Inflation interest rates and QE- everything you need to know

I am currently researching inflation, interest rates, and QE (Quantitative Easing) for an interview later this week, so I thought I would share/track my research here.

QE:
The MPC has been purchasing assets financed by new money the Bank creates electronically. This policy is designed to inject money directly into the economy. This is in response to a sharp fall in demand as business and consumers reduced their spending. In short, there's not enough money in the economy. The aim is to boost spending to keep inflation on track to meet the 2% target. Alongside its decisions on asset purchases, the MPC continues to set 'Bank Rate' (more on this later) each month.

The Bank purchases assets from private sector businesses, including insurance companies, pension funds, high-street banks and non-financial firms. Most of the assets purchased are government bonds. There's a large market available, so the Bank can buy substantial quantities of assets fairly quickly.

The injection of money into the economy works through different channels and has a variety of potential effects. When the Bank buys assets, this increases their price and so reduces their yield- that means the return on those assets falls. This encourages the sellers of assets to use the money they receive from the Bank to switch into other financial assets like company shares and bonds. As purchases of these other assets start to increase, their prices rise, which pushes down on yields generally. Lower yields reduce the cost of borrowing for businesses and households. This in turn leads to higher consumer spending and more investment.

Higher asset prices also make some people better off, which provides an extra boost to spending on goods and services. The Bank of England is also buying smaller amounts of private debt like corporate bonds. These purchases are aimed at improving conditions in capital markets, making it easier for companies to raise money which they can invest in their business.

There is another way the Bank's purchases of assets could put more money into the economy. Those selling assets to the Bank deposit more money into their bank accounts, so commerical banks have more funds which they can use to finance new loans, and more bank lending supports spending and investment. But this channel is likely to be relatively weak as banks continue to repair their finances in the wake of the crisis. That's why the Bank of England is buying most of the assets from firms other than banks. The extra money the Bank of England is injecting into the economy should increase spending to help keep inflation on track to meet the Government's 2% target.

Without that boost, the amount of money in the economy would be too low, spending would be weaker, and inflation might fall below target. But as perceptions of an improvement in the economy begin to spread, this will stimulate business and consumer confidence. That will help to underpin expectations that policy is beginning to work, which should itself encourage more spending and keep inflation in line with the target.

As it sets policy each month, the Monetary Policy Committee will continue to be guided by the outlook for inflation relative to the 2% target. If the Committee thinks inflation looks set to rise above target, it could raise Bank Rate, and sell assets to remove the extra money it has put into the economy.

Source: Bank of England

How Monetary Policy Works: 

When the Bank of England changes the official interest rate it is attempting to influence the overall level of expenditure in the economy. When the amount of money spent grows more quickly than the volume of output produced, inflation is the result. In this way, changes in interest rates are used to control inflation.

The Bank of England sets an interest rate at which it lends to financial institutions. This interest rate then affects the whole range of interest rates set by commercial banks, building societies and other institutions for their own savers and borrowers. It also tends to affect the price of financial assets, such as bonds and shares, and the exchange rate, which affect consumer and business demand in a variety of ways. Lowering or raising interest rates affects spending in the economy.

A reduction in interest rates makes saving less attractive and borrowing more attractive, which stimulates spending. Lower interest rates can affect consumers’ and firms’ cash-flow – a fall in interest rates reduces the income from savings and the interest payments due on loans. Borrowers tend to spend more of any extra money they have than lenders, so the net effect of lower interest rates through this cash-flow channel is to encourage higher spending in aggregate. The opposite occurs when interest rates are increased.

Lower interest rates can boost the prices of assets such as shares and houses. Higher house prices enable existing home owners to extend their mortgages in order to finance higher consumption. Higher share prices raise households’ wealth and can increase their willingness to spend.

Changes in interest rates can also affect the exchange rate. An unexpected rise in the rate of interest in the UK relative to overseas would give investors a higher return on UK assets relative to their foreign-currency equivalents, tending to make sterling assets more attractive. That should raise the value of sterling, reduce the price of imports, and reduce demand for UK goods and services abroad. However, the impact of interest rates on the exchange rate is, unfortunately, seldom that predictable.

