The Bank of England unleashed £75bn of emergency support yesterday after admitting “tensions in the world economy” threatened the UK's recovery.
Its Monetary Policy Committee (MPC) voted to boost the Bank's quantitative easing (QE) programme — effectively printing more cash — from £200bn to £275bn and hold interest rates at 0.5%.
The move, dubbed QE2, is the first change to QE since November 2009 and is the clearest signal yet that the Bank thinks Britain is on the brink of a double-dip recession.
Business leaders welcomed the announcement after figures revealed Britain suffered a deeper recession and is recovering more slowly than first thought.
However, the decision raised fears of a surge in the already high rate of inflation, which would erode savings and pension funds.
Elsewhere, the European Central Bank (ECB) offered new emergency loans to banks to help steady a eurozone financial system shaken by the region's deepening debt crisis.
Alan Clarke, UK economist at Scotia Capital, said: “Once again the BoE has made use of its secret weapon — shock and awe. Pretty much everyone expected QE to restart at some point — but it was only a minority view that it would start this soon, or in excess of £50bn.”
A report by the Bank into the effect of QE on the economy previously found the stimulus measure provided a “significant” benefit to growth and helped GDP increase by around 1.5% and 2%. This was equivalent to dropping interest rates by between 1.5% and 3%.
The MPC said its members made the decision to boost QE over the next four months because the slack in the UK economy will likely be “greater and more persistent than previously expected”.
The Bank said the pace of growth in the UK's main export markets had slowed while the eurozone debt crisis and its impact on financial markets were dragging on Britain's recovery.
The committee also warned the squeeze on household incomes and the Chancellor's austerity measures are likely to continue to restrict spending while ongoing strains on the banks will limit credit supply.
The deterioration in the economic outlook means it is more likely that inflation — which hit 4.5% in August — will undershoot the 2% target in the medium term, the Bank added.
David Kern, chief economist at the British Chambers of Commerce, welcomed the move but said increasing QE was not enough to support businesses.
“In the face of the risks facing Britain's recovery, it is important to make every effort to underpin business confidence and avoid a setback,” he said.
“However, higher QE on its own is not enough, and we urge the MPC to look at other radical methods.”
John Walker, national chairman of the Federation of Small Businesses, said it was vital the cash went to businesses and was not swallowed up by the banks.
He said: “It is important that in an attempt to boost short-term demand that small businesses can directly benefit from this cash injection and that the banks use it to decrease the cost of credit and to increase the availability of lending.”
QE can fuel inflation which could spell more gloom for savers who have seen their pots chipped away by the high cost of living and low interest rates.
In addition, QE increases the cost of gilts — government-backed bonds which fund annuities, the level of pension payments — and by keeping interest rates down, reduces the return on pensions.
Joanne Segars, chief executive at the National Association of Pension Funds (NAPF), warned that increased QE would have “adverse consequences” for pension funds in the short-term.
She said: “Quantitative easing makes it more expensive for employers to provide pensions, and will weaken the funding of schemes as their deficits increase. All this will put additional pressure on employers at a time when they are facing a bleak economic situation.”
Dr Ros Altmann, director general of over-50s lobby group Saga, said further QE was “like launching the Titanic” due to its potential impact on savings.
She said: “The last round of QE was supposed to stimulate UK growth and fight deflation, but instead it boosted prices, bank bonuses and borrowers' balance sheets. It created asset bubbles and inflation, not sustainable growth.”
Elsewhere, fears are increasing over the future of the eurozone as Greece fights to stave off a debt default, Italy's public finances come under pressure and major European banks falter.
The ECB held interest rates but instead offered an unlimited amount of 12-month and 13-month loans to banks. The measures aim to keep the financial system working properly.
What does it all actually mean?
Q: What is quantitative easing?
A: Simply put, quantitative easing, or QE, is an emergency measure used by policymakers to boost economic growth. This is something the Bank of England would usually try to achieve by slashing interest rates, as lower rates encourage people to spend and not save. But when rates cannot go any lower - as is nearly the case in Britain, where they are at a record low of 0.5% - the Bank will pump cash directly into the economy to encourage lending and activity. This is QE.
Specifically, the Bank will do this by buying assets - such as government and corporate bonds - with money that is effectively created out of thin air.
Q: Hasn't the Bank done this before?
A: Yes, the Bank started to inject more money into the economy in March 2009. Before today's decision, the level of QE issued by the Bank stood at £200bn.
Q: So why has the Bank increased QE again?
A: Banks are worried about the strength of their finances and since the onset of the credit crunch have tightened up lending dramatically.
Lending to businesses and individuals is still at low levels, despite attempts by the Government to improve the climate, such as the so-called Project Merlin agreement with the banks.
As rates have been held at 0.5% for more than two-and-a-half years, the Bank is left with few options.
Q: Isn't QE just printing money?
A: In effect it is, although the Bank does not literally turn on the printing presses to send a huge flurry of new notes into the economy.
What will happen is that the Bank will create the money to buy the assets and credit the reserves of various banks and financial institutions with the new money.
Politicians and the Bank will be keen to distinguish QE from central bank funding of Government deficits - also known as "monetising the debt" - which is more akin to the idea of printing money in the popular imagination.
This is outlawed under the Maastricht Treaty.
Q: What else can QE do?
A: As well as creating more money, the Bank's actions should create more liquidity in commercial paper, helping to get capital markets moving more easily again.
Q: How much money has the Bank said it will create?
A: The Bank said it will inject a further £75bn into the economy, bringing the total level of QE to £275bn.
Q: So now banks should go out and lend more money?
A: This is the 64,000-dollar question. In principle, QE should boost the money supply, but fears of debt contagion from Europe and major changes to regulation in the UK still mean banks are being cautious.
Q: Will it work?
A: A report from the Bank - its first to measure the effect of QE on the economy - found the stimulus measure provided a "significant" benefit to growth and helped GDP increase by around 1.5%.
The experts' verdict: business must benefit
Dr Esmond Birnie, PwC's chief economist in Northern Ireland
"The MPC's decision to expand its QE programme by pumping a further £75bn into the economy over the next four months is unsurprising, given recent economic developments.
"Quantifying the exact impact of QE is difficult; nevertheless business will welcome this announcement in the hope it will encourage business confidence, investment and exports.
"It now remains to be seen what the Government plans for its 'credit easing' proposals for small and medium-sized businesses."
David Gibson, director of Coleraine-based Gibson Financial Planning
"That GDP in the second quarter has now been downgraded and more money is being printed, is further proof of the weakness of the economy.
"While the protracted low interest rate environment we're in is good news for borrowers and homeowners, it is bad news for pensioners and savers.
"For investors, there are still opportunities in the current environment, but a well-diversified portfolio has never been more important."
Wilfred Mitchell, Policy Chair, Federation of Small Businesses
"With growth revised downwards, pumping money into the economy through quantitative easing is welcomed.
"However, it is important that in an attempt to boost short-term demand that small businesses benefit from this cash injection and banks use it to decrease the cost of credit."