Quantitative healing

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One year on from the collapse of Lehman Brothers and the darkest hours of the financial crisis, the prospect of a return to economic growth has helped equities markets recover from their March lows.

The special measures taken by central banks at the height of the crisis look to have played a vital role in stabilising world financial markets.

But have historically low interest rates and quantitative easing (QE), the creation of new money to purchase existing assets in an attempt to stimulate credit flow across the economy, really worked?

As fears about the prospect of inflation lift gold prices and start to replace worries about systemic crisis, what is the verdict on the QE policies? Have the large sums involved spread properly through the system, or does a lingering lack of available credit for small business and personal borrowers indicate a failure of the policy?

Which nation will be the first to unwind their special measures, and how soon will others follow? Should central banks be preparing to normalise their policies or is it still too early?

Grant Lewis is head of Fixed Income Research at Daiwa Securities SMBC Europe. His answers to your questions on the effectiveness of QE and the dangers that lie ahead are below.

If the Bank of England’s QE measures really have saved us from an even worse recession, why is there still an undersupply of credit for mortgages and small business lending? Isn’t that a sign that the QE measures have helped bank’s business models and share prices rather than the wider, real economy?
Deborah Slater, London

Grant Lewis: Quantitative easing is not aimed solely at boosting bank lending, although it is an area where the BoE is hoping that it will have some impact.

The reduction in the availability of credit is a consequence of a mixture of banks’ attempts to reduce risk and boost their profitability through higher margins, a reduction in competition in the sector (with the merger of several domestic banks) and the withdrawal of many foreign lenders from the UK.

Other than providing ample liquidity to banks to ensure that they do not feel concerned that their access to funds will dry up, it is difficult for central banks to directly affect the availability of credit when its withdrawal is driven by structural changes in the banking sector.

What is the time-lag between the Bank of England issuing news money to buy gilts, the purchase of the gilts and then the spread of the funds used around the system? Is it actually possible to follow the money?
Dennis Parker, Kent, UK

GL: There is no time lag between the creation of the new money and the purchase of the gilts (or corporate bonds).

The Bank of England simply purchases the assets from private sector institutions and immediately credits the seller’s bank account. From there, however, following the money becomes much more difficult.

The monetary policy commitee (MPC) is looking at a wide range of indicators to assess if the money it is creating is flowing into the wider economy.

It is paying particular attention to the growth of “broad money” – indeed, a key reason why the MPC opted to raise its asset purchase target at its August meeting was that broad money growth remained weak.

The MPC is also looking at developments in asset prices, notably equity and bond prices, but also real estate prices. Fundamentally, the MPC is looking for any evidence of the extent to which the money is boosting money growth and spending by households and businesses.

The Bank of England itself has recently acknowledged that it may well take longer than it initially thought for the full impact of QE to be apparent.

What do you expect to happen in the government bond market when QE ends? One might expect a large jump in bond yields as one of the biggest buyers becomes a seller?
Roger Strange, unknown

GL: The Bank of England will end QE when the medium-term outlook for growth has brightened and the risk of inflation undershooting its target has receded - developments that, of themselves, will lead to a rise bond yields.

The rise in yields will almost certainly be exacerbated by the BoE ending its gilt purchases.

But it doesn’t necessarily follow that the Bank will become an outright seller of gilts once it decides that monetary policy needs to be tightened. It will be able to raise Bank Rate, while its gilt holdings will fall naturally over time as the bonds it holds reach maturity and are not replaced.

The quantitative easing started at the same time as the stock market rally. Did QE create the confidence? Is there any fundamental change that gives more logic to this confidence. How does the current deleveraging and diving levels of consumer credit look after QE evolves?
Adrian NixonAdrian Nixon, New Zealand

GL: One of the rationales behind QE was to boost confidence and the reaction of both equity markets and the economy more generally suggest that, coupled with the large-scale fiscal packages and the support packages for banking sectors around the world, it has achieved this aim.

But while government and central bank actions may be slowing the pace at which the deleveraging of the consumer and banking sectors in both the US and the UK is happening, it cannot prevent it happening altogether.

