Q&A: Quantitative easing

QE explained in 108 seconds

UK interest rates are currently at 0.5% - the lowest level in the Bank of England's 315-year history.

The dramatic series of cuts was aimed at easing the credit crunch and getting the banks to lend again.

But that did not happen, at least not to the extent that the Bank thought was necessary to revive consumer spending and economic growth.

So the Bank is expanding the amount of money in the system by £200bn through a process known as "quantitative easing".

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What is quantitative easing?

Usually, central banks try to raise the amount of lending and activity in the economy indirectly, by cutting interest rates.

Lower interest rates encourage people to spend, not save. But when interest rates can go no lower, a central bank's only option is to pump money into the economy directly. That is quantitative easing (QE).

The way the central bank does this is by buying assets - usually financial assets such as government and corporate bonds - using money it has simply created out of thin air.

The institutions selling those assets (either commercial banks or other financial businesses such as insurance companies) will then have "new" money in their accounts, which then boosts the money supply.

QE had never been tried before in the UK.

Is this printing money?

These days the Bank doesn't have to literally print money - it is all done electronically.

However, economists would still argue that QE is the same principle as printing money as it is a deliberate expansion of the central bank's balance sheet and the monetary base.

How does it work?

The Bank has been conducting reverse auctions for government bonds, in which the sellers compete in order to drive down prices. The results are announced every week on Thursdays at 4pm.

The action by the Bank is supposed to have two effects. The first channel is through the direct effect on the banks' bank accounts. With more money sloshing about in their accounts, the banks may decide to lend more to businesses and individuals, and increase the amount of activity in the economy that way.

The second channel is through the effect on the cost of borrowing. When the Bank buys bonds, it reduces the supply of those bonds in the economy. That should increase the demand for new bonds and, at the same time, make it cheaper for businesses to borrow.

Having taken short-term interest rates as low as possible, the idea would be for the Bank to push down longer-term rates as well, which are the rates that companies and individuals borrow at. These are used by companies making longer-term investments and banks setting mortgages, for example.

If QE works, credit growth will pick up and businesses will find it easier to get credit. That, in turn, should help to stimulate the economy.

Has it worked so far?

So far, the Bank says it has spent £175bn on this policy - with another £25bn to be injected by the end of January 2010.

The surprisingly weak third-quarter GDP numbers, which showed the economy contracted by 0.4% between July and September, indicated the economy is still struggling to recover.

DeAnne Julius, a former member of the Monetary Policy Committee, says there's very little evidence that quantitative easing is providing any support for the "real" economy i.e. for industries other than banking.

However, she says there are some signs that it has helped the financial markets by keeping down the interest rate on government bonds.

Are there any risks?

QE is a high-risk strategy. If it is not done aggressively enough, banks will remain unwilling to lend and the crisis could drag on. To some extent that is what happened in Japan when this was tried 10 years ago.

Like old-fashioned money printing, QE also runs the risk of going too far: pumping too much money into the economy and causing high inflation - even hyperinflation - as seen in 1920s Weimar Germany and modern-day Zimbabwe.

Why are the UK's actions different from 1920s Germany and Zimbabwe?

Printing money can be defined as the central bank financing of government debts. This is what happened in both 1920s Germany and Zimbabwe and what the British government will insist it is not doing, although the short-term effect is similar.

According to the Maastricht Treaty, EU member states are not allowed to finance their public deficits by printing money. That is one reason why the Bank of England will buy government bonds from financial institutions, not directly from the government.

The Bank believes this form of QE is different because it is "printing money" as part of monetary policy - to prevent deflation. It is not printing money to help the government finance its deficit.

Also, unlike Zimbabwe, this is a temporary policy: the Bank expects to sell the government bonds back into the market when the economy recovers.