Has the Bank of England underestimated the dangers of low rates and QE?

by Dr. Ros Altmann

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The Bank of England seems to believe that the impact of its policies on savers, pensioners, pension funds and annuities is not of serious concern. The Bank has finally acknowledged that savers have suffered a substantial (£70billion) loss of income while borrowers are benefiting from much lower interest rates, but it suggests that things would have been far worse without its policies (which is impossible to prove as we do not know what else might have been done instead) and that pensioners have not been badly affected. It could be that the Bank has significantly underestimated the effect of low rates and Quantitative Easing (QE).

The Bank asserts that without QE and 0.5% bank rate, the recession would have been even deeper. Of course, low interest rates should have provided some help to the economy, but low rates do also have negative impacts. It is important to assess whether this policy of ultra-low short and long-term rates was the best way to try to boost spending and lending in the UK, or whether other policies could have been more effective - and with far less damaging side-effects. QE is not - and never was - the only way to attempt to stimulate the economy. The Bank has not evaluated alternative possibilities, but has assumed that buying gilts was the only policy option. In reality, however, low rates and buying gilts can have unintended consequences that may undermine the policy objective of boosting the economy, especially with an impaired banking system and an aging population.

Low interest rates have negative, as well as positive effects on the economy:
Low interest rates can act like a tax increase - they reduce savings income, leaving savers with less money to spend. It is important to assess these potential costs of monetary policy as well as the benefits that may see borrowers able to keep borrowing and spending more. So far, the Bank's estimation of the overall impact has been partial and somewhat misleading, since the supposed benefits rely on assumptions and assertions which cannot be measured, while the costs and side-effects have been underestimated or assumed away. For example, by assuming that buying gilts was the only possible stimulus measure available, the potential benefits of alternative policies other than QE have not been estimated at all. It is impossible to know what would have happened without QE, or whether different policies might have produced a superior outcome for growth.

Persisting with more and more QE, despite lack of recovery, raises important questions:
Even if the first round of QE was the only possible policy option for the Bank as an emergency policy, when unconventional measures were considered worth trying, given the lack of recovery and ongoing inflation overshoot, the continuation of QE is less justifiable. Firstly, given the double dip recession, one must question the effectiveness of the policy itself. Secondly, the Bank originally suggested that subsequent rounds of QE would be less effective than the first round, but its recent paper assumed that the impacts of subsequent rounds of QE will have been of the same magnitude as the initial programme. That seems a questionable assumption. Surely, the effect of any stimulus will reduce as rates keep falling lower and moving further away from fundamentals.

How is QE supposed to stimulate the economy?
The Bank says it is buying gilts from 'non-bank' financial institutions, in order to boost spending and inflation in the economy. The theory is that buying gilts with newly created money will mean sellers of gilts will deposit more money in the banks and that this will mean banks increase lending and people can borrow more easily to get the economy growing again. The Bank says this means the banking sector gains both new reserves at the Bank of England and a corresponding increase in customer deposits, which will increase lending and support economic activity. Therefore, the success of the policy relies on banks to increase the availability of credit. Buying gilts is also designed to boost bond prices, so that long-term interest rates fall, which again is supposed to help borrowers obtain loans at better rates and companies finance themselves more cheaply. Buying gilts may also push up asset prices across the economy, which could increase economic confidence. Finally, even if QE results in investors switching to overseas assets, the Bank assumes sterling will weaken which should also stimulate the economy and increase inflation.

QE is designed to increase inflation:
Of course, the original aim of QE was to fight deflation. QE assumes that inflation will be below the Bank of England's target and that the Bank needs to bring price increases back up to help avoid the kind of deflationary spiral that was so damaging in Japan. In a full-blown deflation, with prices actually falling, people may postpone their spending, thus weakening growth, which is what happened in Japan. Therefore, in 2009 in order to avert this deflation risk, the Bank pumped £200billion of new money into the gilt markets. In the end, of course, there has not been deflation, but inflation has consistently been above target. Despite this, the Bank has persisted in printing a further £175billion to buy more gilts, on the premise that inflation will fall back below target in future. However, the Bank's inflation forecasts have consistently been wrong, and with rising commodity and food prices, there remain significant dangers that its inflation forecasts will continue to prove too optimistic. The impact of overshooting inflation on the economy has not been factored into its forecasts or its assessment of the distributional consequences of monetary policy.

