Since the global financial crisis, both the Bank of England and the US Federal Reserve have used the policy of quantitative easing (QE) to try to revive consumer spending and economic growth.

When the economy is struggling, cutting interest rates is the traditional way to get us to spend more. If rates are low, saving is not such an attractive option ? and we're more likely to spend. But when rates are already very low, as they've been, central banks try to increase spending in the economy in another way, by injecting money directly into the economy. We've seen this practice, known as QE, used in both the UK and US since the financial crisis stepped onto centre stage.

Creating money
When interest rates are already low, QE is a way for the world's central banks to boost the economy and avoid deflation. They 'create' money ? not actually printing it but electronically ? and use it to buy assets from financial businesses. Typically, they buy government bonds. The banks, insurance companies and pension funds selling such bonds can then use the proceeds either to invest in other assets or to lend to consumers and businesses at attractive rates. Money is released, lent and spent. Or that's the theory.

We first saw QE in 2000 in Japan when the central bank used it to ease deflation. The US Federal Reserve (Fed) employed QE in 2008, while the Bank of England's Monetary Policy Committee (MPC) followed in 2009.

 The practice hit the headlines when the Fed announced last year it would begin reducing its QE. The result was that stock markets fell, mortgage rates spiked and mortgage refinancing activity plummeted as investors worried about the extent and timing of the 'tapering'. Tapering is a term that former Fed Chairman Ben Bernanke used in testimony before Congress when stating that the Fed may taper ? or reduce ? the size of the bond-buying programme.

Side effects
One of the side effects of QE is to hike up the price of government bonds, consequently reducing their yields or income. This ripples into other areas.

Firstly, it steers investors into assets with the potential for higher returns, such as stocks, property or bonds issued by companies. We certainly saw rallies in stock markets during 2013. In the US, investors leapt into stocks; the S&P 500 stock market index gained almost 30% in 2013, its best year since 1997[1]. However, anecdotally, US QE also resulted in investors looking overseas for potentially higher returns, for example, in emerging markets, at a time when the Fed was trying to bolster domestic activity.

Secondly, QE has been blamed for the increase in deficits in many pension funds. The cost of paying pensions is calculated by final salary schemes, assuming that all their assets are bonds. If income from bonds drops, it means we need more assets to generate the same level of pension. And if you're buying an annuity (an annual pension) with your accumulated pension pot, a fall in yields means less income.

Market impact
Investors are concerned about how the Fed's withdrawal of QE will ripple through the economy. As we know, what happens in the US has a major impact on other global markets. But while QE tapering will be implemented throughout this year, the Fed first told markets about it last summer, and much of the potential impact on markets is already 'priced into' bond and stock valuations.

The good news is that a reduction in monetary support from the central banks indicates that there are signs of real growth appearing. Financial markets are often worried when the central bank begins to tighten policy. History suggests that investors need not be overly concerned about a turning point in monetary conditions, as long as they become reassured that no policy error is being made. In other words, markets will perform well if they are convinced that the main reason that policy is being tightened is because the economic cycle is lengthening and becoming more robust.

Source:
[1] Daily Finance Investor Centre 31 Dec 2013.