What impact will "printing" new money really have?

5 November 2009

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.”


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