Why is the economy still so weak or in recession despite QE and low rates?
This is an important question and it could well be that the answer lies in the problems of relying on an impaired banking system to boost lending when the banks prefer to boost their balance sheets. The banking system has not behaved as QE would predict. In reality, bank lending has not been increasing and, indeed, the costs of overdrafts, loans and credit cards have been rising, despite ultra-low interest rates. The Bank of England also assumes that increasing asset prices will mean higher spending, but despite rising asset prices, household consumption has actually been falling. As inflation remained high, the squeeze on real incomes has also meant that consumers have retrenched, rather than increased spending. Corporate sector investment has not driven growth either. Companies do have cash, but they are either deciding not to spend it, or in some cases are having to use it to boost their pension contributions due to increasing deficits that have resulted from QE. It is therefore important to consider whether the bank has overlooked or underestimated the negative impacts on growth from the side-effects of QE and low rates, and also whether it has been sufficiently concerned about the impact of inflation remaining above target.

What side effects of QE have there been?
Apart from inflation, the impact of QE and low rates may have damaged economic activity due to the effect on savers, pensioners, annuities, income drawdown and pension funds.

Savers and pensioners:
The squeeze on real incomes of older generations and the negative effects on pension funds and annuities have perhaps been insufficiently recognised. By creating inflation, QE coupled with low rates has lowered older generations' real incomes, which has actually lowered their spending. The most recent GDP figures show that household consumption is falling, which has led to some of the weakness in growth. Part of this is attributable to older generations cutting back in the face of fears of falling current and future incomes. Income drawdown and annuity holders have also seen falls in real income, which have not normally been offset by rising asset values. Again, the Bank fails to fully appreciate this.

Rising asset prices are not actually relevant to most savers - their income falls when rates stay low and inflation overshoots.
In fact, most savers are hurt by low rates, even though the Bank suggests this effect may be offset by rising asset prices or cyclical trends. As most savings are on deposit, rising asset prices are no help, but negative real interest rates mean rising inflation reduces their spending power. The Bank of England says QE has boosted the value of financial assets and that this protects the value of savings and wealth. In fact, this argument is irrelevant to savers. What is far more important to them - and is hardly mentioned by the Bank - is the fact that QE has also increased inflation which, combined with falling savings income and negative real interest rates, has devalued savers' money. The Bank's analysis confirms that the majority of savings are held in shorter term deposits, with only 10% of savers' money being held in accounts with maturity of more than 2 years. It estimates that savers have lost £70billion due to the fall in interest rates since 2008. In fact, rising asset values are of no relevance here and therefore savers have been negatively affected by falling interest rates and high inflation, without any offsetting benefits. In fact, rising asset prices have mainly helped the better off, with the top 5% being the main beneficiaries according to the Bank.

Borrowing rates have hardly fallen and some have risen, despite low official rates
The following Table demonstrates that, despite the expectation that lowering rates will mean consumers can borrow more cheaply, this has not really happened, because banks have taken the opportunity to increase their margins. Lenders are also imposing high fees and charges and tough conditions on borrowers, especially small firms, who are finding it too expensive to borrow.

Effective interest rates %
Source: Bank of England

Date Overdrafts New personal loans Credit cards
(interest bearing only)
Three-month Libor Bank Rate
Oct 2008 9.86 9.01 17.89 6.18 4.50
Mar 2009 8.44 7.87 17.82 1.83 0.50
Apr 2009 8.48 7.07 17.93 1.48 0.50
Oct 2009 8.45 6.63 18.00 0.56 0.50
Oct 2010 8.21 6.71 18.52 0.75 0.50
Oct 2011 10.78 6.84 18.11 1.02 0.50
Jun 2012 9.93 7.08 18.21 0.97 0.50
CHANGE + 0.07 - 1.93 + 0.32 - 5.21 - 4.00

Inflation can damage private consumption, especially in an aging population with pensions under pressure:
Inflation is a danger for savers and pensioners. If savers' capital is eroded, they will have less money to spend and this will weaken economic activity in the short and medium term. If pensioners see the real value of their pensions eroded, they will also have to cut back spending. Anyone living on a fixed annuity (and over 90% of annuities have no inflation protection) will have seen inflation whittling away their purchasing power. Inflation has been silently stealing older people's assets.

Pension funds:
The Bank has now admitted that if pension funds were in deficit (as they almost all were of course) then QE will have worsened those deficits. However, it does not then go on to quantify how much that has reduced potential economic activity. For example, many firms have put billions into their pension schemes, yet the deficits have grown larger. This prevents them from expanding their operations, stops them creating more jobs and has even caused some to go into receivership. More recently, it has become clear that firms with pension schemes are finding it far harder to borrow money, with lending markets now often closed to such companies, as lenders are wary of the deficit financing pressures. By interfering with long-term interest rates that are used for valuing pension liabilities, the Bank's policies have damaged parts of corporate UK. It is simply not the case that pension fund asset values have risen to offset the fall in gilt yields even if theoretical arguments suggest this should be the case. Estimates suggest that a 1 percentage point fall in gilt yields leads to approximately a 20% rise in pension liabilities, but only a 6-10% rise in typical pension fund asset prices.

