Five extraordinary years

This is the main text for my Fund Strategy cover story on five years of extraordinary monetary policy in Britain. I will post the accompanying boxes over the next couple of days.

It is easy to forget how much Britain’s financial architecture has changed in just five years. Back in early 2009 the term quantitative easing was often written with inverted commas or with the prefix so-called. Only the most hardcore financial nerds would feel comfortable referring to the concept by its initials.

Nowadays not only has QE become a routine moniker but a host of other terms have joined it including forward guidance, funding for lending and macroprudential regulation (see box one). In parallel with this development the system of financial regulation has undergone fundamental reform. The Financial Services Authority is no more but the Financial Conduct Authority, Financial Policy Committee and Prudential Regulation Authority have come into existence. The latter two are under the direct control of the Bank of England.

These new sets of terms and initials reflect the important changes that have come to the regulatory system and economic policy. In relation to monetary policy specifically the authorities have searched desperately for new ways to shore up demand and bolster confidence. Once interest rates hit their historical low of 0.5% in early 2009 new tools were needed. QE is the most important of these but it is only one of a range of unconventional measures designed to keep the economy afloat.

Whether such measures have proved successful is open to debate. The problem, as is often the case, is that there is no counterfactual. There is no parallel universe where QE was not tried. Perhaps the closest is southern Europe where countries such as Greece and Spain have had no control over their currency or interest rates. Those countries have certainly suffered worse economic times than Britain in recent years with sharper falls in output and higher unemployment. However, such comparisons with other countries are inevitably inexact.

This leaves it open for supporters of unconventional policy to argue that without extraordinary monetary measures the economy would have faced disaster. They claim that Britain would have fallen into a 1930s-style deflationary spiral. The result would have been mass unemployment and a far harsher squeeze on living standards.

In contrast, the critics argue that unconventional monetary policy has only postponed the day of economic reckoning. It has kept the economy ticking over but in the meantime government debt levels are still rising, productivity is stagnant and asset prices are artificially high. Such problems, they contend, are better dealt with sooner rather than later. Postponement will only make them worse.

This article will grapple with these questions in three parts. First, it will examine the economic dimension of unconventional monetary policy with the advantage of five years of hindsight. Second, it will consider the impact on financial assets including bonds, equities and property. Finally, it will look at the difficulties presented by exiting from the prolonged period of monetary activism.

Economy effects

One reason it is difficult to judge the success of extraordinary monetary policy is that the rationale for it has changed over time. For example, in March 2009 the chief economist of the Bank of England, Spencer Dale, gave a keynote speech in which he said that: “The objective of the asset purchase programme is to boost nominal spending in order to hit the inflation target”. (“Tough Times, Unconventional Measures”, 27 March 2009) .

From this perspective QE was a temporary measure designed to ensure the economy did not fall into a liquidity trap as a result of falling prices. In such a situation both consumers and companies are reluctant to spend as whatever they buy in the present is likely to be cheaper in the future. This is the situation Japan found itself caught in for many years.

Consumer Prices Index inflation did drop in Britain in the six months following Dale’s speech, bottoming out at 1.1% in September 2009, but after that it started to rise until it hit 5.2% two years later. Yet the Bank continued to make new asset purchases under QE until July 2012. As time went on it became increasingly difficult to rationalise QE in terms of heading off possible falls in consumer prices.

With the benefit of five years of hindsight it is clear that unconventional monetary policy can no longer be described as temporary. Typically unconventional monetary policy is justified today as a way of shoring up demand and bolstering confidence. This can happen through several channels but essentially it works by bolstering the money supply. As a result credit becomes cheaper, borrowing becomes easier and asset prices can rise.

Government is one of the main beneficiaries of this process. James Carrick, an economist at Legal & General Investment Management, says: “It’s been easier to maintain government spending with limited tax receipts because you’ve had a lot of gilt issuance purchased by the Bank of England.”

For supporters of QE unconventional monetary policy has created the basis for the signs of recovery in recent months. The economy is estimated to have grown by 1.9% over the past year, inflation is at its target level and unemployment has fallen sharply in recent months.

Advocates of QE can concede that the economy still has some way to go before there is a balanced recovery. Output is still 1.3% below its peak level in the first quarter of 2008, business investment is weak and productivity is below its peak in 2007. For the optimists it is only a matter of time before such indicators improve. QE has put the economy in a position where they can be tackled.

For critics, who tend to be those who emphasise the importance of the supply side of the economy, the weaknesses are a sign that economic problems have not been resolved. Rather than promote an economic restructuring the authorities have simply kept things afloat on cheap credit. Such measures only postpone a time of reckoning that is bound to come sooner or later.

