It involves the following processes. A central bank (such as the Bank of England) creates new money. The bank injects this money into the commercial banking system by buying gilts in the general market. As commercial banks hold these gilts, they can sell them to the Bank of England.
The liquidity problem in the economy improves because the commercial banks use this new-found liquidity to restart lending to deal with the problem of banks failing to lend.
The commercial banks effectively exchange gilts for the newly created cash.There are three intentions for this move. First, it reduces yields on gov-ernment bonds. As a matter of demand and supply, as demand has increased, prices rise and yields fall. Second, it reduces bank overnight interest rates, that is, Libor. Again this is the result of increased money supply. Third, it encourages banks to look for more profitable uses for this money, such as, lend more or buy other riskier assets such as corporate bonds.
The Bank of England says it will adopt this process for up to £150bn, with £75bn within the next three months. Gilt prices have already increased, which is an automatic result.
But QE is an untried method and a number of issues remain unresolved.
- Will the banks lend the cash they have obtained? If not, further pressure may be required.
- Is £150bn enough? If not, will the bank continue these unconventional measures?
- Will it actually work? Japan adopted a process of QE and this failed to create the required stimulus. However, it is not known whether the economic situation in Japan would have been much worse without the adoption of QE. The economic situation in Japan was much more localised than the global recession this time.
What are the inflationary risks of QE? It could be argued these are high but this would be good news for equities which have performed well in inflationary environments. The Bank of England needs to take great care to ensure this policy does not create excessive inflation which would be very bad for long-term economic prospects.
QE is an unconventional approach which the Government has implemented to help solve market illiquidity. There is no guarantee it will be successful. Nevertheless, it is an approach that is generally welcomed by economists. Its success will be measured initially by the reaction of the commercial banks.
In the meantime, IFAs battle with clients’ needs to provide a yield from cash. There are many solutions, including structured products, corporate bonds and equity income funds. IFAs should focus on quality and not shy away from difficult discussions in difficult times.
Peter Heckingbottom is deputy managing director and investment director at Pearson Jones