Central Banks Use Of Quantitative Easing Example For Free - Free Essay Example

Sample details Pages: 7 Words: 1962 Downloads: 9 Date added: 2017/06/26 Category Finance Essay Type Narrative essay Did you like this example? The financial crisis which broke in August 2007 hit the worlds economy significantly, leading to a widespread and continued recession. Specifically in the UK, the GDP growth rate experienced a drastic decrease from 2.4% in the third quarter of 2007 to the bottom of -5.9% in the second quarter of 2009. The consumer price index (CPI) also fell sharply from 5.2% in September 2008 to 1.1% in September 2009 (National Statistics, 2009), surpassing the 2% target set by the central bank. Under such circumstances, the Bank of England took a range of monetary policies to curb the worsening economy. One of those was to lower the Bank Rate from 5.2% to 0.5% just within 6 months, reaching a 315-year historical low and just above its floor of 0 (Bank of England, 2010). But given the still sluggish spending and staggering economy, the Bank of England decided to take a step further by initiating an unconventional programme-Quantitative Easing (QE). The aim of QE was to meet the c entral banks 2% inflation target. Nearly two years have passed since then. It is necessary to give an initial assessment of QE for the purpose of assessing appropriate measure in future years. Basically, there are three areas for QE to take effect, so the method this essay used is to assess each area of them. 2. Main Body Quantitative Easing means that the central banks first credit their own accounts and then purchase assets from public and private sector institutions, including insurance companies, pension funds, high-street banks and non-financial firms. The assets could be government bonds, corporate bonds or commercial paper. As for the UK, on 5 March 2009, the Bank of England announced that it would purchase  ¿Ãƒâ€šÃ‚ ¡75 billion of assets, most of which were government bonds (gilts) with a residual maturity between 5 and 25 years. Following that, further asset purchases were announced at May, August and November 2009. Specially, the August announcement also made two more changes: the first one was to extend the gilts maturity range to three years and over. Second, they launched a gilt lending programme, which allowed counterparties to borrow gilts from Asset Purchase Facilitys portfolio in return for a fee and alternative gilts as collateral (Bank of England, 2010). By November 2009, the total amount of assets purchased had increased to  ¿Ãƒâ€šÃ‚ ¡200 billion, an amount equivalent to 14% of total GDP. Finally, on 4 February 2010, The MPC announced that the asset purchased would be maintained at  ¿Ãƒâ€šÃ‚ ¡200 billion and they would expand this number if it is necessary. Notably, all these purchases were undertaken by the Bank of England Asset Purchase Fund Facility (APF), a wholly-owned subsidiary of the Bank of England. There are three key areas in which QE was expected to take effect. The first one is to push up asset prices through artificially higher demand. The second one is to increase total wealth and lower the cost of borrowing. The third one is to stimulate bank lending through more money supply. The best results of QE would be that: the higher asset prices would enhance the wealth of the assets owners, making them more willing to spend or invest. Besides, the higher asset prices go higher would lower the yields, which would make it cheaper for households and businesses to finance spending. Furthermore, as the sellers of the assets deposit their money into their bank accounts, the commercial banks could have more money for them to lend, which can boost borrowing and spending significantly. However in practice, from my point of view, the effectiveness of QE in UK is very weak, at least for now. But given the fact that it may take longer time for QE to fully reach its function and its novelty, we may need more time to reach a final conclusion. The first area for QE to take effect was to increase asset prices. Generally speaking, QE successfully pushed up asset prices, especially for gilts , but for some other assets, like corporate bonds or equities, the degree of its influence may be hard to identify. The report working paper NO.393-the financial market impact of quantitative easing from the Bank of England showed that every additional  ¿Ãƒâ€šÃ‚ ¡1 billion QE announcement will lead to around 0.6 basis point fall in gilt yields, and the average changes summing over all the announcements could be 100 to 125 basis points (Bank of England, 2010). The lower gilt yields would stimulate investors to transfer their money into corporate bonds, shares and other assets, which would potentially facilitate the funding for companies bypassing banks and increase the liquidity of capital market. Thus, from this point of view, QE can be considered as a relative success though the final conclusion may take some time to reach. As for other assets prices, from March 2009 to May 2010, the sterling investment-grade corporate bond yields fell 400 basis points and the non-investm ent grade corporate bond yields fell by 2000 basis points (Bank of England, 2010). But it is difficult to asses QEs attribution to this given the fact that the corporate bonds prices recovered internationally during that period. Besides, the FTSE All-Share prices during that period went up by 50% with huge volatility, and there were no immediate announcement impact at all (Bank of England, 2010). The reason for this might be that more than half of the companies listed in FTSE were from foreign countries which were also undergoing profound stimulus projects. This made it hard to single out QEs function. As for the sterling exchange rate, it did fall 4% on average following the six announcements, but over the whole period it increased 1% (Bank of England, 2010), which may because of the already substantial depreciation over the previous period. Thus, various kinds of influence from home and abroad make it hard to identify QEs impact on these assets prices. The second area for QE to take effect was to increase total wealth and lower the cost of borrowing, aiming at stimulate nominal spending