In these worrying economic times the official authorities (made up of governments and the central banks) have done much to try to stimulate their anaemic economies. We have seen the governments act with several fiscal stimulus packages with a combination of higher official spending and lower taxes. At the same time the central banks have cut short-term interest rates to record lows. In the latest case the European Central Bank cut their main rate to just 2% last week. Sadly despite these measures the world economy looks to be on the verge of a deeply worrying meltdown. As a result the authorities are now considering yet more desperate measures. One of these is called quantitative easing. So what does this mean?
To put it simply the central bank injects extra money into the economy as a means of expanding the money supply. This is normally done through the process of the central bank acting to buy various types of government securities in the international bond market. The intention of this activity is to drive down the rate of longer-term interest rates to match the reductions already made in short-term rates. You should remember that the interest rate on the bond (or yield as it is normally called) goes down as the price increases in response to the extra government-induced demand for these securities. This would also tend to cause other long-term interest rates to fall including some mortgage rates and most importantly the corporate lending rates. In addition the banks will end up with extra cash resources to lend to either individuals or companies as they swap their bonds for cash which they receive from the central banks.
The downside of this policy is the risk that it can be seen to be increasing inflationary pressures especialy when the economic activity eventually picks up again. At the moment this looks like a risk that the authorities will be prepared to take.
If you go to see my latest blog for "Reading and Understanding the Financial Times" I will tell you more about this policy tool.
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2 comments:
How does the government buy these bonds? Do they print money to buy them? If so woundn't it cause the money to lose its credibility?
Also I read about some comments made by US economist Milton Friedman about dropping money from helicopters if the economy is experiencing deflation. What can be the implications of such an absurd measure if it can ever happen?
Hi Mohamed,
Thanks for your interesting comment.
1) The Government can print money to buy these bonds and it might well do so in an extreme case. However, in the first instance it will use its existing cash reserves to buy the bonds. There is a danger of carrying out this policy to extreme lengths. However, a cautious approach woould be justified given the dire state of the economy.
2) The idea of dropping cash out of helicopters is not new. This was almost tried in Japan in the early 1990s. The intention is to give people an unexpected windfall of cash that will encourage them to spend. Simple tax cuts etc can just result in more savings.
Thanks again for your questions
Kevin
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