Is printing more money the answer?
The Bank of England has been creating new money - known as quantitative easing - since March 2009. But is this the answer to the economic crisis?
Alistair Darling first gave the central bank the green light to embark on a measure of quantitative easing, with the creation of £75 billion of new money, in March. In that month, the Bank of England also cut the base rate to an all-time low of 0.5% - the sixth consecutive monthly cut made.
However, as the base rate cannot turn negative, it also decided to adopt other measures to inject capital into the economy. In a statement regarding the move, the Bank of England said that the low base rate by itself still leaves a "substantial risk" of the UK entering a period of deflation.
In April and May the Bank of England kept the base rate at 0.5%, and in the latter month it also announced that it would increase the amount of cash created by £50 billion to £125 billion.
In a statement, the central bank said it will take three months to complete its quantitative easing programme, with the amount of money created kept "under review”.
Then, in November, the Bank of England increased the amount of new money being created to £200 billion.
But is printing more money really the answer to the economic crisis, and what impact will it have on the economy and on your finances?
How does quantitative easing work?
Quantitative easing is often referred to as printing money, but technically no physical notes are produced. Instead, the Bank of England creates more money for itself electronically.
The new money is then used to buy assets, such as gilts and bonds, from banks, insurers and pension providers.
Participants will then not only improve the health of their balance sheets, they will also increase the amount of cash in their coffers. Of course, there is no guarantee that this money will be used to step-up lending.
But as banks see their cash reserves increase they will need to offload some of this money to ensure a balanced book. The Treasury is also likely to make it a condition of quantitative easing that participants channel the money into their lending operations.
At the same time, by decreasing the supply of gilts, the Bank of England will effectively be pushing up their price. As gilt prices increase, their yields - or potential for income - fall.
Gilt yields are used to set interest rates on overdrafts, some fixed-rate mortgage products and business loans. Lower rates should make borrowing more attractive to consumers.
Will it work?
The potential impact of quantitative easing is unclear. While the measures looks good on paper, the extraordinary circumstances the UK economy currently finds itself in could distort their significance.
For example, while lower interest rates on mortgages, business loans and overdrafts should encourage consumers to borrow, a lack of confidence and job insecurity could offset the temptation.
In March Vicky Redwood, UK economist at Capital Economics, warned the effectiveness of quantitative easing depends on how "vigorously the Bank of England embraces it”. She added: “The main danger is doing too little, too late.”
Howard Archer, an economist at Global Insight, was broadly optimistic that increasing the money supply would help the UK economy. But, he warned: “Quantitative easing will take time to have an impact and there will not be an immediate turnaround or a sharp improvement."
There is also a risk that quantitative easing could cause an uplift in inflation, with prices potentially rising very rapidly. This does not appear to have happened yet.
One measure of the cost of living, known as the Retail Prices Index (RPI), turned negative in March for the first time since 1960. Meanwhile, the Consumer Prices Index (CPI) – the official measure of inflation that, unlike the RPI, does not include mortgage interest payments – also fell in March, to 2.9% down from 3.2% in February and 3% in January.
However, CPI remains above its 2% target.
In October, the CPI rose to 1.5% from 1.1% the previous month. The Office for National Statistics, which publishes the monthly inflation figure, also announced RPI rose to -0.8%, from -1.4% in September.
When inflation is high or rising, the Bank of England tends to increase the base rate to cool spending, as it becomes more expensive to borrow. When it falls, the base rate should also be reduced - however, at the moment this is unlikely to happen as it cannot turn negative and there is little room for further cuts.
The jury is still out on whether inflation will rise or fall in the coming months. The fact that energy bills and food (two measures that pushed inflation up last year) have fallen in recent months do suggest a return of high inflation is not on the cards.
At the same time, the depressed state of the economy could lessen the danger of a period of hyperinflation - or steep price rises. Having said that, quantitative easing measures could offset these downward pressures on inflation.
Ros Altmann, an economist and pensions and savings expert, is concerned that quantitative easing poses long-term dangers – such as a sharp rise in prices.
“The amounts of money being printed are so huge and the effectiveness of the policy are so uncertain that I am sure this is another huge policy error,” she says. “This holds enormous dangers for next year and beyond, especially for people such as pensioners living on fixed incomes.”
Altmann argues that there are already small signs that the economy is stabilsing, so increasing the amount of money in supply might not be needed. Plus, she is concerned that the benefits of quantitative easing won’t reach the people that really need them – like small businesses.
“We cannot afford such a dangerous experiment and the likely inflationary consequences are dire,” Altmann warns.
However Jonathan Loynes, chief European economist at Capital Economics, argues the “vast amount of spare capacity in the economy” - basically, weak economic growth - will help prevent quantitative easing from creating hyperinflation.
“Remember that headline inflation went above 5% back in 2008, with no real ‘second round effects’ on wages and inflation expectations,” he explains. “And the economy was in a much healthier state back then. In short, no need to panic.”
Lower interest rates encourage people to spend, not save. But when interest rates can go no lower and there is a sharp drop in consumer and business spending, a central bank’s only option to stimulate demand is to pump money into the economy directly. This is quantitative easing. The Bank of England purchases assets (usually government bonds, or gilts) from private sector businesses such as insurance companies, banks and pension funds financed by new money the Bank creates electronically (it doesn’t physically print the banknotes). The sellers use the money to switch into other assets, such as shares or corporate bonds or else use it to lend to consumers and businesses, which pushes up demand and stimulates the economy.
Replaced as the official measure of inflation by the consumer prices index (CPI) in December 2003. Both the Retail Price Index and CPI are attempts to estimate inflation in the UK, but they come up with different values because there are slight differences in what goods and services they cover, and how they are calculated. Unlike the CPI, the RPI includes a measure of housing costs, such as mortgage interest payments, council tax, house depreciation and buildings insurance, so changes in the interest rates affect the RPI. If interest rates are cut, it will reduce mortgage interest payments, so the RPI will fall but not the CPI. The RPI is sometimes referred to as the “headline” rate of inflation and the CPI as the “underlying” rate.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
This is the opposite of inflation and refers to a decrease in the price of goods, services and raw materials. Economically, deflation is bad news: the only major period of deflation happened in the 1920s and 1930s in the Great Depression. Not to be confused with disinflation, which is a slowing down in the rate of price increases. When governments raise interest rates to reduce inflation this is often (wrongly) described as deflationary but is really an attempt to introduce an element of disinflation.
The Consumer Price Index is the official measure of inflation adopted by the government to set its target. When commentators refer to changes in inflation, they’re actually referring to the CPI. In the June 2010 Budget, Chancellor announced the government’s intention to also use the CPI for the price indexation of benefits, tax credits and public sector pensions from April 2011. (See also Retail Prices Index).
Also referred to as the bank rate or the minimum lending rate, the Bank of England base rate is the lowest rate the Bank uses to discount bills of exchange. This affects consumers as it is used by mainstream lenders and banks as the basis for calculating interest rates on mortgages, loans and savings.
The familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.