The bank of england

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Research Proposal

1. Proposed Working Title

A critical review of quantitative easing and its impact on uk's economy

2. Research Background / Context

This research proposal proposes the impact on uk economy when the central bank do quantitative easing. On 19 January 2009, the Chancellor announced that the Government had authorised the Bank of England to create a new fund, the Asset Purchase Facility. In a letter to the Governor of the Bank on 29 January 2009, the Chancellor said: As announced on 19 January, this facility provides a framework for the Monetary Policy Committee of the Bank of England to use asset purchases for monetary policy purposes should the Monetary Policy Committee conclude that this would be useful for meeting the inflation target.

In the event of the MPC believing this would be necessary, the Governor would write to the Chancellor setting out the MPC's reasons. The Chancellor would reply to the Bank and advise Parliament that such consent had been given.

The Chancellor informed Parliament that the Asset Purchase Facility would be used for monetary policy purposes in a written statement on 5 March 2009.3 The written statement said that the Governor had written to the Chancellor on 17 February requesting authorisation to use this facility ( bankofengland.co.uk )

What is quantitative easing?

Quantitative easing is the modern way to print money. The central bank doesn't actually have to use a four-colour press to spew out crisp notes. There are more sophisticated ways to boost a nation's money supply. But ultimately the impact is not very different from dropping dollar bills from a helicopter as Ben Bernanke once described this policy before he became the Federal Reserve's chairman.

On 5 March 2009, the Bank of England announced that it would begin a policy of quantitative easing. The MPC will vote each month on the asset purchases it believes are necessary to meet the inflation target.6 The Bank will purchase £75 billion of assets, financed by the issuance of central bank reserves.7 In April 2009, the Bank reported on the assets purchased up to 26 March. Gilts (government bonds) made up over 90% of the purchases with commercial paper and corporate bonds accounting for the remainder.

In May 2009, the MPC voted unanimously to increase the level of asset purchases by £50 billion to £125 billion.9 The minutes of the MPC's May 2009 meeting noted that “there was a persistent degree of slack forecast for the economy” and that without further monetary stimulus there was a risk that inflation could significantly undershoot the inflation target.

In August 2009, the MPC voted to increase the level of asset purchases to £175 billion. This required authorisation from the Treasury which had previously set a limit on purchases of £150 billion. ( telegraph.co.uk )

3. Organisation Background

The Bank of England is the central bank of the UK, and is the centre of the UK's financial system. The Bank is responsible for promoting and maintaining a stable and efficient monetary and financial framework, as well as providing a number of other unique services such as printing bank notes in England and Wales. 'The Bank's roles and functions have evolved and changed over its three-hundred year history. Since its foundation, it has been the Government's banker and, since the late 18th century, it has been banker to the banking system more generally - the bankers' bank. As well as providing banking services to its customers, the Bank of England manages the UK's foreign exchange and gold reserves and the Government's stock register.'

In March 2009, the Monetary Policy Committee announced that, in addition to setting Bank Rate at 0.5%, it would start to inject money directly into the economy in order to meet the inflation target. The instrument of monetary policy shifted towards the quantity of money provided rather than its price (Bank Rate). But the objective of policy is unchanged - to meet the inflation target of 2 per cent on the CPI measure of consumer prices. Influencing the quantity of money directly is essentially a different means of reaching the same end.

Interest rates in the UK economy are set by the Monetary Policy Committee (MPC) of the Bank of England. This has been the situation since 1997 when the government gave operational independence to the Bank of England. The MPC are set an inflation target (currently 2%) and they have to maintain inflation within 1% either side of this target. If inflation goes outside this range then the Governor of the Bank of England has to write an open letter to the Chancellor of the Exchequer explaining why they have missed the target and what they will be doing to bring inflation back within the range.

To work out what to do with interest rates, the Committee will look very carefully at a wide range of factors that can contribute to the pressure on prices to rise in the economy over the next two to three years (inflationary pressures). Each of these contributes in differing degrees to the level of demand in the economy, as excess demand will tend to increase prices. If the level of aggregate demand (AD) in the economy is growing strongly this could lead to a rise in the general price level. This is known as demand-pull inflation. If the MPC feel that the level of demand is likely to be too high in the coming months, then they will put interest rates up to try to reduce the growth of demand. This should help stop inflation rising. However, if they feel demand growth is likely to be too slow they will cut interest rates to try to boost the economy.

