QE: Quantitative easing

Background: In the end of 2008, there was a rising realization that the global economy is heading for a recession with a large part from a financial meltdown that was sparked in Wall Street by the Credit Default Swap exposure. CDS is a swap designed to transfer the credit exposure of a fixed income product between parties. CDS is also referred to as a credit derivative contract where the purchaser of the swap makes payments up until the maturity date of a contract. In return, the seller agrees to pay off a third party debt if this party defaults on the loan. ACDS is considered an insurance against non-payment. A buyer of a CDS might be speculating there is a possibility that the third party will indeed default. Due to the loans on the mortgage market going bad and many financial institutions buying up lots of CDSs, CDSs sellers were forced to cough up the money to CDS buyers. CDSs sellers such as AIG were on the verge of collapsing and this would have major consequences and banks who had taken on too much financial risk without enough capital such as Northern Rock and RBS who had taken the step of expanding their risk appetite by engaging in trading of CDS and CDOs, with many other banks holding on to bad loans, there was a risk that the financial market would implode and the USA would be mired in a great depression had it not been the MPC (Monetary Policy Committee) who stepped in to use monetary policy to bail out banks and inject liquidity into the market. CDOs (Collateralized debt obligation) is a type of structured asset-backed security (ABS) originally developed for corporate debt markets. Over time, CDOs developed to encompass mortgage-backed securities like other private label securities backed by assets. CDO can be thought as a promise to pay investors in a prescribed sequence based on cash flows. If some loans default and the cash collected by the CDO is insufficient to pay all of its investors, those in the lowest junior trances get cut down.

As a result, Quantitative Easing (QE) has came in the picture in the economy. This is also cause by the super low interest rate, which is as low as 0.5%. This makes it impossible to further lower aggregate demand through the expansion of the monetary policy. Hence, the central bank has to consider printing out tons of money, injecting it directly to the economy, which will result in the expansion of the balance sheet because this is their only way to boost up the economy and to aid the financial system to recover from the financial crisis. Based on “Economics Today”, in March 2009, Andrew Sentance who was in MPC has initially agreed to inject £75 billions and up to the early 2010, a total amount of £200 billions was injected to the economy, which was known as QE1. The economy was still in a severe recession condition hence a round 2 QE which was known as QE2 has been implied by the MPC. During October 2011 to October 2012, 175 billions was generated which was then injected to the economy, bringing a total amount of £375 billion overall which was added to the Bank’s balance sheet. The bank now uses the money to purchase government bonds, this created a rise in the asset prices as the government bond lowers down the yield. Yield/coupons and bond are negatively correlated, a rise in the bond prices will result a downfall of the yield/coupons and this bring a negative impact to the bondholders and the investors as at the end of the maturity date, they receive a lower rate of return. So most to all of the investors would not hold on to the bonds, what they do is that they will sell the bonds and purchase assets and corporate bonds. During the period of recession, FED (Federal Reserve) will lower down the interest rate which embolden the consumers to purchase more credit products and loan. Households, businesses etc can now borrow more loans from the bank and the cycle continues, this has significantly increase the overall economy. However, banks have to be aware that they do not lend out all the money they have because once recession strikes again, the loans can not be paid back, the bank will then go into bankruptcy. Nevertheless, the low interest rate has brought about benefits to the borrowers. According to “Economics Today”, since September 2008, borrowers have paid £100 billion less in interest. Not only that, most of the financial wealth in the UK has gone to the top 10% richest households. Each gained on average from a paper gain of £129,000.

In a nutshell, QE has brought benefits to the weak economy which encourages consumers to spend, increase in the asset prices and help the economy to meet the 2% target. However, there are still some bad impacts to the savers and in the long run - will QE have negative effect on the economy and how will the Bank approach QE when the recovery comes?