Beyond rescue

Fund Strategy - 23 Jul 2012 | By Tomas Hirst

The Bank of England’s decision to pump an additional £50bn into its quantitative easing programme demonstrated policymakers’ conviction in the continued effectiveness of extraordinary monetary policy. Yet the central bank may be forced to spend much more to achieve less with each new round.

At its latest meeting on July 5, the monetary policy committee voted to expand the amount the Bank can spend on gilt purchases from £325bn to £375bn. They also voted the leave interest rates unchanged at 0.5 per cent.

To an extent,. the move was predictable. Indeed, many commentators had begun mooting the idea at the start of the year. Economic conditions both within the UK and on the Continent had proven much more difficult than forecast and Bank purchases had been bumping against their upper limit since May.

The particular driving factor behind this latest round, however, appears to have been the sudden drop in consumer price inflation over the past few months. According to figures from the Office for National Statistics CPI inflation fell from an average of 3.5 per cent in March to 2.4 per cent in June.

Although the figure is still 40 basis points above the Bank’s 2 per cent target the MPC said in its statement explaining the decision that, from their forecasts, “it was more likely than not that inflation would undershoot the target in the medium term”.

In order to form an understanding of this latest decision, therefore, we have to move away from focusing purely on short-term concerns and look out further to where the MPC must be seeing the iceberg through the mist.

“The impact of the earlier purchases on activity was something like 1.5-2 per cent of GDP and on inflation something like 1.5 per cent peak impact”

The first point to make is that it is very difficult to gauge the impact of monetary policy actions immediately after they are undertaken. Traditionally, there is very little correlation between central bank moves and short-term economic data, especially inflation figures.

Of course, members of the MPC will be well aware of this fact. Indeed, Mervyn King, the governor of the Bank, has written extensively on the subject. His views were summaries by Gavyn Davies, the chairman of Fulcrum Asset Management and co-founder of Prisma Capital Partners, in his blog for the Financial Times:

“In the past, there has been an extraordinarily strong correlation between the medium term rate of growth in the monetary base and the rate of inflation…Correlations over short periods of a couple of years are not very impressive. However, over longer periods like five to 10 years, the correlations become almost perfect.”

So, to spin this logic another way, the MPC must be concerned about the inflation outlook not only in the near term but over the next five-to-10 years. This alone should sound a warning over the Bank’s estimation of Britain’s economic prospects over the next few years.

What it also demonstrates, however, is that inflation targeting through capital injections is an imprecise science. We may not know for a few more years what the effects of the first £200bn of QE in 2009 are on inflation and economic growth.

As such, if we can surmise anything, it is that while underlying activity remains weak the cost of financial stability is likely to continue to rise. Such a conclusion can be reached both through a look at the transmission mechanisms that allow QE to filter out into the broader economy and the Bank’s own estimates for its effect so far.

Giving evidence before the Treasury select committee in October last year following the announcement of the second round of QE, Charles Bean, the deputy governor of the Bank, outlined the view of the MPC on its likely consequences.

“The impact of the earlier purchases on activity was something like 1.5-2 per cent of GDP and on inflation something like 1.5 per cent peak impact,” he said. “As regards the second phase that we’ve just started, we think it’s reasonable to think it will have largely equivalent effect.”

Embarking on a third round of easing less than a year after giving this statement makes clear that these expectations have not been met. This is despite the fact that inflation remained significantly above target for the entire period.

Clearly, either the Bank’s forecasts were overly optimistic – as an investigation by Fund Strategy suggested at the time – or the economic outlook has deteriorated to such a degree as to counteract the impact of monetary loosening.

At a seminar hosted by Barclays in June Adam Posen, a senior fellow at the Peterson Institute for International Economics who sits on the MPC, admitted that the initial forecasts for the policy had been too ambitious.

Speaking about his voting record, Posen said: “My published votes for no change in the stock of asset purchases at the MPC meetings of April and May this year reflected my expectation that prior QE measures would be sufficient to give the British economy a good chance of returning to sustainable growth consistent with meeting the inflation target.

“I was too optimistic about the forces at work, including the impact of the LTROs [long term refinancing operations] in the euro areas, as well as perhaps about QE’s impact.”