Cutting interest rates is termed a reflationary policy, whereas a rise in interest rates is called a deflationary policy.

The MPC has nine members. Five of them are from within the Bank of England and include the Governor and two Deputy Governors; the other four are called external members and are appointed by the Chancellor. At each monthly meeting the members vote on what they believe should happen to interest rates. If the vote is equal, then the Governor of the Bank of England has the casting vote. The minutes of all the meetings are published shortly after the meetings.

4. Rationale for the Chosen Topic

In this research it is decided to research on the proposed topic due to my past working experience in finance industry based in India. So this topic helps me to understand the basics of in and out of central bank and quantitative easing which affects the inflation and interest rates.

5. Research Questions

Essentially, this research proposed the examination of one basic question: how does the quantitative easing affect the uk economy? How does the interest rates set and impact the uk economy? Is quantitative easing risky? How do asset purchase work? How does quantitative easing affect inflation?

6. Research Objectives

As a summary of the above, the research objectives are enlisted below:

  1. To critically evaluate the impact on uk economy by doing quantitative easing.
  2. To explore the currency , that what will happen to the british pound.
  3. To examine what causes inflation and how does interest rates set.

7. Literature Review

Quantitative easing is a method of boosting the money supply. Its aim is to get money flowing around an economy when the normal process of cutting interest rates isn't working - most obviously when interest rates are so low that it's impossible to cut them further.

In such a situation, it may still be possible to increase the “quantity” of money. The way to do this is for the central bank to buy assets in exchange for money. In theory, any assets can be bought from anybody. In practice, the focus of quantitative easing is on buying securities (like government debt, mortgage-backed securities or even equities) from banks.

Where, one might ask, does the central bank get the money to buy all these securities? The answer is that it just waves a magic wand and creates it. It doesn't even need to turn on the printing presses. It simply increases the size of banks' accounts at the central bank. These accounts held by ordinary banks at the central bank go by the name of “reserves”. All banks have to hold some reserves at the central bank. But when there is quantitative easing, they build up “excess reserves”.

If banks swap their securities for reserves, the size of their own balance sheets shrinks just as the central bank's balance sheet expands. Assuming they want to keep their own balance sheets static - admittedly a big assumption in the current climate - they will then start lending to end-borrowers and so start putting more liquidity into the economy.

To some extent, central banks have been engaging in quantitative easing for the past year. The Fed, for example, has had a range of programmes and ad hoc initiatives that have resulted in it acquiring securities from the banking system and more recently from the US government. The Fed may not have justified these under the rubric of quantitative easing. But its balance sheet has certainly mushroomed: it is up 18-fold in the past 4 months to $820bn.

Does it work?

Such quantitative easing certainly hasn't yet done the trick so far in this recession. Credit conditions have continued to tighten in the US. Things, of course, could have been even worse if there hadn't been any easing. Equally, although an 18-fold increase in the reserves on the Fed's balance sheet sounds impressive, it is still below 6pc of GDP. It may therefore only be once quantitative easing properly gets going that the benefits will flow through.

Similarly, history isn't much use in judging the therapy's effectiveness. There has been only one significant trial - in Japan between 2001 and 2006. Excess reserves held by banks at the Bank of Japan rose from Y5 trillion to Y35 trillion, roughly 6pc of GDP.

Scholars cannot agree whether the technique worked. On the positive side, Japanese GDP didn't shrink. On the negative side, GDP growth was moderate and not sustained after quantitative easing ended. Also, the experiment coincided with a big programme of government spending, so no one can tell whether it was the unusual monetary policy or the intense fiscal policy that kept the wolf from the door.

Almost no one would argue that Japanese quantitative easing was an unqualified success. But some economists think the Japanese were too slow and too half-hearted in applying the therapy. What's more, the Japanese record isn't necessarily all that meaningful for the US and the UK. Quantitative easing may work better - or worse - in a country like Japan with a cultural preference for savings and a huge trade surplus than in lands where borrow-and-spend have been the rule for years.

Unintended side-effects

Even if quantitative easing isn't necessarily effective, it would certainly be worth a try if it carried no danger. But its safety is far from certain. It could theoretically lead to the debauchment of a nation's currency and inflation.