Those critics who warned that QE could lead to rampant inflation have, at least so far been proved wrong. As Andrew Godwin, a senior economist at Oxford Economics, says: “It is difficult to see any evidence of a massive uptick in inflation.” CPI inflation has at times been significantly above the Bank’s target level but it has not run completely out of control. However, it should also be recognised that asset price rises also constitute a form of inflation.

Where the critics have a clearer point is that unconventional monetary policy seems to have widened inequality. Since the rich typically hold more assets than the poor the wealthy have typically done much better as a result of QE. Many see this trend as particularly painful during a time of austerity.

Up to a point it is possible to square the positions of the two sides. Even the most ardent proponents of unconventional monetary policy have only promoted it as a temporary measure.

As Mervyn King, until recently the governor of the Bank, noted in his valedictory speech at the Mansion House in June 2013: “It can only buy time to bring about the necessary structural changes in investment, trade and capital flows.” (“A Governor looks back – and forward ”, June 19, 2013 . From this perspective the key question is whether the time bought by QE and other such policies has been put to good use.

Andrew Milligan, the head of global strategy at Standard Life Investments, endorses King’s point when he says that: “Both arguments are right. QE has had an impact but all it has done is buy time”.

The majority view among experts is certainly that, on balance, unconventional monetary policy has proved worthwhile. “Any downsides are outweighed by the positives,” says Oxford Economics’ Godwin. “We are in a much better place because of it.”

Financial markets

In a sense it is inevitable that unconventional monetary policy should affect asset prices. QE involves the authorities buying gilts, which in turn raises their price and therefore lowers their yield. Since gilts provide the benchmark against which other assets are priced – since their yields constitute what is generally considered to be a risk free rate – other bonds, equities and property will all be affected to some degree. The difficult question is the extent of the impact.

LGIM’s Carrick points a picture of fixed income investors being pushed towards slightly more risky asset classes. “There are signs that by boosting government bond prices that’s forced investors who normally invest in gilts into the corporate bond markets,” he says. “And that’s forced investors who normally invest in corporate bonds into the junk bond market.”

The effect on equities is more difficult to quantify although they have certainly recovered strongly since the dark days of early 2009. The FTSE 100 has risen from about 3,500 back then to about 6,500. Middle-sized firms have done even better. Part of the impact is no doubt down to the apparent escape from the edge of the precipice and the subsequent economic recovery. However, unconventional monetary policy has also played a role.

Nevertheless most experts see the stockmarket as at least reasonably close to fair value. “I don’t think you could say that QE has created bubbles”, says SLI’s Milligan.

As for property it is clear that monetary policy has played a significant role in its recovery. The average British house price has risen from about £150,000 in early 2009 to about £174,000, according to figures from Nationwide. Lower borrowing costs have certainly helped but, as with equities, there are other factors at play too. For example, emerging market investors have helped push up house prices in central London.

Exit strategy

However the economy and the markets have got where they are there is the thorny issue of how to exit from extraordinary monetary policy. The authorities are certainly anxious about the possibility that a precipitate exit could cause problems. That is why they have experimented with forward guidance in an attempt to make sure markets remain calm.

In a narrow technical sense QE stopped in July 2012. Since then the Bank has not added to its stock of assets although it has not cut them back either. This is in sharp contrast to America where Fed “tapering” essentially means a slowdown in the rate at which QE is expanding.

But the US comparison is not clear-cut. For a start the Bank of England expanded its balance sheet more quickly than the Fed in its early stages. In addition, the FLS has in some respects taken over from QE’s role in shoring up the money supply.

Opinions vary on how difficult the exit will be in Britain. Oxford Economics’ Godwin is relatively sanguine. “As long as there is no uptick in inflationary pressures I think it will be steady as she goes.”

In contrast, Michael Howell, the managing director of Crossborder Capital, sees no easy exit.“They will have to be extremely cautious about deciding to take liquidity down”, he says.

In Howell’s view the Bank has in effect filled in a funding gap in the wholesale markets. Passing the responsibility back to the private sector will be a tricky task. “I think the Bank of England has got to at least keep the current size of its balance sheet, possibly grow it, but almost certainly not shrink it rapidly otherwise you’ll get another financial crisis.”

Despite the heated debates about unconventional monetary policy there are several points on which there is a clear consensus. There is a widespread agreement that the structural problems facing the British economy, such as a poor productivity record and low business investment, remain to be tackled. The disagreements are mainly around how close they are to being resolved.

There is also a consensus that a degree of austerity is likely for several years to come. For example, the Institute for Fiscal Studies, an independent think tank, says that it is highly unlikely that average living standards will recover to their pre-crisis levels by 2015-16.

Finally, whatever the merits or defects of extraordinary monetary policy it looks set to remain part of the financial landscape for at least several years yet.