What is quantitative easing?*

First we have to understand the role of interest rates, the main weapon in central banks’ armouries. The rate set by a central bank is soon followed by other banks, thereby influencing the “price of money” – how much you have to repay on a loan, how much the bank will pay you for your savings and how much the government will pay to borrow money.

Central banks set different rates, depending on the type and length of the loan. In general, the shorter the payback period, the higher the rate. The rate most often referred to as “interest rates” is the so-called base rate or prime rate used to calculate the other interest rates.

Central banks use interest rates for two main reasons. First, rates may be raised to “cool” the economy when there are fears about inflation. The idea is that by making credit more expensive, demand will be restrained and prices will not rise so quickly. Second, when economic growth is too slow, a cut in interest rates makes it cheaper to borrow money to purchase goods or to invest in a business, thereby stimulating growth.

In April 2009, the average interest rate set by the central banks of the Group of Seven nations fell to 0.5% and has been hovering around this level since. What happens when money is so cheap it can’t get any cheaper? In other words, what can governments do when interest rates can no longer be cut because they are so low already?

Quantitative easing is one possibility. The central bank injects money into the economy by buying certain financial products, notably government bonds (also known as gilts). The sellers are expected to use the money to lend to businesses and households or to invest (although they may just leave it in bank deposits or send it offshore). The US Federal Reserve applied quantitative easing during the banking crisis that followed the 1929 Wall Street Crash, and the Bank of Japan adopted a similar approach to dealing with the crisis in the 1990s following the crash of the property market.

The media often present this as “the government printing money”. The reason is that instead of borrowing money in the usual way by issuing new bonds, the government, through the central bank, simply creates the money and uses it to pay the banks and other financial institutions it intends to help.

We’ve become so used to describing the crisis in terms of trillions of dollars that the ECB’s 60 billion euros a month, seem modest by comparison (and it is compared to the $3.7 trillion the Federal reserve spent buying bonds in the US QE programme). But to put that into perspective, in March 2009 when the Bank of England announced it was making available £75 billion to buy gilts and corporate debt as part of its QE strategy, that was one and a half times the total value of all banknotes and coins circulating in the UK at the time.

If quantitative easing succeeds in making government bonds more attractive, the interest paid on these bonds does not have to be as high as it was previously. As I write, that seems to be happening. The Financial Times’ latest headline is “Eurozone bonds on fire after ECB launches QE”, with the paper reporting drops to record lows in the interest rates on 10-year government bonds in Eurozone countries.

That’s good news for governments who have to borrow money and to finance the debt they have already accumulated. But it may not be good news for everybody, pensioners for instance. Pension funds are massive holders of government bonds, so a drop in the interest paid on them (the yield) translates directly into a loss of income to the funds. And since the pensions industry uses bond yields to calculate pension payments such as annuity income, pensioners will be affected. Company pension schemes could be affected too. The yield on government bonds is an important element in calculating the future liability of pension funds, and when yields fall, liability increases.

*from OECD Insights Blog