Thursday, 5 March 2009

Interest rates reduced to 0.5% with £75 billion being pumped into the economy

At midday today the Bank of England announced that interest rates were to be lowered from 1% to 0.5%, the 6th reduction in interest rates since October 2008 (see a breakdown of these reductions below). The Bank of England added that it is going to pump £75 billion into the British economy in an attempt to boost bank lending, through a policy called ‘quantitative easing’. Unsure what ‘quantitative easing’ is? Read on to find out.

When interest rates are lowered people are encouraged to spend money not save it. However when interest rates can go no lower, as became the case today, money has to then be pumped directly into the economy to encourage people to lend and spend. Japan undertook this policy in 2001, but economists still question whether this was successful or not. This policy is similar or dissimilar (depending on your views) to ‘money printing’, which occurred in 1920s Weimar Germany and modern-day Zimbabwe, and inevitably led to hyperinflation. This process electronically, not physically, credits the money to banks’ accounts. Still confused? Click here for a BBC video explaining it.

Quantitative easing can be broken down into 7 stages:

  1. The Bank creates new money electronically in its accounts.
  2. The Bank buys bonds (companies’ IOUs) and gilts (Government IOUs) from commercial banks.
  3. The value of the bonds and gilts bought is now credited to banks that sold them.
  4. The commercial banks can make new loans against the increased funding.
  5. Extra lending boosts cash and credit flowing in the economy.
  6. Extra demand for bonds and gilts from the Bank drives down interest rates for business and consumer borrowers.
  7. Flows of extra and cheaper money stimulate growth.
Such a process could help resolve the current economic depression, but this strategy is of very high risk so it has its critics. If it is not done aggressively enough, banks will remain unwilling to lend, causing the crisis to continue. Similarly to money printing, the process also runs the risk of going too far, in that it could pump too much money into the economy thus causing high inflation, making money worthless. The main concern though, is that High Street and commercial banks will not lend on the Bank's extra money and will instead use the money to improve their liquidity, meaning more risk is being taken on by not just the Bank, but also the taxpayer.

Here is a breakdown of the 6 interest rate reductions (shown in a chart here) since October 2008:

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