The Partial Success and Unintended Consequences of Quantitative Easing

Posted on 21/09/2010


When the Bank of England formally launched its quantitative easing program in March 2009, the minutes from the meeting stated that this policy mechanism would work by:

stimulating the demand for corporate credit instruments [and] improve the supply of funds to the corporate sector. The purchases would also mean that the banking system would be holding a higher level of reserves in aggregate, which might cause it to increase its lending to companies and households.

Assessing the performance of the program on this initial objective of improving the supply of funds to the corporate sector, we can see that as far as large companies are concerned, this policy has been a massive success. Credit default swap (“CDS”) spreads – a proxy for interest rate spreads (over LIBOR) that large companies pay as part of their borrowing costs – have declined substantially since March 2009, as shown in the chart, below.

This has consequently led to a massive increase in issuance in the corporate bond markets, with companies refinancing bank debt, extending maturities, renegotiating terms and securing lower interest rates. Indeed, it has been so successful that some are even likening the current bull market in corporate credit to the “dot-com” equity bubble:

The amount of money flowing into bond funds is poised to exceed the cash that went into stock funds during the Internet bubble, stoking concern fixed-income markets are headed for a fall.

However, although large corporates have benefited hugely from the quantitative easing policy, the same cannot be said for small and medium-sized businesses (“SMEs”). Because SMEs cannot access the securities markets (they are too small for this to be cost-effective) they are only able to borrow from banks, which are still in deleveraging mode due to new post-crisis regulations and the impact of loan losses (see post “” for more on this). Because banks are using excess funds to deleverage, rather than to make new loans, the cost of capital for small businesses remains high, as shown in the chart below.

We can also see from the chart that the only declines in SME interest rates occurred as the Bank of England base rate was reduced from November 2008 to March 2009. There seems to be no impact on SME interest rates from the program of quantitative easing that was announced in March 2009. Consequently, UK SMEs have remained in the mode of paying-down existing loans on a net basis, rather than borrowing to expand and grow, as shown in the chart below.

From this perspective, we can judge quantitative easing to be a partial success, bringing massive benefits to larger businesses, but having little impact on their smaller brethren. However, it is not only upon companies that quantitative easing (and wider monetary policy) has been having an impact. While large businesses have been benefiting from reduced borrowing costs, UK savers have been paying the price via negative real interest rates, as shown in the chart below.

This, after all, is one of the transmission mechanisms by which the monetary policy is intended to work – low interest rates on savings are expected to act as an incentive for people to spend rather than save, thus stimulating aggregate demand in the economy. However, although this works (to some extent) at the macroeconomic level, not all individuals are in a position to reduce their saving. Under the life cycle hypothesis, economists predict that consumers will save during their working years to finance retirement. Clearly, those approaching retirement have little discretion over their saving. This is particularly true of individuals who are at the point of retirement at present. One common way to finance retirement is to use a defined benefit pension fund to purchase an annuity – a financial instrument that pays an income until death. However, with the sharp interest rate cuts since the beginning of the recession, followed by the Bank of England’s quantitative easing strategy, annuity rates have fallen dramatically, from 7.92% in Sept 2008, to 6.65% today. The impact of this can be seen in the table below, which shows the pension fund required to purchase an annuity paying from £7,500-50,000 per annum in income, for a male aged between 55-70.

The table shows that in order to retire at 65 on an income of £25,000pa (not increasing with inflation), an individual will need to have saved approximately £375,000, something we can see from the table below requires savings of £110 per month (assuming an annual real return of 7% – which could well be optimistic.

These recent declines in annuity rates, combined with medium-term weak economic growth (hence interest rates are likely to remain low) mean that individuals in the UK will need to save more, retire later, or accept lower retirement incomes. The above tables make quite bleak reading for UK savers, indicating the sheer enormity of the task ahead of them to secure a reasonable retirement income, a task that the Bank of England’s policies have just made much harder.  It will also impact the government deficit, leading to higher means-tested benefits payments to pensioners.

Posted in: Economy, My Thoughts