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Is quantitative easing as practiced by the Bank of England in response to the financial crisis ineffective?
MPC – Monetary Policy Committee
BoE– Bank of England
QE – Quantitative Easing
QE refers to an unconventional monetary policy undertaken by the central government or the monetary authority of a country to revive consumer spending and promote economic growth. This is done by purchasing government or other securities from the market which helps to reduce interest rates. A direct effect of this is an increase in borrowing activity that causes the money supply to increase. QE is a viable option when short term interest rates are close to or approaching zero. However, it does not involve printing money (Ellis, 2010).
QE was deployed by the Bank of England’s (BoE) Monetary Policy Committee (MPC) in response to the financial crisis in 2008. In its efforts to support demand and loosen monetary policy, the MPC slashed the interest rate by three percentage points during 2008 Q4 and followed this with a reduction in the bank rate by one-and-a-half percentage points in early 2009. The bank rate was reduced to half a per cent in March 2009 which was effectively its lower bound. However, despite the substantial reductions in the interest rates, the BoE’s MPC felt that the nominal spending would not be enough to meet the two per cent inflation target (Joyce, McLaren and Young, 2012). Martin and Milas (2012) in their research, outline the fact that QE is more or less a last resort option and is undertaken only in times of severe economic stress, when a more conventional monetary policy cannot be adopted because the policy rate is already at its lower bound. Therefore, the BoE decided to address the problems in the country through QE.
Joyce, McLaren and Young (2012) highlight the aim of this policy as being to inject money into the economy which would inevitably improve the nominal spending and help to achieve the two per cent inflation target. The authors further throw light on the fact that the BoE’s asset purchases predominantly consisted of UK government bonds (gilts): £200 billion worth of assets were purchased by the BoE between March 2009 and January 2010. This represented 30 per cent of the gilts outstanding held by the private sector. This was also approximately 14 per cent of annual nominal GDP.
The government also encouraged the BoE to engage in practices that would instigate an improvement in the functioning of specific financial markets (Fisher, 2010). Thus the BoE involved itself in purchasing high quality commercial paper as well as corporate bonds; however, the scale of operations was not as significant when compared to the BoE’s purchases of gilts.
The BoE has since then made a series of purchases including £75 billion in October 2011, £50 billion in February 2012 and £50 billion in July 2012, bringing the grand total of asset purchases to £375 billion. However, while there have not been any further asset purchases, funds received from maturing bonds have been reinvested to ensure the balance remains at £375 billion (Joyce, McLaren and Young, 2012).
A number of research reports have thrown light on what the outcome would have been if the BoE had decided not to pursue QE thus allowing us to conduct a counterfactual analysis. Kapetanios et al. (2012) conducted one such study in which they made use of three different time series models to assess what would have happened had QE not been undertaken.
Results from all the three models used produced findings in favour of QE and showed that without QE, the UK might have been victim of an even deeper financial crisis. The findings of the counterfactual analysis suggest that declines in real GDP during 2009 would have been much more significant and CPI inflation would have been very low or negative. Based on their research, the authors provide their own take on the subject and in their conclusion offer support of QE, claiming it was an effective policy during the financial crisis.
Counterfactual analysis conducted by other researchers support the conclusions offered by Kapetanios et al. (2012). Lenza, Pill and Reichlin (2010) in their research, provide us with numerical evidence of how a QE policy prevented the economic downturn in the country. According to the report, QE had a positive impact on the unemployment rate which was half a percentage point lower than it would have been following the aftermath of the financial crisis had the BoE not taken unconventional measures. There was also a positive influence on the flow of loans to households as well as the corporate sector. In the case of households, the positive impact cumulates to one-and-a-half percentage points on the annual growth of loans after two years. The effect is even better in the case of the corporate sector but experienced a longer lag.
Bridges and Thomas (2012) have also drawn similar conclusions to the aforementioned research. From numerical evidence the authors proved that in the absence of QE, growth in asset prices as well as GDP would have been notably weaker in 2009 and 2010. According to the authors, QE had a positive impact of 20 per cent on asset prices. Further, it fuelled consumption and investment, thereby enhancing the level of GDP. The evidence of the research suggests that QE had a peak level impact of two per cent on GDP.
Another argument in favour of the QE policy as adopted by the BoE is that the targets set prior to its initiation have been achieved with wider economic benefits, on the whole. One of the effects of QE is to drive up the price of government bonds and to subsequently push down the yield they provide to investors. Joyce et al. (2011) in their research, provide evidence that this has been the case and that QE has successfully reduced medium- to long-term government bond yields by approximately 100 basis points.
Baumeister and Benati (2010) have also offered support for this argument and in their discussion of the macroeconomic effects of QE on the UK. The authors claim that long-term bond spreads have been reduced as a result of the BoE’s asset purchases. They further deduced that a contraction in yields also had a positive impact on the growth in output and inflation.
The inflation report of August 2014 published by the BoE shows just how far the UK economy has come in its quest for revival. The report explicitly states that growth over the past year has now taken output to above its pre-crisis peak whereas unemployment continues to fall. A newspaper article published in the Guardian coupled with results produced by the Office for National Statistics prove that UK unemployment has fallen below the two million mark for the first time since the global financial crisis six years ago (Monaghan and Inman, 2014). The report further throws light on the spending pattern that is expected to continue with less uncertainty. This is well supported by the improvement in the availability of credit. In line with all the aforementioned developments, the MPC has successfully achieved its pivotal target in the long run which was to maintain inflation at close to two per cent.
Even though it is difficult to ascertain how much of these developments are a direct effect of the QE policy undertaken by the BoE, the arguments above show that the decision to adopt an unorthodox strategy has paid dividends and that QE prevented the UK economy from plunging into a deeper crisis.