As this deleveraging continues in the months and years ahead, this will have implications for both the pace and composition of growth. And that, in itself, provides a key reason why QE will not be reversed quickly.

The US is already talking about unwinding its QE. The govenor of Bank of England recently argued for an even bigger increase in the UK’s scheme. Is the UK in deeper trouble than other western nations, and what are the economic consequences if it has to leave its monetary policy in crisis mode for longer than anyone else?
Alan, Ipswich

GL: The US Federal Reserve has talked about its eventual exit strategy, as have the other major central banks. But it has not suggested that selling the assets it has bought (i.e. unwinding QE) is imminent.

Rather, it has signalled that it does not plan to increase its purchases of US government debt once the $300bn of purchases it has already announced are completed by the end of October. It is also continuing to purchase a total of almost $1,500bn of other assets (primarily agency mortgage-backed securities) by the end of the year.

In the UK, the Bank of England is currently increasing its total asset purchases by a further £50bn, with the purchases expected to be completed by the start of November, reflecting the fact that the MPC still sees a significant risk that it will undershoot its inflation target in the medium term without the additional purchases.

So, for now, QE looks set to stay in place in both economies.

How would you characterize the European Central Bank’s handling of the crisis compared with other central banks? Has it come out with its reputation enhanced?
Angleo Taylor, Brussels

GL: The European Central Bank has not been as aggressive in its use of asset purchases (quantitative easing) as either the US Federal Reserve or the Bank of England.

The Fed has committed to buying assets equivalent to around 12 per cent of gross domestic product and the Bank of England 13 per cent - the ECB, on the other hand, has only offered to buy €60bn of covered bonds less than 1 per cent of the eurozone’s GDP.

At the same time, at 1 per cent, short-term interest rates in the euro area are above those in the US, UK and Japan. So, in that sense, its reaction to the crisis has been more muted.

On the other hand, it has been very aggressive in providing banks with liquidity.

The difference in approach reflects both the nature of the economic and financial conditions the ECB is facing and the institutional arrangements and constraints under which it operates.

In particular, the euro area economy is not facing the sort of deleveraging pressures from the household sector that exist in the US and UK right now.

In addition, the ECB’s status as a supranational institution makes buying government debt difficult (how would it decide how much of each country’s debt to buy?).

But only time will tell if the ECB has got it right, although the positive growth seen in both France and Germany in the second quarter was encouraging.

What would be the best exit strategy from quantitative easing policies and when will it make sense to start it?
Viktor O. Ledenyov, Ukraine

GL: The timing and method of exit from QE will vary across countries.

But, given that interest rates are so low, tighter monetary policy is almost certain to come via higher short-term interest rates in the first instance.

Withdrawing the the additonal liquidity provided by QE will be trickier.

While stopping purchases of financial assets will mean that the additional money will be withdrawn naturally (as the financial assets held by the central bank mature), central banks may decide that the process will not happen quickly enough by itself. In that case, the options would be either to sell the assets, risking a big jump in yields, or issuing central bank debt.

In terms of timing, we remain a long way from the world’s major central banks raising interest rates, let alone starting to withdraw QE.

Now the Fed owns collateral that might only be worth half of what they paid for it when purchased because of mortgage defaults, How does it safely drain the money added to the system and when their collateral it has been buying, such as mortgage-backed securities, has lost so much value?
Justin Adams, Kelly, Wyoming, USA

GL: In terms of the assets it has bought, the Fed’s approach to QE has been deliberately cautious, concentrating its purchases on agency mortgage backed securities, the debt of the mortgage agencies themselves (who, of course, are now under the control of the US government) and US government debt.

Given that the US government itself effectively guarantees these assets, if the Fed holds these assets to maturity, full payment of the principal would be expected. In addition, the Fed earns interest from these assets for as long as it holds them.

Details of the impact of the Fed’s various credit and liquidity programmes on its balance sheet are publically available.

The latest balance sheet shows that in the six months to the end of June this year the Fed made $16bn in net earnings on the assets held in its System Open Market Account (SOMA) portfolio - the account where the Fed holds its domestic and foreign portfolios.


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