If it’s not in your interests for other people to understand something, just apply basic marketing principles in reverse:
- Give it a name that gives little clue as to what it actually is
- Ideally, make that name difficult to say so you feel awkward even trying to mention it
- If pushed for an explanation, give one that’s technically true but deliberately omits the context of the question
A prime example of the genre is Quantitative Easing (henceforth “QE” to save keyboard wear and tear).
As you’re the type of person to find this blog, you’ve almost certainly heard of QE. I’d guess you know roughly what it is, but would struggle to explain it well to a friend.
This isn’t because you’re stupid: putting this article together has taken hours of research, because there are plenty of scattered facts but it takes a lot of effort to join the dots. I get a strong feeling that nobody involved wants you to truly understand it or think about it carefully, because the whole financial system is based on confidence – and you’ll be feeling a lot less confident once you do understand it.
Yet I believe it’s worth understanding – not least because in 2020, the whole purpose of QE changed. And hardly anyone is talking about it.
So at the risk of bringing down the global financial system, let’s dive in…
Background: How money is created
The Bank of England (BOE) has instructions from the government to produce inflation of 2% per year. In other words, the government wants everything you buy to cost you 2% more next year than it will this year, and it’s the BOE’s job to make it happen. (I explain why they make this seemingly odd demand in this article.)
The original meaning of inflation was “inflation of the money supply”, and this is what makes a general and sustained “inflation of prices” happen: when more money is created and the amount of goods available to buy is the same, you’d expect the price of those goods to rise.
So to make your weekly supermarket shop more expensive, the BOE needs to increase the amount of money in the economy – and to stop prices from rising (if inflation is too high), it needs to shrink the amount of money in the economy or at least stop it from growing so fast.
You might then think that the BOE creates all the money, and it varies the rate of creation depending on what prices are doing. But no – in fact, only about 3% of all the money in existence is created by the BOE. The other 97% is created by banks.
How banks create money
Money is created when a loan is made, and destroyed when a loan is repaid.
(Let me know if you want me to write an article explaining this more fully. It’s interesting and hardly anyone understands it because it’s never taught, but I don’t want to get sidetracked with it here.)
Therefore if the BOE wants more money to be sloshing around, it needs to encourage banks to lend and people to borrow. If it wants less money in the system, it needs to discourage those behaviours.
It does so by setting the “base rate”, which determines (via a complicated mechanism we won’t get into right now) the interest rate at which it’s practical for banks to lend money.
Say the base rate is 3%. At this rate it might be desirable for a bank to make loans at an interest rate of 5% by the time they’ve factored in their expenses and profit margin. At this borrowing cost of 5%, let’s imagine there’s demand for £1bn of borrowing by companies and individuals.
Then let’s imagine the BOE cuts the base rate to 1%. Now, the bank can make loans at an interest rate of 3%. Clearly, more individuals and businesses will want to borrow money at 3% than at 5% – so perhaps there’s now demand for £5bn of borrowing.
Because money is created whenever a loan is made, lowering the base rate has resulted (via higher borrowing) in there being an extra £4bn sloshing around in the economy. As we’ve seen, more money (inflation in the money supply) should push prices up (inflation in prices).
The BOE therefore controls the amount of money in the economy indirectly, by setting the price of money.
Bloody hell — all this way in and we haven’t even got to QE yet.
QE is born
In the aftermath of the 2008 financial crash, companies and individuals were more minded to repay their loans than to take out new ones – and many loans had to be written off as bad debts (which also destroys money).
This is anti-inflationary, so the BOE cut the base rate from 5% all the way down to 0.5% – making borrowing more attractive.
Still though, this wasn’t enough: psychology plays a part, and you can’t force people to borrow if they’re worried about the future. Also, banks were struggling with so many of their loans defaulting so didn’t have the capital or appetite to make new loans.
