Quantitative easing – demystifying QE

Investing

Gareth Trainor

29th April 2014 at 4:11pm

It feels we’ve been listening to news for a while now on how central banks are intervening to support the economy – but is that intervention working?

When the economy is struggling, cutting interest rates is the traditional way to get us to spend more. If rates are low, saving is not such an attractive option – and we’re more likely to spend. But when rates are already very low, as they’ve been for a while now, central banks try to increase spending in the economy in another way: by injecting money directly into the economy. We’ve seen this practice, known as quantitative easing (QE), used in the UK and US since the financial crisis stepped onto centre stage in 2007.

So What’s QE? 

When interest rates are already low, QE is a way for the world’s central banks to boost the economy and avoid deflation. They ‘create’ money — not actually printing it but electronically — and use it to buy assets from financial businesses. Typically they buy government bonds. The banks, insurance companies and pension funds selling such bonds can then use the proceeds either to invest in other assets or to lend to consumers and businesses at attractive rates. Money is released, lent and spent. Or that’s the theory.

When interest rates are already low, QE is a way for the worlds’ central banks to boost the economy and avoid deflation. They ‘create’ money. We first saw QE in 2000 in Japan when the central bank used it to ease deflation. The US Federal Reserve (Fed) employed QE in 2008 while the Bank of England’s Monetary Policy Committee (MPC) followed in 2009.  In summer last year the practice hit the headlines when the Fed announced it would begin reducing its QE; stock markets fell, mortgage rates spiked and mortgage refinancing activity plummeted as investors worried about the extent and timing of the “tapering”. Tapering is a term that Fed Chairman Ben Bernanke used in testimony before Congress when stating that the Fed may taper – or reduce – the size of the bond-buying program.

Does it work?

The MPC made £200 billion worth of QE purchases between March 2009 and January 2010. Bank of England economists estimate this may have increased UK real Gross Domestic Product (GDP) by as much as 2% and Consumer Price Index (CPI) inflation by 1%. GDP is one of the primary indicators used to gauge the health of a country’s economy. It represents the total monetary value of all goods and services produced over a specific time period – you can think of it as the size of the economy.

However, they noted these estimates were subject to much uncertainty!1 In the US, the Fed’s QE led to low interest rates in areas like car loans and mortgages, important ones to consumers. The Fed itself said its large scale asset purchases may have raised the level of economic output by almost 3% and boosted private payroll employment by more than 2 million jobs2. The reality is that we can never know what state the UK or US economy would have been in following the financial crisis without the QE measures.

On the flip side critics say lending to businesses and individuals remains sluggish. There’s no guarantee the proceeds of any asset sales are used to invest or lend, and indeed many banks have simply used QE to help strengthen their balance sheets.  The reality is that we can never know what state the UK or US economy would have been in following the financial crisis without the QE measures. QE impact is difficult to measure, it’s not immediate or direct and at the same time the economy is influenced by other drivers.

Are there consequences?

One of the side effects of QE is to hike up the price of government bonds, consequently reducing their yields, or income. This ripples into other areas.

Firstly it steers investors into assets with the potential for higher returns, like stocks, real estate or bonds issued by companies. We certainly saw rallies in stock markets during 2013. In the US investors leapt into stocks; the S&P 500 stock market index gained almost 30% in 2013, its best year since 19973. However, anecdotally, US QE also resulted in investors looking overseas for potentially higher returns, for example in emerging markets, at a time the Fed was trying to bolster domestic activity.

Secondly, QE has been blamed for the increase in deficits in many pension funds. The cost of paying pensions is calculated by final salary schemes assuming that all their assets are bonds. If income from bonds drops it means we need more assets to generate the same level of pension. And if you’re buying an annuity (an annual pension) with your accumulated pension pot, a fall in yields means less income.

All eyes on US QE this year

Investors are concerned about how the Fed’s withdrawal of QE will ripple through the economy. As we know, what happens in the US has a major impact on other global markets. But while QE tapering will be implemented this year, the Fed first told markets about it last summer and much of the potential impact on markets is already ‘priced into’ bond and stock valuations.

In many ways the news is good; a reduction in monetary support from the central banks tells us that signs of real growth are appearing. Andrew Milligan, Head of Global Strategy at Standard Life Investments, tells us:  “Financial markets are often worried when the central bank begins to tighten policy. History suggests that investors need not be overly concerned about a turning point in monetary conditions as long as they become reassured that no policy error is being made. In other words, markets will perform well if they are convinced that the main reason that policy is being tightened is because the economic cycle is lengthening and becoming more robust.”

If you’re keen to keep an eye on how the Fed manage the tapering and what it means for markets, check out the updates and views from the Global Strategy team at Standard Life Investments.

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The information in this blog or any response to comments should not be regarded as financial advice. Please speak to an expert to get guidance on your own situation.

1Source: The Bank of England Quarterly Bulletin 2011 Q3

2Source: BBVA Research, Economic Analysis 31 Aug 2012

3Source: Daily Finance Investor Centre 31 Dec 2013