Changes in spending feed through into output and, in turn, into employment. That can affect wage costs by changing the relative balance of demand and supply for workers. But it also influences wage bargainers’ expectations of inflation – an important consideration for the eventual settlement. The impact on output and wages feeds through to producers’ costs and prices, and eventually consumer prices.

Some of these influences can work more quickly than others. And the overall effect of monetary policy will be more rapid if it is credible. But, in general, there are time lags before changes in interest rates affect spending and saving decisions, and longer still before they affect consumer prices.

We cannot be precise about the size or timing of all these channels. But the maximum effect on output is estimated to take up to about one year. And the maximum impact of a change in interest rates on consumer price inflation takes up to about two years. So interest rates have to be set based on judgements about what inflation might be – the outlook over the coming few years – not what it is today.

In March 2009, the Monetary Policy Committee (MPC) announced that it would reduce Bank Rate to 0.5%. The Committee also judged that Bank Rate could not practically be reduced below that level, and in order to give a further monetary stimulus to the economy, it decided to undertake a series of asset purchases. (See QE above)

Source:Bank of England

Transmission Mechanism of Monetary Policy:
The Monetary Policy Committee (MPC) sets the short-term interest rate at which the Bank of England deals with the money markets. Decisions about that official interest rate affect economic activity and inflation through several channels, which are known collectively as the ‘transmission
mechanism’ of monetary policy.

First, official interest rate decisions affect market interest rates (such as mortgage rates and bank deposit rates), to varying degrees. At the same time, policy actions and announcements affect expectations about the future course of the economy and the confidence with which these expectations are held, as well as affecting asset prices and the exchange rate.

Second, these changes in turn affect the spending, saving and investment behaviour of individuals and firms in the economy. For example, other things being equal, higher interest rates tend to encourage saving rather than spending, and a higher value of sterling in foreign exchange markets, which makes foreign goods less expensive relative to goods produced at home. So changes in the official interest rate affect the demand for goods and services produced in the United Kingdom.

Third, the level of demand relative to domestic supply capacity—in the labour market and elsewhere—is a key influence on domestic inflationary pressure. For example, if demand for labour exceeds the supply available, there will tend to be upward pressure on wage increases, which some
firms may be able to pass through into higher prices charged to consumers.

Fourth, exchange rate movements have a direct effect, though often delayed, on the domestic prices of imported goods and services, and an indirect effect on the prices of those goods and services that compete with imports or use imported inputs, and hence on the component of overall inflation that is imported.

Source:Bank of England

August 2012 inflation report: 
Global demand growth has slowed, with activity in the euro area being especially weak. In the
United Kingdom, output has been broadly flat over the past two years. Although output is
estimated to have fallen for three consecutive quarters, the scale of that contraction was amplified
by a number of erratic factors and so probably exaggerates the weakness of underlying activity.
Even so, underlying demand growth is likely to remain muted in the near term. But a gentle pickup
in the growth of households’ real incomes, combined with the stimulus from the asset purchase
programme and the Funding for Lending Scheme should spur a modest recovery. The impact of the
euro-area debt crisis, together with the fiscal consolidation and tight credit conditions at home, is
likely to continue to weigh on demand.

CPI inflation fell further, standing at 2.4% in June. The near-term outlook is lower than three
months ago, reflecting falls in energy prices and some broader-based weakness in price pressures.
Under the assumptions that Bank Rate follows a path implied by market interest rates and the size
of the asset purchase programme remains at £375 billion, inflation is a little more likely to be below
than above the 2% target for much of the second half of the forecast period, as the impact of
external price pressures wanes and domestic cost pressures ease. The risks to inflation around the
target are judged to be broadly balanced by the end of the forecast period.

Would definitely recommend reading the Bank of England's report if you wish to learn more- it is very accessible!

Hope this was helpful!