So in 2009, for the first time ever, the BOE engaged in QE. As concisely and as simply as I can possibly put it, it works like this:
- The BOE creates new bank reserves (a type of money) out of nothing
- It uses these reserves to buy government bonds from the institutions that currently hold them – like banks, pension funds and insurance companies
- The BOE now holds the bonds, and the seller has money which it can use to buy other assets
In an even smaller nutshell: the BOE “prints” money (more like “types it into a big spreadsheet”), then gets it out into the world by swapping it for bonds.
This is massively simplified and not strictly correct, but gets the main point across. Incidentally, the actual process is so complex and opaque that the country’s most eminent economists and policymakers are still arguing about precisely how it works in accounting terms. This in itself makes me nervous.
The first round of QE in 2009 involved the BOE buying £200bn of bonds. They then followed up with:
- £175bn in 2012
- £70bn in 2016
- £450bn in 2020 (we’ll get to this later!)
What’s the purpose of QE?
So now we sort-of understand the mechanism and know the scale… but what’s the point?
QE has multiple effects:
- It increases the amount of money in the economy in a more direct way than fiddling with interest rates.
- The supply/demand balance in the government bond market has changed, because there’s a big new buyer: the BOE. This increases the price of bonds, which decreases their yield.
- This means the government can issue new bonds at a lower yield, making it cheaper for them to borrow. They also (effectively) pay no interest on the bonds that the BOE now owns, reducing borrowing costs further.
- The price of other assets rises – which we’ll come to.
So QE is good for the BOE because it gets to give the economy an extra boost when it can’t cut interest rates any further, and good for the government because it reduces borrowing costs. But why does it make asset prices rise? Two reasons:
- The institutions that sold their bonds to the BOE now have cash that they can use to buy other assets with – which could be more government bonds, but could also be corporate bonds, stocks, property, and so on.
- The yield investors require from other assets is partially determined in relation to government bond yields: government bonds are seen as super-safe, so investors want a “risk premium” for investing in anything else. If a government bond previously yielded 3% and now yields 1%, you might now accept a yield of 3% on a company’s shares where you previously would have wanted 5%. This pushes up the price of shares.
A particular type of inflation
Remember: the theory goes that putting more money into the economy is inflationary in terms of prices. But there’s more to it than that: it matters where the money goes.
The £445bn of extra money that was created by QE before 2020 didn’t go into the pockets of consumers: it went into the coffers of banks and big financial institutions.
So rather than individuals feeling wealthier and rushing out to buy cars and holidays (pushing up consumer prices), these institutions bought financial assets (pushing up asset prices). At the same time, the falling yield on government bonds pushed up asset prices by another mechanism.
Has QE been inflationary, then? For consumer prices, not really: inflation since 2009 has run at about 2.9% per year. That’s above the BOE target, but not drastically so.
But what about asset prices? Well, over the last 11 years or so:
- The value of the FTSE All-Share has almost doubled
- House prices are up up 63%
- Gilts are up by 80%
- Gold is up by 180%
Name any asset, and its price has increased far beyond the rate of consumer price inflation. In other words, if your wages have risen at the rate of general inflation over the last decade, you’ll find it harder to buy a house – or any other asset that you might want to fund your retirement, for that matter.
So in summary: the BOE has pursued a policy that’s good for the government, good for financial institutions, good for those who already own assets, and bad for people (especially young people) who are trying to accumulate assets in the first place.
But in 2020, there was a further twist that no-one is talking about…
The year that QE changed
QE had many effects as we’ve seen, but (in the UK at least) it wasn’t used to directly fund government spending. It did reduce government borrowing costs, but the newly created money didn’t go to the government.
We can see this by looking at government spending patterns following rounds of QE:
- The year after the BOE engaged in £200bn of QE in 2009, government spending only increased by £40bn.
- The year after the BOE engaged in £175bn of QE in 2012, government spending only increased by £20bn.
The government was trying to pursue a policy of austerity and stop running a deficit at the time, so this makes sense.
In 2020, the BOE engaged in £450bn of QE – more than all previous rounds of QE added together.
And what did the government do? They issued £485bn in new bonds.
