What impact will "printing" new money really have?
The Bank of England has increased the amount of new money being created to £200 billion, and voted to maintain the interest rate at 0.5%.
As expected, the central bank’s Monetary Policy Committee (MPC) has announced an extension to its plans to help lift the UK out of recession. It has already created £175 billion of new money as part of its radical quantitative easing scheme, but will now increase this amount by £25 billion.
Despite hints from the newest member of the MPC, Adam Posen, earlier this month that quantitative easing wouldn’t be extended further, the slow economic recovery appears to have prompted the Bank of England to take action.
Official data recently revealed that the UK remained in recession in September, with the economy contracting 0.4% since July. The country has now seen six consecutive quarters of economic contraction for first time since figures were first recorded in 1955.
Meanwhile, the official rate of interest has remained at an all-time low of 0.5% since March, having been cut from 5% in October last year. The MPC has maintained the base rate at 0.5% for a further month, until the outlook for economic recovery and inflation are more certain.
The sharp reduction in the base rate was intended to not only help control inflation, but also ease the pressure on credit-crunched households. However, one of the knock-on effects of the low rate is that it arguably discourages banks from lending, as they cannot afford to issue loans and mortgages based on such a low rate of interest.
For that reason, some pundits think the base rate may be increased slightly in December or the new year.
Generally speaking, periods of high inflation are tackled with high interest rates, as this makes it more expensive for people to borrow to spend and, therefore, dampens demand.
Currently the headline rate of inflation, known as the Consumer Prices Index (CPI), is just 1.1% - its lowest level for five years and well below the Bank of England’s 2% inflation target.
However, how long inflation remains low remains to be seen, as quantitative easing by its very nature poses the risk of high inflation – or hyperinflation. This happened in Germany in the 1920s and modern-day Zimbabwe.
Ros Altmann, an independent policy expert, has previously warned that quantitative easing is a “dangerous experiment” and poses “dire” inflationary consequences especially for pensioners on fixed incomes.
The fact that, since the quantitative easing programme was started, inflation has fallen rather than risen is testament to the hold the economic crisis really has on the UK.
"Ordinarily when governments print money, sell bonds, nationalise banks and go on an enormous ‘quantitative easing’ spree, the eventual outcome is inflation," says James Hughes, chief economist at Black Swan Capital Wealth Management.
A £25 billion extension to quantative easing is, however, expected to have a negative impact on the value of the pound. Duncan Higgins, senior analyst at Caxton FX, says: "[Extending quantitative easing will] further dampen demand for UK assets, sending the pound broadly lower, particularly as other central banks have given signals that they will soon begin tightening their respective monetary policies.”
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.
Monetary Policy Committee
A committee designated by the Bank of England to regulate interest rates for the UK. The MPC attempts to keep the economy stable, and maintain the inflation target set by the government and aims to set rates with a view to keeping inflation at a certain level, and avoiding deflation. The MPC meets on the first Thursday of each month and discusses a variety of economics issues and constitutes nine members: the governor, the two deputy governors, the Bank’s chief economist, the executive director for markets and four external members appointed directly by the Chancellor.
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.
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).