In November 2020 the Bank of England announced a further increase in its asset purchase programme, otherwise known as Quantitative Easing (QE).
This takes the total amount of QE in 2020 to £450bn.
The reason for implementing quantitative easing is to support the economy (more on this below), something the Bank of England first did in 2009 in response to the Financial Crisis.
Quantitative easing is often referred to as ‘money printing’, implying that new physical currency is printed as banknotes. As we’ll see below, new money is invented through quantitative easing, it’s just not physically printed and it isn’t quite money as most people know it.
How Does Quantitative Easing work?
In a nutshell, quantitative easing is an asset purchase programme launched by a central bank which involves creating new money and using it to buy assets from the private sector.
For more on money and how it’s created:
The vast majority (over 95%) of these purchases are of government debt, sometimes known as gilts. This debt is in the form of bonds – a type of debt issued by governments and large corporations – that pays a fixed rate of interest.
Governments issue bonds to fund their spending when they are running a budget deficit, which means that they are spending more than they are receiving through taxation and other income.
Pension funds and other asset managers and commercial banks are typically the main buyers of government bonds.
When the Bank of England purchases government bonds it is often from pension funds. To do so, they will digitally create new central bank reserves (base money) and deposit them with the pension fund’s bank.
Central bank reserves, or base money, is a type of money that only the central bank and licensed commercial banks have access to.
This means that the central bank cannot use the newly created base money to purchase the government bonds directly from the pension fund. It must use a commercial bank as an intermediary.
It does this by crediting the commercial bank with base money to the value of the government bonds it wants to purchase from the pension fund. The pension fund’s bank therefore receives and holds newly created base money.
Because the commercial bank cannot transfer base money to the pension fund, it instead creates new broad money of the same amount as the base money. It will deposit this newly created broad money into the pension fund’s bank account.
Therefore, bank deposits have risen by the same amount as central bank reserves. In other words, the total money supply in the economy has increased through both base money and broad money.
It is important that bank deposits (broad money) have increased, as this is what drives spending and investment in the wider economy. Broad money is what most people think of as money – the cash in your bank account.
On the other hand, only commercial banks have access to central bank reserves which can’t be spent into the wider economy.
To summarise, new money is injected into the economy by the central bank with the hope that it is spent or invested, which in turn stimulates economic activity.
Here’s what the Bank of England’s asset holdings look like as of November 2020:
Why Do Central Banks Carry Out Quantitative Easing?
Central banks such as the Bank of England implement QE to support the economy. Normally, a central bank’s primary tool to influence the economy is by changing the central bank interest rate (Bank Rate).
Since the Financial Crisis a decade ago however, the Bank Rate has remained at historically low levels in the UK. This leaves little room for further interest rate based actions, although there is increasing talk of negative interest rates. I’ll write about negative interest rates in a future post soon.
Given that interest rates are already low, quantitative easing is seen as another – more drastic – tool to stimulate or support the economy.
There are two main effects that quantitative easing has in order to support an economy.
First, it is designed to encourage existing asset holders, such as pension funds in the example above, to use the cash they have received from selling government bonds to the Bank of England for other investments. Typically, this will be in equities (shares) but it can also be in other asset classes.
This pushes up the prices of these assets over time as it increases demand for them. By supporting asset prices, the Bank of England hopes to stimulate the wider economy by incentivising increased consumption and investment.
When the economy is struggling – like it is now due to the global pandemic – economic output falls and, due to the nature of the modern economic system, there is a danger of deflation.
The second way in which QE influences the economy is by driving up government bond prices. The large-scale purchases of government bonds (often known as gilts) that quantitative easing requires has the affect of increasing bond prices.
This is similar to the effect discussed above: the Bank of England is driving up demand for gilts by announcing that it will purchase them, which pushes up prices.
This has the effect of lowering bond yields. This is because the yield, or interest paid, on government bonds is fixed. Bonds can be traded so their value is not fixed – it will rise and fall with demand.
So as the price of government bonds increases through QE related purchases, the interest return as a percentage of the price decreases.
Example: A £1000 government bond is issued paying a fixed rate of interest at 2% of par, i.e. 0.02 x £1000 = £20.
The central bank launches a QE programme and intends to buy a large number of government bonds. Because the market knows that there is a large and committed buyer of these bonds, prices rise. A £1000 par value bond is now worth £1100.
The interest rate however is still based on its original value and the interest payment therefore stays at £20. The effective interest rate is, however, now below the original 2% based on the higher bond price: £20 / £1100 = 1.8%.
This effectively lowers government borrowing costs over time by driving down interest rates. Other interest rates are linked to government bond yields, so the idea is that the wider cost of borrowing in the economy will also decrease.
It is hoped that this lowering of interest rates then stimulates borrowing by businesses and consumers for investment and consumption. In turn this should increase economic activity, which drives inflation – or at least should prevent deflation.
Although the majority of the Bank of England’s asset purchases have been government bonds, they have also bought a (relatively) small number of corporate bonds:
Understanding QE As An Investor
QE necessarily has a significant effect on financial markets, given the way in which it works – as we’ve seen above.
In 2020 to date, the Bank of England has injected £450bn into the financial markets therefore creating increased demand for financial assets.
Ordinarily, an increase in demand would lead to rising prices of these assets. However the aim of quantitative easing is primarily to support asset prices in order to stop them falling and to prevent wider deflation in the economy.
In fact, the inflation rate as of December 2020 is 0.3%, well below the Bank of England’s target of 2%. It’s not out of the question for the Bank of England to further increase quantitative easing, or to implement negative interest rates.
To understand what might happen to asset prices going forwards, let’s look at what happened in the past after QE was implemented:
The above chart shows the average UK house price (orange line) and the FTSE100 index (blue line) from January 2005 up until January 2020, just before the coronavirus pandemic took effect.
As you can see, both UK house prices and UK equities (the FTSE100 index) increased soon after each round of quantitative easing.
It’s important to state that there were many other factors at play throughout the period shown above. These increases were not solely due to the effects of QE.
However, the effects of pouring hundreds of billions of new money into the economy cannot be underestimated.
Looking at QE is just one of many factors that I’m interested in as an investor. And it’s one that can’t be ignored.
What I’m Doing Now
In simple terms, an enormous amount of money is being used to boost asset prices. The last time large scale quantitative easing programmes were implemented, equities and house prices ballooned.
Here at Generation Money, we’re interested in how we can use economic understanding to increase wealth. Whether that is through trading & investing, business(es) or other assets.
However, it’s important to remember that we are still in a period of significant uncertainty, which is why I take a balanced approach to investing and trading.
Personally, whilst I’m still cautious on the performance of equities over the next 12 months, I’ll be increasing the monthly contribution I make into equities. This is of course done in accordance with my overall portfolio balancing.
Whilst I don’t own any investment property, I am a homeowner. I’m much more cautious on the prospects of house price growth and, for me, property does not represent a good investment right now.
Note: none of the above constitutes investment advice, nor does it claim to predict what may or may not happen in the economy and the financial markets.