Huge rise in PPF deficits
The Pension Protection Fund regularly reports on the health of UK pension schemes. It is not correct to conclude that QE has not affected them, nor can its impacts be ignored. The volatility of pension deficits and the risk to corporate UK make the changes in gilt yields particularly damaging to companies already struggling to support their pension promises. Just as an example of the volatility, on 12th July 2011, the PPF deficit for UK pension schemes was £8.3bn. Just six weeks later, the PPF deficit had increased to £117.5bn. Then in July 2012 deficits had ballooned to £300billion. The Bank of England's complacency on this issue is troubling. The way pension funds work, if investment markets rally on the day that their valuations are done, their deficit will be lower than if they do their valuations in a week where asset markets have been weak. Pensions are meant to be long-term funds, but QE has distorted them over the short-term. Forcing pension deficits to rise will have negative effects on growth.

How do rising pension deficits damage corporate UK?
Firms have had to put far more money into their pension schemes, as their pension deficits increase. This has the economic side-effect of lowering tax revenues and will certainly have contributed to the lower than expected tax receipts recently. However, it also means firms cannot spend that money on expanding their businesses or creating jobs. Mergers and acquisitions or corporate restructuring are hampered. Indeed, there is evidence that the performance of companies with pension fund deficits has significantly lagged the stock market. This means that firms with pension schemes are suffering in financial terms as a result of the impact of QE. A recent note from Morgan Stanley estimated that the firms with the biggest pension deficits compared to their market capitalisation have underperformed the stock market by 28% in the past three years. Companies with pension schemes are also finding that banks refuse to lend to them.

QE is locking many defined benefit pension schemes in a vicious spiral
They are becoming locked in a vicious circle in that they need money to support their business so they can earn more money to fund their pension scheme, but they cannot obtain more money because of the scheme itself. In addition, the problems for pension trustees of rising deficits often lead them to look to 'de-risk' or to try to buy out their liabilities to reduce risk. But the more the Bank of England buys gilts, the more expensive - and unaffordable - it becomes for trustees to buy assets to reduce risk. If they compete with the Bank of England to buy more gilts, they drive gilt prices up even more, which increases their deficits even further. For many schemes, this can be a 'death spiral'. The Bank assumes pension funds are or should be invested in assets that 'match' their liabilities so that falling gilt yields will not impact them. This misunderstands how UK pension funds operate in reality. Firstly, there are no matching assets. Index-linked gilts match inflation risks but only partially. Secondly, there are only £270billion in total of index-linked gilts so pension funds could not match their liabilities anyway as they would need far more than £270billion. Thirdly, UK pension funds hold a diversified range of assets which means their assets which means their assets have not kept up with gilts which have seen artificial demand due to Bank of England buying.

Should central banks artificially distort asset markets? Gilts are supposed to be 'risk-free'
One also has to ask why it should be the role of the central bank to try to artificially boost shares or other asset prices. Should the central bank interfere with equity or other asset prices and then claim credit for doing so? Should pricing not be left to the markets? One of the huge risks of QE which has hardly been acknowledged is that gilts are supposed to be the 'risk-free' asset, on which all other asset prices are based. If the Bank of England is artificially distorting gilt prices - as it must be when it is buying nearly half the market - then it is also adding risk to that market and potentially creating an asset bubble in the very market that is supposed to be risk-free. This adds risk to all other assets.

Bank cannot be confident that equity markets will sustain their gains. Equity valuations depend on factors other than just interest rates - volatility suggests QE cannot be relied on to boost assets.
Indeed, pushing up equity prices is a risky exercise itself and markets have remained volatile. Only those who can afford to, or have the knowledge, to time markets are most likely to benefit and the impacts are not evenly spread across the economy. The Bank's own estimates suggest it has been mainly the top 5% of households who are most likely to have benefited from higher equity values and while equities may have been boosted by low gilt yields, the trajectory of stock markets has not been smooth. Timing will be an important factor determining whether particular pension investors do actually benefit from higher asset prices. If they happen to reach retirement in months when stock markets are at depressed levels, they will find the value of their pension fund is low, but the cost of buying their annuity stays high. Most ordinary investors' pension funds are not in gilts, but tend to be in more risky assets which have performed poorly at times, while gilt prices have still been rising. If retirees happen to need to buy their annuity at a low point in the equity market, or if their investment funds do not perform well, they will be worse affected by annuity rate rises. They will have been damaged by QE and will never be able to recover their losses - their annuity is fixed for life and normally without any inflation protection at all.

