The ABC of QE

It has been dubbed the greatest economic experiment in history, but has QE worked? What will its legacy be?

A is for Aftermath
In the wake of the 2008 financial crisis, quantitative easing (QE) programmes were designed to save the global economy from tipping into a prolonged depression in the wake of the financial crisis.

Since the US Federal Reserve launched its first round of QE that year, more than $6.7tn of bonds repurchases have been either made or are pending in programmes in the UK, Japan and the European Union (EU). To put this into context, this is more than the total GDP last year of Germany and the UK combined.

What the long-term effects of QE will be, though, remains a subject of hot debate. It is worth noting that Japan tried QE at the turn of the century, and its experience did not stop the country repeating the experiment last year. However, it is too early to judge whether the programmes have truly succeeded in the countries where they have been introduced. And no one has yet worked out the implications of unwinding the programme when, or indeed if, it has achieved its objectives.

The amount that some suggested the BoE should give to every household to spend, instead of purchasing bonds
Big questions remain, then, over whether QE has proved a success.

What is widely agreed is that QE is an economic policy of last resort. Interest rates are the conventional tool used by money authorities to manage the economy: raising them when growth is accelerating and inflation is rising, and cutting them when things are not going so well.

The shock to the financial system in 2008 was so severe that policymakers worldwide slashed short-term interest rates to unprecedented levels. In the UK, interest rates have been at 0.5% since 2009; the US rate stands at just 0.25%, although a rise this year is likely; the eurozone charges a negligible 0.05%; while some countries, such as Sweden and Switzerland, actually have negative interest rates.

B is for Banking Because of the precarious state of the global banking industry, these low rates alone have not been enough to get the economy moving again. A toxic combination of over-exuberant lending, lax capital regulation and a fatal misunderstanding of high-risk derivatives plunged many global banks into large losses.

Meanwhile, the tightening of capital regulations means banks now have to hold far more assets against their activities, pushing riskier lending down the list of priorities.
The stark truth is that QE simply has to work: there are no other tools in policymakers’ armoury left to tryQE is aimed at stimulating the economy through a large expansion of the central bank’s balance sheet. This is effected by the purchase of assets – in most cases, government bonds – from financial institutions aimed at forcing down long-term interest rates, encouraging investors into higher risk investments and, crucially, stimulating bank lending by injecting liquidity into their balance sheets.

The UK and US ended their QE programmes after three tranches, but central banks in Japan, the EU and Sweden are all still actively buying bonds and other assets, while China has recently announced its own version. Indeed, across the globe, 20 central banks have cut their interest rates this year, adding further liquidity to markets. But how successful have these initiatives been?

Mario Draghi, President of the European Central Bank, is bullish. “There’s clear evidence that the monetary policy measures we’ve put in place are effective,” he said earlier this year. “We expect the economic recovery to broaden and strengthen gradually.”

Here, the Bank of England (BoE) produced a report on the outcome of its QE policy in July 2012, which concluded: “Without the Bank’s asset purchases, most people in the UK would have been worse off. Economic growth would have been lower. Unemployment would have been higher. Many more companies would have gone out of business. This would have had a significant detrimental impact on savers and pensioners along with every other group in our society.”

Independent commentators partly concur, albeit with qualifications and the caveat that there is still no clear path for unwinding QE.

Andrew Kenningham, Senior Global Economist at Capital Economics, points out that no other really big policy was seriously considered, although the options are limited. The main alternative would have involved giving the money more directly to the financial markets rather than purchasing bonds – some even suggested giving every household £100 to spend – but the difference is mainly one of delivery rather than intent.

He says: “QE was very important as a response to the crisis. If there had been no QEIII [as the third tranches in the UK and US were dubbed], it may have made no difference, but the earlier ones have been more effective.”

C is for Critics Many critics of QE have claimed that the monetary policy has only benefited the wealthy. This criticism stems from the one area where QE does appear to have made a significant impact: asset prices.

Stock markets, particularly in the US, have risen sharply since 2008, and the S&P 500 is now well past its previous peak. Meanwhile, the UK’s FTSE 100 has topped previous highs (although its progress has been volatile), and Japan’s Nikkei has reacted well to QE. These increases sparked by QE have also had a knock-on effect, with the rises creating wealth, improving market sentiment and encouraging businesses to invest.

Bond prices, and particularly government bonds that have been the target of QE, have also risen: the German bund yield, which moves inversely to prices, has actually been negative for brief periods this year. In the UK, house prices have started rising again, while the US market is also showing tentative signs of recovery.

QE critics say that this asset-price inflation means the programme has just benefited speculators and those wealthy enough to own these types of assets. Those who rely on cash savings, by contrast, have suffered a loss of income due to record low interest rates, while those preparing for retirement are faced with punitively low annuity rates, which reflect long-term interest rates.

Lending rates have also fallen, which has largely benefited older borrowers with plenty of assets to use as collateral. The reluctance of banks to lend to riskier borrowers means first-time house buyers, by contrast, have been forced to save far larger deposits to be granted a mortgage.

D is for Drawdown The BoE acknowledges that QE has particularly benefited the top 5% of households, which hold 40% of financial wealth outside pension funds.

But it adds that the adverse impact on savers has primarily been due to the fall in base rates rather than the QE programme, and says that those drawing down pensions have benefited from the increase in the value of the assets in the underlying funds, which has compensated for the decline in annuity rates.

E is for Evidence (or the lack of it) While the BoE has defended its QE programme and hailed it a success, in Kenningham’s analysis of the effectiveness of QE policies when the European Central Bank launched its expanded asset purchase programme earlier this year, he concluded that there was no clear evidence that previous programmes elsewhere had done much to stimulate either bank lending or the money supply.

He also found that, while it did appear to have been good for share prices, “the wider economic benefits from higher equity prices appear to have been small”.

Management consulting firm McKinsey also concludes that the impact has been mixed. In its report, QE and ultra-low interest rates: Distributional effects and risks, the consultancy says governments have benefited from ultra-low interest rates, which "have substantially lowered their borrowing costs, enabling them, in some cases, to finance higher public spending to support economic growth".

McKinsey continues: “Non-financial corporations have also benefited as the cost of debt has fallen, although this has not translated into increased investment, perhaps because the recession has lowered their expectations of future demand.

“Households, in contrast, have fared less well in terms of interest income and expense, although the negative impact on household income may be offset by wealth gains from increased asset prices.”

F is for Fragile Because the global recovery is still fragile and interest rates remain at record lows, it will be years before a definitive judgment on the success of QE can be made.

Judgment will also have be delayed due to the challenge central banks face in getting rid of the bonds they have bought – the size of the holdings means that achieving this could prove a mammoth task.

The US Federal Reserve has already announced its unwinding plans: it will not start selling until 2017 at the earliest, and will reduce its holdings partly by retaining them until they mature. The BoE has been less overt about how it will wind down its holdings, although it has made it clear that the process will be slow and carefully managed.

The stark truth, however, is that QE simply has to work: there are no other tools in policymakers’ armoury left to try. Interest rates are at rock bottom, while QE has left markets awash with liquidity, and asset prices are increasing briskly. The question is whether all these gains will turn into a sustained increase in consumer spending – something which is still tentative, at best, across developed markets.

Investors are, however, very nervous. Bond markets have already suffered a couple of periods of violent swings amid fears of rate rises – so-called ‘taper tantrums’ – and there are fears of further turmoil when interest rates start rising. QE, it seems, still has some major hurdles to clear before the so-called greatest economic experiment in history can be hailed a big success.

The original version of this article was published in the September 2015 print edition of the Review.
Published: 16 Sep 2015
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