Part of this over-optimism may have resulted from the exhausting of some of the transmission mechanisms identified during the first round of QE in March 2009. The five key transmission channels identified were: policy signalling effects; portfolio balance effects; liquidity premia effects; confidence; and bank lending.

“I was too optimistic about the forces at work, including the impact of the LTROs [long term refinancing operations] in the euro areas, as well as perhaps about QE’s impact”

In its Q3 2011 Quarterly Bulletin, the Bank attempted to disambiguate the total perceived impact of the initial £200bn worth of QE by transmission mechanism. The report concludes that the programme had helped to bring down yields on gilts through policy signalling and portfolio rebalancing effects while the additional liquidity helped to unfreeze interbank lending markets.

Corporate bond yields were also driven down with sterling investment-grade corporate bond yields falling overall by 70 basis points, with spreads relative to gilt yields remaining broadly flat.  Non-investment grade corporate bond yields dropped even more markedly falling by 150 basis points, with spreads over gilts narrowing by 75 basis points.

On bank lending, however, the evidence was inconclusive over whether the injection of capital had managed to lower rates for end consumers even as interbank lending rates came down. Furthermore, while there was an equity rally the Bank concedes that “it is not possible to know how much of those rises were directly attributable to QE in the United Kingdom, as this was part of a more general pickup in international asset prices, reflecting the large fiscal and monetary stimulus across the advanced economies” (Q3 2011 Quarterly Bulletin).

Independent estimates suggest that the first injection of monetary easing added about 1.5 per cent to the UK’s GDP, with inflation rising by about 1 per cent. Some may argue that it represents a fairly meagre return for £200bn. Given that the banking crisis represented an existential threat to the global economy, however, these policy outcomes can and should be seen as a resounding success.

Yet although it is clear that the unprecedented collapse of lending markets between September 2008 and March 2009 required extraordinary action for policymakers, its initial successes do not mean that the policy can continue to provide anything more than a parachute for the economy. That is, it can help to slow the pace of decline but cannot in itself provide the conditions for recovery and growth.

“It is not possible to know how much of those rises were directly attributable to QE in the United Kingdom, as this was part of a more general pickup in international asset prices”

With the benchmark 10-year gilt currently yielding 1.5 per cent the ability of QE to bring down government borrowing costs already looks limited. Moreover as interest rates have remained unchanged since March 2009 and QE has become almost a permanent feature in the marketplace there seems little to gain in terms of policy signalling.

On the other side of the debate, there are still justifiable concerns over the longer-term inflationary consequences of central banks pumping money into the economy. Davies spelt out the problems facing the MPC in a February blog post entitled “Is QE Still Working?”:

“While encouraging, this evidence [of QE’s success] does not prove that future injections of QE will have the same benign effects, either in scale or even in direction. Much of the evidence seems to indicate that the first bout of QE had the most significant impact on bond yields, with subsequent bouts having far less bang for the buck. There are various reasons, including the increasing importance of the liquidity trap, and the waning impact of signalling effects about future central bank policy, that suggest this drop in efficacy may continue to be the case.”

In these conclusions Davies is supported by Azad Zangana, a European economist at Schroders, who says it remains unclear how additional monetary easing will make its way into the broader economy.

“I don’t think that the Bank believes QE will stimulate lending at all. From what we can see lending is still negative. Banks don’t want to lend at these levels and borrowers don’t want to take on additional debt,” he says.

“Even in terms of portfolio rebalancing it is unlikely to have more than a limited impact.”

“The problem is that eurozone problems have become a larger influence on what investors do, countering any positive effects of QE”

One of the key factors behind the success of the first round was that it provided liquidity to otherwise stalled lending markets, thereby freeing up the market to begin operating again. What is holding back the UK economy now is not a lack of available credit, but the unwillingness of private institutions to put their capital reserves to use.

Accountancy firm Deloitte released a report showing that cash reserves held by non-financial companies in the country reached a record £731.4bn in the third quarter of last year. The report found that a third of these companies planned to hold on to their cash piles as a buffer against market uncertainty.

This is already providing a strong headwind to growth and helps explain why QE money is failing to make its way into the broader economy. In essence, while economic fears remain prominent QE may simply be helping to increase corporate capital buffers.