Again history doesn't provide much of a guide. Japan hasn't suffered any bad side-effects - inflation is low and the yen is strong. However, in some more extreme examples of old-fashioned money printing, the results were disastrous. Witness the assignats of the French Revolution, Confederate dollars in the Civil War, Reichsmarks in Germany after World War I, Russian roubles after the fall of communism and the current hyper-inflation in Zimbabwe.

The US and UK are, of course, in a far healthier state than revolutionary France or the Weimar Republic. So there isn't a danger of such alarming consequences. But central banks might lack the will to engage in “quantitative tightening” when the economy starts to pick up.

In theory, reversing the policy should be quite easy. The central bank could just sell the excess assets on its balance sheet, sucking money out of the system. In practice, the political pressure to keep the party going might be too hard to resist.

This is particularly so because, in order to engage in quantitative easing in the first place, some central banks may well need the permission of their governments. The more they work in cahoots with politicians, the more their independence will come under threat. Already, Alastair Darling, the UK Chancellor of the Exchequer, has made it clear that the government - not the Bank of England - will play an active role if quantitative easing proves necessary.

It is therefore essential that both central banks and finance ministers commit themselves to reverse quantitative easing when the good times return - before they go wild and open the spigots. Quantitative easing is risky. It needs to be practised safely.

What Will Happen to the British Pound ?

Quantitative easing sends a message to the foreign exchange markets that a flood of British Pounds is about to be unleashed onto the market that is outside the normal expected mechanisms of government debt issuance, this in effect insures that the value of all notes in circulation will be devalued and hence investors and speculators act ahead of the curve by continuing to liquidate out of sterling whilst at the same time increasing short positions against sterling i.e. betting on a continuation devaluation in favor of the worlds reserve currency the U.S. Dollar the trend for which is for continuing strength as per theUS Dollar Bull Market Forecast for 2009.

UK Economy Worst Since the Great Depression

Theanalysis of 18th Feb 08forecast that the UK economy, is heading for its worst recession since the great depression as illustrated by the below graph in that the severe recession is expected to bottom at an annualised rate of -4.75% GDP in the fourth quarter of 2009 (small quarterly gain on the 3rd quarter), which will be followed by a recovery as the rate of annualised GDP contraction improves as government stimulus and Quantitative easing measures as well as near zero interests start to impact on the economy. The UK economic recovery is expected to continue into the fourth quarter of 2010 i.e. after the general election. The total recession from peak to trough is expected to see GDP contract by 6.3% and therefore this will be the worst recession since the 1930's Great Depression.

8. Methodology

The nature of this proposed research is exploratory, rather than explanatory, as As such, the research will adopt a grounded theory approach developed by Glaser and Strauss (1967). According to them, grounded theory is the discovery of theory from data and that is systematically obtained from research. The theory developed is derived from data and then illustrated by the characteristics examples of the data. In other word, the theory is inductively derived from the study of the phenomenon it represents (Strauss and Corbin, 1997).

The research proposes Quantitative easing is the process of the Bank of England creating money in order to buy investments. The process does not involve the printing of additional bank notes, but the purchase of assets, such as gilts, from sellers who will be credited electronically with new money.

A combination of data collection method of in-depth interview, semi-structured interview and participant observation will be used in the proposed research. An in-depth interview or unstructured interview is an informal type of interview aimed to explore in depth a general area such as trade promotion activities. The interview will be conducted without any predetermined list of questions, although a clear ideal area to explore need to be established prior to the interview. In such data collection method, interviewee is given the opportunity to talk freely about trade promotions, the behaviour and belief with regards to the topic area (Saunders, Lewis and Thornhill, 2003). This phenomenon is sometime known as the informant interview as it is the interviewee perception that guides the conduct of the interviewer (Robson, 2002).

Participant observation is where “the researcher attempts to participate fully in the lives and activities of subjects and thus becomes a member of their group, organisation or community. This enables the researcher to share their experience by not merely observing what is happening but also feeling it” (Gill and Johnson, 1997). Even though participant observation has been used much less in management and business, it can indeed be a very valuable tool especially when the research is adopting triangulation approach (Saunders, Lewis and Thornhill, 2003).

