The dark side of quantitative easing
Since the Great Recession there has been a slow recovery fuelled by nearly universally loose monetary policies around the world. We have now reached a point where many countries’ long term interest rates are negative, but there is still little sign of inflation.
Will continuing this policy work? How far can it go?
The intention behind these policies is to encourage companies and consumers to spend and invest their cash, dissuaded by low interest rates on their cash, and fixed income savings. For companies, this means investing to create new jobs, and for consumers, spending more of their extra cash available from savings on lower mortgage payments.
However, markets are rather efficient, so each time the monetary policy becomes more aggressive, asset prices rise and long term interest rates decline. Now people who don’t own assets (such as a home, pensions and savings) have to save much more to be able to afford a deposit on the ever higher house prices, or for their retirement as assets pay a lower income. The result of this is that people don’t actually spend more; they are forced to save more. Similarly, companies offering defined benefit pension schemes have to spend a lot of money on funding pensions, removing cash from investments. In other words, people’s financial goals become more and more unattainable as the return on capital decreases.
Therefore, loose monetary policies create a bigger divide between the asset owners and the non-owners. Not by hard work, or being intelligent, but by design. This is a political situation with a time limit.
Companies and individuals have a choice to make when they are being offered low interest rates, and the answer depends on their risk appetite. If a lender reduces their lending rate and a customer has a repayment mortgage that allows overpayments, one low risk option is to continue with the same mortgage payment amount that was being made before the rate reduction. This will have the effect of reducing the capital sum borrowed and therefore reduce the amount of interest payable as well. Likewise, if the mortgage is interest-only, one could put aside the saving made on the rate reduction and pay off lump sums of the capital, thereby again reducing interest payable. A company also has the option to change their capital structure by issuing bonds with a long maturity, on very low interest rates, and to use the proceeds to repurchase their own stock, thereby increasing the share price (simply by introducing demand). This has the added benefit of sometimes decreasing annual pay-outs as the dividend rate is often higher than the interest on the bonds issued. This is particularly true for large, high quality companies that savers rely on for dividend income. This clearly does little for the economy. However, it can be the right thing to do for companies, and an easy way for senior executives to increase the share price of their companies without necessarily increasing risk; a reason much of the money “injected into the economy” has not been spent on generating jobs. The other alternative is the higher risk option of spending or investing the money. In order to make this decision, investors must have confidence in the future.
Leaving monetary policy in ‘emergency mode’ for a prolonged period of time might logically reduce people’s confidence in the future. This can be seen in the ‘quality’ of jobs created after the recession. Many are temporary or part time contracts as companies do not want to commit for the long term. Many investors have also been sceptical, kept funds liquid and therefore not participated in the buoyant markets since the recession. For these investors it can be hard to commit cash to markets, some of which look long in the tooth by historical measure. However, the past is not a good guide to the future and monetary policy can get a lot looser than we have seen so far. Thus leading to markets going ever higher, if only because of the fact that cash becomes less desirable. This results in leaving conservative investors who are not invested even further behind, a situation that could worsen should inflation return with a vengeance.
We can see that so far quantitative easing seems to have had some positive effect in driving unemployment numbers down in the US and UK, but inflation numbers remain stubbornly low suggesting that spare capacity still remains and that the money is not reaching/being spent by consumers.
The well advised would have stayed invested in the markets and enjoyed the tide of liquidity lifting most asset classes, but this type of market cannot be good for capitalism in the long term as bad businesses are allowed to stay afloat for far longer than ‘normal conditions’ would allow. Leaving a generation out of reach of buying a home or building up adequate retirement funds has political disaster written all over it.
There are many interesting ideas floating around out there; extra cash to everyone is in vogue, a form of ‘helicopter money’ – how would this affect people’s motivation to work? Advanced economies’ government debt has grown significantly since the crisis, the IMF suggested in a white paper a while back that the debt bought by central banks could just be deleted – what will that do to market’s confidence in central bank assets? We live in interesting times and no one knows which ideas will win out. All eyes are on Janet Yellen, the governor of the US Federal reserve, for any hints that the US will tighten, but often things happen where people are not looking. We argue for staying diversified and making sure portfolios are well structured.