and domestic demand. For this purpose, QE might have failed, especially from the perspective of households. As the money supply increases, one possible result would be inflation, just the situation UK is undergoing right now. Due to the higher food, commodity and energy prices, it is difficult to promote peoples desire to demand more and consume more. People may spend more only when their income is guaranteed, and borrow more only when they were convinced their future income could cover the debts. Thus, the primary issue for general public, at a time of uncertainty, is how to pay off debt and how to live a stable life. The rational behaviour for them would be saving other than spending or borrowing. Moreover, the prevailing spending-cut programme of the present UK government and pessimism in the Euro-zone economy as well as the flawed banking system would only deepen this worry. Therefore, against this backdrop, QE might not be so powerful in persuading the public to spend. As for financial institutions and private corporations, QE did helped lower the cost of borrowing, which can be demonstrated by higher liquidity and stronger issuance of corporate bonds and shares. But this effect was limited to big companies as they have higher credit and capacity raise funds. The small and medium-sized companies or the wider economy, which had already been trapped in financial dilemmas would have less access to borrow money as the banking lending and credit are still so tight. Just as John Redwood, an MP for Workingham noted: the method they choose did not release more credit and money for the hard pressed small business sector, or for much of the wider business community. The third area in which QE is expected to take effect is to stimulate bank lending. But this function was impaired too. Undeniably, QE did boost M4-the broadest measure of money supply, but the increase in M4 did not go to real economy as banks just hoarded the money rather than lending out. Thus, the key issue is why these banks are unwillingly to lend. The reasons could be their own huge debt, or a lack of confidence for future returns due to the not so optimistic economic outlook or the potential default risk from future borrowers. As we do not have clear evidence for which of these is the dominant factor, we can not be convinced that quantitative easing will directly boost lending (Richard Berner, 2009). When interest rate goes up, from my perspective, the Bank of England do have two instruments, with Open Market Operations, especially Repo transactions to adjust the short-term interest rates while quantitative easing to influence the long-term interest rates. However, the long-term interest rates will go up under the use of QE. Repo transactions mean that the central bank buys securities from banks with a promise of resale at an agreed price at an agreed date. The difference between the price the security when bought and sold by the Bank of England determines the rate of return of the Repo to the Bank of England, and the cost of borrowing for the banks. Effectively, that is the official interest rate set by the Bank of England. The securities bought by central bank are usually government bonds since it is very safe. Even if the banks become insolvent, the central banks would still own the government bonds. Thus the securities can be considered as collateral in mitigating credit risk. Specifically, when the interest rate in the UK goes up, the Bank of England intends to stimulate spending and liquidity by implementing expansionary monetary policy, it can buy gilts from commercial banks and resell them at a less higher price in a few days. By lowering bank rate, the banks essentially get a loan from central bank at a lower price, which would cover their needs for cash and stimulate borrowing in wider economy. Quantitative easing can als o influence long-term interest rates. A substantial increase in money supply makes inflation inevitable. Higher prices imply a deterioration of UKs Balance of Payments (BOP) and depreciation of the British Pounds. In the short term, this may help the Balance of Payments (BOP) as the British goods become cheaper. But in the long run, governments cannot allow their currencies to fall indefinitely, because the depreciation will make Britains imports more expensive which has further implications for inflation. To correct this, the government would be likely to push up interest rates. This could be the long term consequence of quantitative easing. 3. Conclusion QE is an unprecedented monetary policy for the Bank of England. The aim of QE was to stimulate spending to meet the central banks 2% inflation rate target by lowering the cost of borrowing and increasing bank lending. Although it successfully pushed up asset prices, but the transmission mechanism was in stuck in stimulating borrowing and lending. From the perspective of demand, the lack of borrowing may not be the reason for the insufficient spending or staggering economy. On the contrary, too much borrowing, the worry about the collapse of asset bubble, the lack of confidence for the economy growth might be the real reasons for the lack of spending. Especially under the pressure from the upcoming of the UK governments spending-cut programme and soaring commodity prices, people tend to save more, rather than spend more or lend more. Beside, from the perspective of supply, the increased M4 did not go to the real economy since the bank lending is still very tight and credit markets is still . Finally, when interest rates go up, the Bank of England can influence the short-term interest rates through Repo transactions and influence the long-term interest rates with QE. As the increase of money supply, inflation and currency depreciation would be highly like to happen. In the long run, the government would not allow their currency to depreciate indefinitely which might mean the deterioration of the whole economy. Thus, they government would increase the interest rates to prevent this tendency, that might be the long run effect of quantitative easing. Don’t waste time! Our writers will create an original "Central Banks Use Of Quantitative Easing Example For Free" essay for you Create order