Earlier this month the Bank of England announced a halt to its quantitative easing programme. Other central banks also have complex exit strategies to undertake. But how successful has QE been and did it have the desired effects?
When historians look back on the financial crisis and equity bear market of 2007-09, they will point to the exceptional response: nationalisations, liquidity support, interest rate and tax cuts.
One of the most notable decisions was quantitative easing (QE). Almost one year on from its introduction how successful has it been? Can we see benefits? Will there be problems when this excess liquidity is withdrawn?
Different approaches across the world
The first point to emphasise is different central banks approached QE in different ways.
In the US, the Federal Reserve largely bought mortgage backed securities, and secondarily US government bonds. Its main aim was to lower long term interest rates and thus borrowing costs for hard pressed US households.
In the UK, the Bank of England focused on purchasing government bonds from banks and institutional investors– it now owns over 25% of the market – and to a much lesser extent corporate debt. Japan largely followed a similar route, buying bonds in order to inject liquidity into commercial banks.
Rules and regulations surrounding the ECB forced it to take a different road. As direct purchases of government bonds are not allowed by the Maastricht Treaty, it focused on ‘repo operations’, lending money at cheap rates for up to a year to European banks, in effect providing the firepower for them to purchase higher yielding assets such as government bonds to make a short term profit.
Whatever the route, the sums involved were large: over £200bn of purchases by the Bank of England (15% of GDP), some $12trn by the US Fed (8% of GDP).
Time is the essence
At the outset, it was accepted it would take time to assess the effect of QE. It is an experimental policy. Purchases take time to build up. Investors slowly alter their behaviour.
Even conventional changes to interest rates generally take six to nine months to affect activity.
As credit channels are not working well at present, the impact of QE could be as long or longer.
How effective have the various steps been?
We can measure the success by looking at various channels: whether banks have increased lending to households and businesses, any signs of a wealth effect from higher asset prices, the return of trading liquidity in bond and equity markets allowing companies to raise capital, or changes in inflation expectations.
It might be argued there was little effect on government bond yields. UK and European yields reached a low of about 3% in March and April 2009, before moving moderately higher later in the year. However, what would the outcome have been without QE? UK gilt issuance has been about £200bn this year, when a normally bad year was previously only about £50bn. So far this year alone, eurozone governments have borrowed a record €110bn. QE has mopped up some of this supply, keeping borrowing costs lower than they would otherwise have been.
It can be argued QE has been less successful in one regard. Broad money supply growth has collapsed, close to zero in the US, the UK and Europe. Households have, on balance, repaid debt, while companies have, on balance, preferred to borrow from the corporate bond markets. Banks hold sizeable amounts of excess reserves in their central bank accounts, over £100bn in the UK, over $1trn in the US. Loan officer surveys show companies and households are loath to ask for new loans – no surprise when debt levels are historically high.
Inflation
The effect of QE on inflation is interesting. There was a risk in 2009 deflation could become entrenched. That was removed by QE; indeed a noticeable trend in recent months has been how some investors have been buying inflation proofed debt in order to protect their portfolios from the risks of inflation rearing up in the future. However, that is still only a risk – bond markets indicate inflation expectations are well contained on both sides of the Atlantic.
QE was not aimed directly at the equity or currency markets, although there appear to have been secondary impacts. All other things being equal, the restoration of positive rates of growth and inflation, and thus a return to profits, should be positive for share prices. Indeed, it was noticeable how the Bank of England altered its rationale for QE in recent months, away from boosting money supply towards supporting liquidity in financial markets and influencing investors to take on board more risk.
In spring 2010, investors have a different set of issues to contend with – central banks have decided to withdraw from QE. One argument is their desire to return to conventional policies, a sign of success. A second argument is a recognition, sometimes a fear, amongst central bankers the liquidity wall has inflated asset prices. What happens if they go too far?
The process of withdrawing excess liquidity has begun. The ECB has announced it will no longer do one-year lending, shifting to three and six months instead. US purchases of bonds will halt in March. The Bank of England will not do any further QE purchases – for the time being. The good news for investors is it does not look likely assets owned by central banks will be sold quickly back to the market place – which could have a big impact! Instead, it looks likely bonds will simply be held to maturity.
Careful what you wish for
Investors are understandably relieved QE was instituted but should be wary of that old adage – be careful what you wish for. QE appears to have been successful in broad terms, boosting asset prices, enhancing market liquidity and sustaining consumer confidence, but so far it is difficult to show a strong effect on economic activity. Now central banks have a complex exit strategy to undertake. As QE begins to be withdrawn investors have to consider: does the halting of QE today represent a policy error on behalf of central banks? If so, the consequence for a range of assets could be severe.
Andrew Milligan, head of global strategy, Standard Life Investments