9. Data Collection Methods

The sources of data are the Yahoo Finance, New Issue Statistics, Primary market fact sheet, London stock exchange website, the journal of economics and finance from London school of Economics Library and Brtish Library. The research proposes the commencement of in-dept interview with the employee of central bank to obtain an in-depth exploration of the quantitative easing activities in a broader context. The interview(s) will be conducted by telephone in which the whole conversation will be tape-recorded. Given the disadvantages of conducting interview through telephone, the lack of personal contact and trust establishment will be compensated by the speed of data collection and lower costs associated with long-distance access.The interview(s) is estimated to last between half an hour to an hour, a schedule of questions will be prepared in advance to ensure the clear idea of areas to be covered in the conversations. However, the interview will not adhere to the schedule of questions strictly considering the nature of informant interview discussed earlier.

10. Data Analysis

This research proposes to use a combination of qualitative and quantitative data analysis approach. Data obtained through in-depth interviews and participant observation will be analysed. And data will be analysed and quantified to make the decision that the quantitative easing causes inflation , or does it risky ? using the bank of England data set and protocols which help us to critically evaluate and how does it going to affect the UK economy. With the help of some econometrics models. (Saunders, Lewis and Thornhill, 2003).

11. Resource Requirement

The review of literature will be obtained largely from the library facilities (for published copies) and Learning support Services (for electronic copies).

The commencement of the fieldwork will assume the extensive usage of telephone and Internet facilities. Subsequent interviews on non / new users of trade promotion activities as a result of participating the workshop will also be conducted by telephone or Internet depending on the interviewees' preference.

12. Timescale

Research Gantt Chart (Week commencing 20th October 2009)

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Conclusion:

The governments initial print run is for £150 billion in two halves is expected to be followed again by another two runs of £150 billion each as the May 2010 election is still more than 12 months away, which is the primary focus for the Brown Government. This will eventually lead to much higher inflation and interest rates than most expect at this time. Therefore investors and savers need to start to look at gearing themselves towards this development i.e.

  1. Falling UK government bond prices as the amount of debt the government issues continues to mushroom.
  2. Continuing sterling bear market which targets parity to the U.S. Dollar as a consequence of Quantitative easing and government debt.
  3. Rising commodity prices as the crackpot policy of Quantitative easing is copied around the world which devalues ALL currencies.

Bibliography

  • Ackroyd, S. and Hughes, J. (1992) Data Collection in Context. 2nd Edition. London.
  • Longman. In: Saunders, M., Lewis, P. and Thornhill, A. (2003) Research Methods for Business Students. 3rd Edition. Harlow. Financial Times. Prentice Hall.
  • Bogdan T. (1984) Introduction to Qualitative Research Methods: the search of meanings. 2nd Edition. USA. Wiley-Interscience Publication.
  • Bouchard, T. (1976) “Unobtrusive measures: an inventory of uses”. Sociological Methods and Research. Vol. 4. Pp. 267-300. In: Maanen, J. (1983) Qualitative Methodology. USA. Sage Publications.
  • Bowen, K. (1996) an Argument of Integration of Qualitative and Quantitative Research Methods to Strengthen Internal Validity. [online] 1 April 1996. [cited 27 April 2003] Available from Internet: http://trochim.cornell.edu/gallery/bowen/hss691.htm
  • Brealey, Richard A., Myers, Stewart C. & Marcus, Alan J. (2001). Corporate Finance. McGraw-Hill.
  • Burgess, R. (1988) Studies In Qualitative Methodology. A Research Annual. London. Jai Press.
  • Brigham, Joel & Houston, Eugene Brigham (2001). Fundamentals of Financial Management. Harcourt College Publishers.
  • Helfert, Erich A. (2001). Financial Analysis Tools And Techniques: A Guide For Managers. McGraw-Hill.
  • Mathur, Iqbal (2002). Introduction to financial management. Collier Macmillan.
  • Keown, Arthur J. (2004). Financial Management: Principles & Applications. Collier Macmillan.
  • Jorion, P. (2000). Value at Risk: The Benchmark for Controlling Market Risk. 2nd ed. McGraw Hill.
  • Sagner, James and Allman-Ward, Michele (2003). Essentials of Managing Corporate Cash. Collier Macmillan.

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