At present these fears are directed predominantly at the eurozone, where politicians have proven unable to agree on measures to reassure debt markets over their commitment to the single currency. This has driven sovereign debt yields to worrying levels in Greece, Italy, Portugal and Spain while driving down yields in supposedly safe haven countries like Germany.

For companies in he UK the situation has compounded concerns surrounding the country’s sluggish economic recovery and restricted access to credit because of bank deleveraging. Under these circumstances it is perhaps unsurprising that they are seizing onto central bank asset purchases as a way to raise cheap capital to protect them from any fallout that might result in the eventuality of a sudden shock.

“The Bank would claim that the last round of QE helped raise GDP and boosted inflation expectations, which it did seem to coincide with,” says Richard Batty, a global investment strategist at Standard Life Investments. “The problem is that eurozone problems have become a larger influence on what investors do, countering any positive effects of QE.”

What we can say with some confidence is that the programme cannot provide a firewall between the UK and the eurozone, its largest trading partner. Nor can it force money off corporate balance sheets and into the wider economy. The former requires more concerted political effort than is currently being offered and the latter seem happy to wait for European politicians to realise this.

Under these circumstance perhaps the best we can hope for is that QE provides a stopgap to allow markets to continue to function even in the shadow of eurozone difficulties. Even this relatively modest policy aim is likely to require a significantly larger injection than the £50bn that has already been announced, however.

As Zangana says: “The biggest impact of QE1 was on confidence, but since then it has become clear that the impact of each subsequent round has been smaller. The Bank is restrained by its mandate so the question is what else can they do?”

Although a logical query given the circumstances, the discussion over what central banks should do to “fix” struggling developed economies reveals a much broader shift in thinking. Before 2007 the dominant theory in economic circles advocated a light-touch approach whereby financial markets could be left to police themselves, while the role of central banks and regulators was to manage the fallout when things went awry.

That politicians and central bankers are now being appealed to is itself a signal of the lack of confidence in the private sector. While sitting on huge piles of cash may be viewed as prudent, it is also necessarily dilutive to shareholder returns and as such represents a misallocation of capital.

The longer firms seek to justify inaction, the more pronounced the impact will be on their stakeholders. With the Coalition government trying to engender an activist approach from shareholders, perhaps this is an area where those losing out could exert some influence on the boardrooms.

Undoubtedly those within the central banks themselves would welcome any help in prodding the corporate sector into action. Though they have taken a front-foot approach to monetary policy in order to avoid a Japan style deflation trap, the aim has always been to step back once markets begin to function normally again.

Two years before conceding his over-optimism on QE, Posen had given another speech at the London School of Economics. With the title “The Realities and Relevance of Japan’s Great Recession: Neither Ran nor Rashomon” he tied the experiences of recessions, both for Japan and the UK, to the works of Japanese filmmaker Akira Kurosawa.

In his conclusion he likens central bankers to the samurai in Kurosawa’s film The Seven Samurai. In the movie, a village of farmers are threatened by bandits who plan to steal their crops after the harvest. The samurai fight off the bandits but suffer terrible casualties in the process.

Once the battle is over the village gets back to farming and things quickly return to normal. The three remaining samurai find they no longer have a place in village society now that the threat has been removed, prompting their leader to claim: “The farmers have won. Not us.”

From this Posen hopefully does not draw the conclusion that many central bankers must be sacrificed for markets to begin functioning efficiently. However, he does note a few parallels:

“Part of responding to a large negative shock successfully in fact requires the policymakers to successful instil confidence and mobilize the general public. But when it is all over, and even when the policy response has fended off the worst, the best a macroeconomic policymaker can hope for is for the citizens to return to the normal cycle of life – and desire the monetary samurai to go away again, unless and until another shock comes. May it only be so that the UK recovers to its normal cycle of growth sufficiently, so that I and my colleagues can sink back from the front line into our well-deserved technocratic obscurity.”

With more than two years having elapsed since he gave this speech, perhaps central bankers are more eager than they appear to return to obscurity. After all you cannot blame the doctor for the ailment.Yet we may reach a point when the treatment provides short-term pain relief even as it exacerbates the underlying condition. On current evidence, that point is creeping ever closer.

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