decided to begin doing that in February 2022.
We can use our bank reserves to buy bonds
The money we used to buy bonds when we were doing QE did not come from government taxation or borrowing. Instead, like other central banks, we can create money digitally in the form of ‘central bank reserves’.
We use these reserves to buy bonds. Bonds are essentially IOUs issued by the government and businesses as a means of borrowing money.
Now that we are reversing QE, some of those bonds will mature and we are selling others to investors. When that happens, the money we created to buy the bonds disappears and the overall amount of money in the economy will go down.
We’re not alone in using QE. Central banks in many other countries, including the United States, the euro area and Japan have used it too.
Buying bonds helps to keep interest rates low
When we buy bonds, it pushes down on long-term interest rates on savings and loans. Doing that stimulates spending in the economy.
Here’s how it works. We buy UK government bonds or corporate bonds from investors, such as asset managers. Bonds are IOUs that pay an amount of interest that is fixed in cash terms - £5 per year, for example. This fixed interest payment is called the bond’s ‘coupon’.
When we buy bonds, their price tends to increase compared with the coupon. If the price of a bond goes up, compared with its coupon, the rate of return on the bond, or ‘yield’, goes down.
Suppose a bond was worth £100 and its coupon was £5 per year. The interest rate or yield of that bond is 5 as a percentage of 100, which is 5%. If the price of the bond increases from £100 to £120, then the £5 coupon payment now represents a yield of 5 as a percentage of 120, which is 4.2%.
Yields on government bonds act as a benchmark interest rate for all sorts of other financial products.
So, for example, lower government bond yields feed through to lower interest rates on household mortgages.
In turn, those lower interest rates lead to higher spending in the economy and put upward pressure on the prices of goods and services, helping us raise the rate of inflation if it is too low.
Buying bonds supports the prices of other financial assets
QE increases the price of financial assets other than bonds, such as equities.
Here’s an example. Say we buy £1 million of government bonds from an asset manager. In place of those bonds, the asset manager now has £1 million in cash.
Rather than hold on to that cash, it might invest it in other financial assets, such as equities.
In turn that tends to push up on the value of equities, making households and businesses and other financial institutions that own equities wealthier. That makes them likely to spend more, boosting economic activity.
Higher prices for corporate bonds and equities also lowers the cost of funding for companies and this ought to increase investment in the economy.
QE has supported our aim of having low and stable inflation
Research on the functioning and effectiveness of QE suggests that it has supported our aim to keep inflation low and stable.
The evidence also shows the impact of QE has varied significantly between the different times (we call them ‘rounds’) we used it. The largest impact on the economy was probably after the first round (2009). It also had large effects after the UK’s referendum on membership of the EU in 2016, and at the start of the Covid pandemic in spring 2020.
These were all times when markets were stressed, and QE was particularly effective in helping to lower long-term borrowing costs.
Has QE increased inequality in the UK?
One of the consequences of QE is it increases the value of assets such as equities. That increases the wealth of the people who own them. This is one of the ways in which QE helps stimulate the economy.
Our research on the distributional effect of QE shows that older people, who tend to own more financial assets than younger people, gained the most from increased wealth.
But that’s only part of the story. QE also leads to more spending, which creates jobs and increases wages. As a result, those of employment age benefited from higher earnings. It was younger people who benefited the most from the support to employment and incomes.
When we look at the combined effect of these income and wealth effects, we find that the overwhelming majority of people benefited from QE and that it did not lead to greater inequality.