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Quantitative easing explained - and how to respond to changes

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Michael Brown

Acting Editor

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During times of consistent low economic growth, sometimes moving the Bank of England’s (BoE) base rate is not enough to elicit a positive response in the economy. This has led some central banks to adopt an alternative monetary policy called “quantitative easing”. Below we have explained how this works and, more importantly, how it impacts you.

What is quantitative easing?

Quantitative easing serves as an unconventional function to lower interest rates and stimulate the economy. To make sense of this definition, consider this scenario:

When the economy is in decline, the BoE can lower the base rate to slash savings returns and make borrowing more attractive. The more people borrow, the more financing is used to help people expand their business, buy that car, or even fund a holiday. All this create economic growth.

However, like during the COVID-19 pandemic, the base rate can hover above zero in a low growth environment and leave the BoE with little manoeuvrability for another cut.

This is where quantitative easing has been used.

In an attempt to further encourage greater spending among consumers, the BoE will release more of its reserves, or money, into the economy. It does this by purchasing bonds, stocks and other assets, with the intention of increasing their prices and making the people who hold these assets wealthier.

“[Quantitative Easing's] purpose is that people who already have something like a house or a pension or some shares will see the value of those things go up," George Osborne, former Chancellor of the Exchequer told BBC. 

With more money, these companies or investors can invest more in the economy in an attempt to create growth.

In addition, while the base rate remains the same, banks and building societies can lend money more easily. This is because the price of government bonds, in addition to the base rate, influences the interest rates these providers can offer. As explained later in this guide, since central banks primarily purchase government bonds through quantitative easing, it should have an effect on the financing consumers can access on the market.

Why does the BoE buy Government bonds?

Primarily, a central bank like the BoE will usually purchase Government bonds, more commonly known in the UK as gilts.

This type of investment is a form of loan to the Government to finance a number of activities, from building schools to servicing its debt. In return, the Government will pay back these investors with interest.

One thing to note about UK Government bonds is that they are often used as a safe haven. However, when these bonds are purchased in bulk, their price increases and their yield (i.e. the relationship between the bond’s price and its interest rate) decreases. This encourages investors with Government bonds to switch to alternatives which offer higher potential returns, which will likely be investments that directly fund the economy.

What is quantitative tightening?

When the BoE uses too much of its money for quantitative easing, then it will begin the opposite process called quantitative tightening. This is when the BoE stops buying new bonds and revises what assets it can sell back into the market.

Does quantitative easing cause inflation?

Since quantitative easing  effectively adds more money into the economy, it aims to promote economic activity which in turn allows inflation to increase naturally. So, if all goes according to plan, it will help increase inflation.

However, this is not always the case. The key determining factor is that consumers must spend money.

In a time of economic uncertainty some consumers slow down their spending habits. Perhaps, for some, it becomes better to hold off on buying a new car if unemployment numbers are on the rise. Therefore, any money added into the economy that finds its way to these consumers would not circulate, promote economic spending, and therefore not increase inflation.

How does quantitative easing affect interest rates?

While it does not have a direct impact on interest rates, if it increases inflation in the longer term it may encourage the BoE to raise rates.

How does quantitative easing affect the stock market?

Quantitative easing in theory should make the stock market stronger. As explained, when Government bonds are bought in such bulk, their yield decreases. As a result, investors who already held Government bonds will be tempted to cash-in their bonds and opt for other investment vehicles which have a higher potential return.

Traditional stocks generally fulfil this objective. Increased demand in the stock market will drive prices u and, fund companies further.

If you are looking to invest in shares, consider the stocks & shares ISAs on offer. Otherwise for do-it-yourself investing, a platform such as interactive investor can get you started.

Disadvantages of quantitative easing

Too much quantitative easing can devalue a country’s currency. Remember, quantitative easing is increasing the money in an economy. When this happens, and it does not promote economic growth, the value of this money decreases.

A weaker currency has significant ramifications for consumers. UK importers will start paying more for goods to enter the country, which means consumers will feel the increase too. Even those manufacturing products in the UK who require raw materials from other countries may have to put their prices up.

Disclaimer: This information is intended solely to provide guidance and is not financial advice. Moneyfacts will not be liable for any loss arising from your use or reliance on this information. If you are in any doubt, Moneyfacts recommends you obtain independent financial advice.

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