Traditional monetary policy relies on central banks using short-term interest rates to control the level of economic activity. On 5 March the Bank of England made its latest cut to 0.5%, and this may prove to be its last. (see chart on UK base rates opposite). Cutting further would risk a ‘liquidity trap’ where banks and other lenders have no incentive to lend, thus curtailing, rather than stimulating the economy. As rate cutting approaches zero and becomes exhausted, enter a technique known as ‘quantitative easing’ (QE), to try to give growth a further push. It is not simply a case of rate cuts running out of room. During the credit crunch the relationship between base rate and other interest rates in the economy broke down.
Quantitative easing targets the rates at which companies and individuals can actually borrow money and which have so far proved depressingly and stubbornly high in the face of the Bank of England’s base rate cuts. This is uncharted territory and the combination of huge fiscal deficits, together with the central bank buying government bonds could be explosive. By buying inflation sensitive assets now investors should be able to reap handsome profits. Shares would suggest equities and commodities as ideal investments in an inflationary environment (see page 24).
How to spot QE
The usual route of quantitative easing, and the one which is the central plank of the UK response, is for the central bank to buy government bonds. The Bank of England uses its account to make the purchases, thus creating money. The Bank has authorisation to buy a total of £75 billion of assets, the majority of which will be gilts. It also has the option to use a further £75 billion should it feel the need. At each meeting the Monetary Policy Committee (MPC) votes on whether to continue with the purchases. To date they have bought £30 billion worth of gilts, so the initial £75 billion should be exhausted around June at the current rate.
Another route is for the central bank to purchase private sector assets. This is called ‘credit easing’ when financed by the issue of bills or bonds, and is part of quantitative easing proper when it is not. Credit easing has been the main route of the US Federal Reserve which has been very active in the market for mortgage securities. The Bank of England has also set up a £50 billion asset purchase facility to carry out credit easing, financed through the issue of treasury bills. Because these are financed purchases they do not directly increase the money supply but simply aim to reduce interest rates on for example corporate bonds, or in the case of the US, mortgage bonds. The Bank of England also has authority to buy private sector assets such as corporate bonds within its £75 billion QE remit, but in terms of size, this has played only a small role so far.
How QE works
There are three avenues by which QE can work:
• lending
• interest rates
• asset prices
Of these the first is the most important. Gilt purchases boost bank reserves and thus the ability of the financial system to make loans. The Bank of England buys the gilts from institutions such as insurance companies, fund managers and pension funds, who then place the proceeds in their bank accounts. Banks’ reserves and cash make up the narrowest
band of money, M0. In theory this will have a large multiplier on the widest form of money, M4, as banks lend out far more than they keep in reserves (see chart).
The relationship between M0 and M4 is about 1:20 based on recent history. The Quantity Theory of Money states that MV=PY, where
• M is the broad money supply
• V is the velocity of circulation
• P is the level of prices
• Y is real output.
If the velocity of circulation stays constant, an increase in the supply of money will lead to a commensurate increase in output, and/or prices. According to Legal and General Investment Management M0 is set to increase from around 6% of UK GDP to 16% so the stimulus is very large. It is also rapid, in marked contrast to the actions taken by Japan in the 1990s, where the economy became bogged down in a grinding recession as a result.
The second means of transmission is through the reduction of long-term interest rates. The purchase of gilts reduces yields, which are inversely related to prices. The announcement of the bond purchase plan saw a huge 50 basis point (bp) downward move in the ten-year gilt yield to 2.90%. It has since crept up to 3.45%, but that does not mean the policy is not working, as it would have been higher still without the purchases. Gilts provide benchmarks for long-term interest rates, for instance corporate bonds are priced off them, so a fall in gilt yields should be good for the whole economy.
Thirdly QE aims to boost asset prices. If the institutions selling the gilts do not place all their money in bank accounts they might use it to buy assets such as non-government bonds, shares or property. The risk here is they might buy overseas assets thus exporting the stimulus.
QE could also have a psychological effect. If people fear falling prices they will delay purchases, thus starting a potential deflationary spiral. Convince them the authorities are taking effective action, and you can avoid this self-fulfilling forecast.
How to spot the result
On the one hand there is a danger the stimulus will not be enough. There is a risk of the velocity of circulation falling as banks sit on their reserves rather than use them for lending. Also the money supply figures have probably understated the build-up and then subsequent slowdown in credit growth as they do not take account of the shadow banking sector. Hedge funds and Special Investment Vehicles (SIVs) created seemingly safe triple-A rated assets which then promoted loan growth. It may be a particularly large stimulus through the traditional banking sector is needed to offset the demise of this area of the economy. The retreat of foreign banks in the UK also requires a large policy response through the domestic banks.
As a consequence the Bank of England is only assuming a one-to-one lift in GDP from its measures. Having estimated the output gap at 5% of GDP, or £75 billion, it has arrived at the size of its figure for the gilt buying programme. This is clearly a rough-and-ready calculation. The one-to-one ratio is guesswork, and estimating the output gap is fraught with difficulty.
The other possibility is overshooting. It will be difficult to measure if the policy is working and the danger is the tap is not turned off in time. One way to get an idea of how bold the UK £75 billion plan is to compare it to the $300 billion set aside by America for its own direct purchases of treasuries, a much smaller figure relative to GDP and the size of the domestic bond market. QE resembles a large mallet to adjust a machine which will only respond after long lags in time, and which has no instruments to tell you how it is performing.
How to invest
Should deflation be staved off and inflation rear its head the stimulus will have to be withdrawn and this will mean selling gilts. This might be very difficult given the trajectory of government spending and accompanying vast gilt issuance. One obvious implication of QE is investors should be very very wary of investing in gilts. In addition to the inflationary risk, at some stage both the government and the Bank of England are both going to be huge sellers, so capital losses for bondholders are likely offset the meagre yields on offer. Were the Bank to be tardy in selling gilts and thus shrinking the monetary base prices could take off with a vengeance. Tim Drayson, economist at Legal and General (LGEN), says of this process: ‘I suspect it will be impossible to do smoothly, and the most likely result is an inflation rate in the mid-single digits.’
The action taken by the Bank of England is unprecedented for this country and working out exactly what is means for investors is tricky. To help investors through these uncharted waters, Shares has picked out three good hedges against a possible future inflationary surge:
Equities
db x-trackers All-Share ETF (XASX) 213p Buy
Companies’ earnings should rise with the nominal level of prices, meaning equity prices and dividends rise too. The historical record is a little mixed with the high inflation rates of the 1970s being bad for valuations but as a class equities are set to perform. The easiest way to exploit this is to gain exposure to the entire market either through a tracker fund or through an Exchange Traded Fund (ETF) where the fees tend to be lower. db x-trackers All-Share ETF follows the UK’s FTSE All-Share index.
Precious metals
ETFS Gold (BULL) $12.41 Buy
Gold is the classic inflation hedge. It is also the refuge of those seeking safety from systemic risk. The unwinding of the latter, as confidence begins to return to the banking system means the gold price has been in retreat from just shy of $1,000 and at $900 looks good value. One way to play the market is to buy ETF Securities long gold ETF which will track the gold price.
Industrial metals
ETFS Copper (COPA) $23.90 Buy
All real assets will maintain their worth as inflation erodes the value of paper money. Industrial metals will also appreciate as the level of economic activity picks up and copper will be a major beneficiary of construction activity worldwide. ETF Securities’ fund is designed to follow the DJ-AIG copper sub-index.