So we can add an extra step to our simplified wrong-but-right-enough QE process:
- The BOE creates bank reserves out of nothing
- It uses these reserves to buy bonds from institutions that already own them
- The institution now has cash in place of its bonds
- The government issues exactly the same quantity of new bonds, which the institution now buys
The effect is the same as if the BOE just printed money and bought bonds from the government directly. There are legal and practical reasons why they go through intermediaries (and hey, maybe they want to slightly obscure what they’re doing), but it doesn’t change the fact that the BOE has bought all the debt the government has issued.
According to the BOE’s governor Andrew Bailey as quoted in the Financial Times:
We do not . . . set a level of quantitative easing and asset purchases in any way related to what the government is going to borrow.
Do you believe that? It seems a bit of a bloomin’ coincidence that the amount of QE they decided to do purely to meet their inflation target almost exactly matches bond issuance.
The believability takes a further hit when you look at this chart, showing that the government’s borrowing needs were almost exactly matched on a month-to-month basis by QE:
Why does this matter?
I’m not (in this article, at least) making any judgement about how the government chooses to fund its obligations.
They needed to find an extra £485bn out of nowhere in response to Covid-19. Can they fund that out of taxes? No way – in 2019 taxes only brought in £757bn in total, so they’d need to hike takes by about 80% while economic activity is cratering anyway.
So they have to borrow it. Would there have been enough demand in the market for £485bn of extra government bonds if the BOE hadn’t stepped in as a buyer? Probably – every issuance in 2020 was massively over-subscribed. But could they take that risk when the money was so urgently needed? And would they have been able to borrow as cheaply? Almost certainly not: adding in extra supply with no extra demand would likely have pushed prices down and yields up.
Right or wrong, what matters is where the money is likely to end up.
Remember, in previous rounds of QE the extra money was injected into the “financial economy” and pushed up the price of financial assets.
But in 2020, the QE was going into the “real economy” – by funding government schemes like furlough, the job retention scheme, loans to businesses, increases to benefits, more spending on health, and so on. This is all money that’s mostly ending up in the hands of consumers, one way or another.
When it went into the financial economy, it pushed up asset prices. Now it’s going into the real economy, will it push up consumer prices?
It’s impossible to say – but it’s got to be more likely.
It’s easy to imagine someone in a well-paying middle-class job who’s been furloughed on 80% of their salary (a beneficiary of QE) yet seen their spending drop by 50% or more: no holidays, new clothes, nights out, and so on. If (big if) they keep their job and the world opens up again, there’s potentially a lot of pent-up spending for them to do.
Alternatively, they might decide to invest some of their savings in property or the stock market, pushing up asset prices even more.
What does this mean for the future of the UK economy?
Does this mean we’re in for an inflationary post-Covid world? Nobody knows for sure: the economy is complicated, people are complicated, cause-and-effect can only be guessed at even in retrospect.
But because of where this most recent QE money (which, remember, is more than all previous QE rounds put together) is going, it’s got to be more likely.
If that does happen, then what? If inflation gets above target, in theory the BOE should increase the base rate to dampen it down. But when the Federal Reserve tried to increase the base rate to 2% in 2018 the stock market immediately dropped 20%. It would also hammer the bond market, and have the undesirable effect of making future government borrowing more expensive.
It’ll also be interesting to see if the government starts routinely using QE to fund their spending plans. It’s got to be tempting: it gives everyone what they want in the short-term, it kicks difficult decisions into the future, and they’ve just done it on a huge scale with no adverse consequences (yet).
My guess is that one way or another, QE is here to stay: it will never be unwound, and will become a routine tool rather than a “break glass in case of emergency” hammer to bring out at times of stress (like 2009 and 2012).
How should you respond to all this? Well, ideally go back in time 20 years and buy pretty much any assets. Failing that, start accumulating assets today – and be open-minded about using debt, which you’ll be rewarded for if the near future is inflationary.
We can only guess at the consequences of ever more QE, but clearly it’s something you need to understand – and hopefully, now you do.