Monetary Policy & Quantitative Easing Explained

Closely linked to Inflation, the Monetary Policy looks to ensure Inflation is at 2%. The Bank of England has two main tools at its disposal to achieve this; adjusting the cost of borrowing as well as the amount of money in supply.

The Base Rate refers to the Base Rate or Bank Rate, the cost of other Banks borrowing from the Bank of England to lend money within the Economy.

The second tool is known as Quantitative Easing, it is a way of the Government essentially creating more money.

A Monetary Policy Committee will meet every six weeks, consisting of nine members. They will vote on what measures to take or amend in respect to expected growth of the Economy and Inflation.

Looking at the Global Financial Crisis, let’s understand how the Bank of England could use the two main tools of the Bank Rate and Quantitative Easing to try and boost the Economy.

At the onset of the Crisis, the Bank of England lowered the Bank Rate to 0.5% from 5% – and it’s been down to 0.1% over a decade later.

The lowering of the Bank Rate meant that Banks could lend money to you at cheaper rates – the theory is you will borrow money, spend and get the Economy functioning again. Likewise, businesses will be inclined to borrow to commit to new business ventures and spending.

Whilst clearly this will help boost the Economy, it also needs some help.

Why the Bank of England prints more money to get things moving faster

This is where Quantitative Easing can come in. By creating new money, the Bank of England will look to inject it into the economy in effective and far-reaching ways.

Big purchases of Government Bonds is one of those ways. When the Bank of England buys Government Bonds in such a big volume, it pushes down the yield on the Bonds. This is because the increased demand pushes up the price of the Bond, but what’s being returned as income has been reduced in relation to its new and increased price. This is just like the Dividend Yield formula on a share.

Now, the increase in price of Bonds also reduces the rate of interest offered on loans such as Mortgages. There is an inverse relationship between Bond prices and Interest Rates, that is when Bond prices rise, Interest Rates on loans such as Mortgages and Business Loans decrease. This is mainly due to lenders closely matching their interest rates to Government Bond yields (which have now fallen due to the Bank of England’s purchases).

The purchase of Government Bonds by the Bank of England can also increase the price of other financial assets such as shares. For example if the Government buys Bonds for £10m, an large-scale institutional investor such as an Asset Manager now has £10m of cash. It needs somewhere to place the £10m – it makes no sense to save it or buy more Bonds because of the very low yields.

So it may look to buy large amounts of shares which can offer better returns on their capital – the increase in demand will push up the price of shares in this example. Regular, retail investors like you will feel the benefit and thus have greater wealth and providing a nudge to spend more.

This all may seem like rocket-science, but it really isn’t. It is all about relationships – changing something in order to impact something else. For example, reducing interest rates to encourage spending and grow the wider Economy.

<< Learn How to Understand the Economy Essentials

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