Research and analysisQuantitative easing91
Nominal interest rates cannot generally be negative. If theywere, there would be an incentive to hold cash, which deliversa zero return, rather than deposit money.
So with Bank Rateclose to zero, a further stimulus could no longer be providedthrough a reduction in the policy rate.
Instead, it requiredwhat King (2009) describes as ‘unconventional measures’.When the MPC sets Bank Rate, it is influencing the price ofmoney. Banks hold central bank money in the form of reservebalances held at the Bank of England and they receive intereston those reserves at Bank Rate. Banks then face the choice ofholding reserves or lending them out in the market, and somarket interest rates are influenced by the level of Bank Rate.This then feeds through to a whole range of interest ratesfaced by households and companies which in turn affects theirspending decisions.Asset purchases are a natural extension of the Bank’sconventional monetary policy operations. In normalcircumstances, the Bank of England provides reservesaccording to the demand from banks at the prevailing level ofBank Rate.
When conducting asset purchases, the Bank isseeking to influence the quantity of money in the economy byinjecting additional reserves.
This does not mean thoughthat the Bank no longer has influence over market interestrates. Market interest rates will continue to be affected bothby the level of Bank Rate and, in addition, by the amount ofreserves that the Bank is injecting as investors react to theadditional money that they hold in their portfolios (asdiscussed further in the section on economic channels below).In practice, there are a number of ways of increasing the supplyof money in the economy, and a wider range of‘unconventional measures’ that a central bank may undertakewhen interest rates are very low (see Yates (2003) for areview). This is evident in the different approaches taken bycentral banks in other countries (see the box on page 92). Theapproaches adopted in different countries will in part reflectthe different structures of those economies and in particularhow companies and households obtain finance. The nextsection looks at how quantitative easing is expected to work inthe United Kingdom.
How do asset purchases work?
Injecting money into the economy
The aim of quantitative easing is to inject money into theeconomy in order to revive nominal spending. The Bank isdoing that by purchasing financial assets from the privatesector. When it pays for those assets with new central bankmoney, in addition to boosting the amount of central bankmoney held by banks, it is also likely to boost the amount ofdeposits held by firms and households. This additional moneythen works through a number of channels, discussed later, toincrease spending.The Bank of England is the sole supplier of central bank moneyin sterling. As well as banknotes, central bank money takes theform of reserve balances held by banks at the Bank of England.These balances are used to make payments between differentbanks. The Bank can create new money electronically byincreasing the balance on a reserve account. So when the Bankpurchases an asset from a bank, for example, it simply creditsthat bank’s reserve account with the additional funds. Thisgenerates an expansion in the supply of central bank money.Commercial banks hold deposits for their customers, whichcan be used by households and companies to buy goods andservices or assets. These deposits form the bulk of what isknown as ‘broad money’.
If the Bank of England purchasesan asset from a non-bank company, it pays for the asset via theseller’s bank. It credits the reserve account of the seller’s bankwith the funds, and the bank credits the account of the sellerwith a deposit. A stylised illustration of this flow of funds isshown in
. This means that while asset purchases frombanks increase the monetary base (or ‘narrow money’),purchases from non-banks increase the monetary base andbroad money at the same time. The expansion of broadmoney is a key part of the transmission mechanism forquantitative easing. It should ultimately lead to an increase inasset prices and spending and therefore bring inflation back totarget.
42024681012141985889194972000030609Percentage change on a year earlier
(a)At current market prices.
(1)Yates (2002) notes that if the storage costs of holding cash were significant, thatcould reduce the return below zero and so in principle interest rates could be slightlynegative.(2)In the minutes of its March meeting, the Committee highlighted its concerns aboutfurther reductions in Bank Rate: there might be adverse effects on bank and buildingsociety profits and hence their future lending capacity; and, a sustained period of verylow interest rates could impair the functioning of money markets, creating difficultiesin the future, when interest rates needed to rise.(3)For more details see
The framework for the Bank of England’s operationsin the sterling money markets
, available atwww.bankofengland.co.uk/markets/money/publications/redbookjan08.pdf.(4)Under both forms of monetary policy, the Bank provides banknotes according todemand.(5)The standard UK measure of broad money is M4. This includes the UK non-bankprivate sector’s holdings of notes and coin, sterling deposits and other sterlingshort-term instruments issued by banks and building societies, but excludes reservebalances held by banks at the Bank of England.