An Example: What has happened to pension income since July 2008?
For a Defined Contribution personal pension, which was 100% invested in the stock market, the fall in pension income since 2008 is shown in the Table below. The Bank of England claims that these pension investors should have seen their asset values rise to offset the fall in annuity income - this will manifestly not be the case for many people recently or soon to be retired.

FTSE Annuity rates % Change in FTSE vs. July 2008 Change in Annuity Rate vs. July 2008 Fall in income if 100% UK equities
July 08 5625 7.32
Oct 08 4902 7.27 - 12.9% - 0.7% - 13.6%
Jan 09 4434 7.22 - 21.2% - 1.4% - 22.6%
April 09 3926 6.73 - 30.2% - 8.1% - 38.9%
July 09 4340 6.80 - 22.8% - 7.1% - 29.9%
Oct 09 5140 6.80 - 8.6% - 7.1% - 15.7%
Jan 10 5142 6.76 - 8.6% - 7.7% - 16.3%
April 10 5714 6.68 + 1.6% - 8.7% - 7.1%
July 10 4838 6.37 - 14.0% -13.0% - 27.0%
Oct 10 5548 6.27 - 1.4% - 14.3% - 15.7%
Jan 11 5971 6.40 + 6.2% - 12.6% - 6.4%
April 11 5908 6.51 + 5.0% - 11.1% - 6.1%
July 11 5945 6.50 + 5.7% - 11.2% - 5.9%
Oct 11 5218 6.16 - 7.2% - 15.9% - 23.1%
Jan 12 5624 5.80 0 - 20.8% - 20.8%
April 12 5768 5.85 + 2.5% - 20.1% - 17.6%
July 12 5493 5.62 - 2.3% - 23.2% - 25.5%
Aug 12 5635 5.58 0 - 23.8% - 23.8%

Source: Better Retirement Group

Who benefits if house prices rise - banks and borrowers in particular?
The Bank also suggests that its policies have helped keep house prices up, and that this benefits the economy. Again, the benefits of high house prices are not evenly distributed, with those helped most being people aged 30-50, with the largest mortgage debts, and lenders who might otherwise find more borrowers falling into negative equity and defaulting on the loans. In fact, on most measures, housing is far too expensive, especially for younger generations, and perhaps we should be addressing the shortage of housing, rather than keeping prices unaffordably high.

Older generations do not benefit directly from rising house prices unless they sell, as income is more important than house values:
It is normally assumed that high house prices have benefited older generations. Much of the UK's housing wealth belongs to the over 50s who have largely or completely paid off their mortgages. The wealth effect of high house prices, however, is far weaker than the income effects of falling real incomes. Saga surveys show that the over 50s would not feel so badly affected if house prices fell by 20%. If the value of their house falls, they can still maintain their lifestyle as long as their income remains unaffected. But their spending and lifestyle are damaged if they suffer falls in real income. Unfortunately, monetary policy has done just that.

Low rates have increased inflation and reduced older generations' real incomes:
QE and ultra-low interest rates have lowered real incomes for older generations. The Bank hardly mentions the impact of monetary policy on inflation - nor the fact that, despite record low rates and continually pushing them lower, inflation has remained above target. Most older people did not benefit from the fall in interest rates that has boosted borrowers' ability to repay debt. They have very little debt, they were often relying on lifetime savings for their retirement security. However, lower interest rates have meant lower incomes and the higher inflation caused by QE has eroded their purchasing power. This impact has not been offset by rising house values, unless people have actually sold or released equity from their homes.

If QE pushed up asset values aren't we risking a crash when gilt yields rise?
Markets have become 'hooked' on Bank injections of liquidity, but this cannot go on for ever. With inflation well above 2% and a huge budget deficit, gilt yields clearly do not reflect the UK's economic fundamentals. Indeed, if the Bank is right that QE has pushed up equity and house prices, the corollary of this might be that, when the Bank sells the gilts or when yields eventually rise, other financial asset markets will be vulnerable to a crash because their prices are based on the risk-free asset. How will markets cope with a huge rise in gilt yields in coming years? The Office for Budget Responsibility assumes that the correct level for gilt yields is more than double the current yield - it assumes 4.5-5%, rather than 2% or below as now. Forced buying by institutions competing with the Bank of England's buying programme has pushed up gilt prices, but this is not necessarily sustainable. The markets are currently anticipating more Bank of England QE, therefore they are willing to hold gilts at present levels. But if or when the Bank stops, who will want gilts at these yields?

The current stance of policy amounts to financial repression. QE is not working as intended, it is having damaging negative side-effects and alternative policies need to be considered.

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