27 Oct 2011 | Capital Hill

Capital Hill on...Quantitative Easing 

Just what is quantitative easing, and what does it mean for the economy, interest rates, savings and borrowing, annuity rates and share prices? Capital Hill takes a look...

WHAT does the abbreviation QE2 mean to you? For many people, the classic ocean liner the Queen Elizabeth 2 – the flagship of the Cunard Line for over 30 years – will spring to mind. More recently, though, it has come to denote the government’s drive to get our economy back on an even keel.

The Bank of England (BoE) concluded its October Monetary Policy Committee (MPC) meeting by voting to expand its quantitative easing (QE) programme from £200 billion to £275bn, to be completed over the next four months.

The surprise decision gave a clear indication that the Bank is concerned about the debt crisis engulfing the Eurozone – the UK’s largest export region – and the possibility of the UK slipping into a dreaded ‘double-dip’ recession.

Office for National Statistics (ONS) figures show that the recession was deeper than previously estimated, while growth in recent quarters has been revised downwards. The ONS now estimates that gross domestic product (GDP) grew by 0.4% in the first quarter of 2011 (down from 0.5%) and 0.1% in the second (down from 0.2%).

Ruth Lea, economic adviser to the Arbuthnot Banking Group, said: “The economy has flat-lined since the autumn of last year. Moreover, the indicators going forward suggest only a weak pick-up in Q3.

“[BoE governor] Sir Mervyn King’s apocalyptic warning that we’re in ‘the most serious financial crisis we have seen, at least since the 1930s, if not ever’ should be heeded: it’s not just empty rhetoric.

“It’s indicative of the Bank of England’s deep concerns over the state of the global financial markets and the chance of another major financial crisis.”
 

The economy

Usually, central banks try to stoke economic activity indirectly, by cutting interest rates: this encourages people to spend, not save. Interest rates were kept on hold at a record low of 0.5% at the start of October – for the 31st consecutive month.

When interest rates can go no lower, the only option is to pump money into the economy directly through quantitative easing. This is done by buying assets – usually financial assets, such as government bonds (also known as ‘gilts’) – with money created out of thin air.

This boosts the amount of money sloshing around the institutions selling these assets (commercial banks or other financial businesses, such as insurers). In theory, this encourages them to lend more to businesses and individuals, thereby increasing economic activity.

Will it work? Any impact on the economy is unlikely to be seen for some time, and many commentators expect the MPC to vote to extend QE2 in February 2012: QE1 was extended several times before reaching the £200bn level.
 

Interest rates and inflation

QE2 is a firm indication that UK interest rates will stay low for longer. Patrick Connolly, head of communications at AWD Chase de Vere, the independent financial adviser, said: “This is bad news for those relying on their savings, particularly as QE2 could give another upward boost to inflation.”

Inflation, which has been hovering around the 5% mark, could increase if the money generated by QE2 does not find its way into new goods and services. Higher inflation would hit households already struggling to make ends meet.

However, most economic indicators now suggest that inflation will fall in 2012. Ray Boulger, senior technical manager at independent mortgage broker John Charcol, said: “Although the MPC is still forecasting the CPI [Consumer Prices Index] will rise ‘above 5% in the next month or so’, it is also now being more positive in saying it expects CPI to undershoot its 2% target in the medium term.

“Although... the recently-announced increases in utility prices will boost inflation in the short-term, the sharp falls in the price of oil and other key commodities over the last few weeks will help it fall in the medium-term, along with the elimination of last January’s VAT increase from the calculation in the new year.”

Bank lending and mortgage rates

QE is also designed to boost the economy by driving down the cost of borrowing. When the Bank buys gilts, it reduces their supply in the economy. This increases demand for new gilts – pushing prices up, and yields down.

Lower gilt yields serve to drive down rates on lending to companies and individual borrowers, such as mortgage holders.

Lea believes that more QE should support the banks – but that it is a “calculated gamble”. “The latest tranche of QE, which should improve the ability of the banks to raise capital, is as much about support for the banking system as stimulating the macro-economy – if not more so,” she said.

Given that the MPC is considerably better informed than outsiders on the health of the banking system, the decision to expand the asset purchase scheme is “not encouraging in that context”, according to Boulger.

However, he said that, should the BoE concentrate its buying power at the longer end of the gilt market, as expected, QE2 should allow mortgage lenders to offer longer-term fixed-rate home loans of at least 10 years at “a keener margin over five-year rates than we have seen to date”.

“Although demand for longer-term fixed-rate mortgages is fairly small, the closer the rates get to five year rates, the more borrowers will be tempted to fix for longer,” he added.

Pensions and annuity rates

UK pension schemes could be hit with a ‘QE premium’, according to actuarial consultant Punter Southall. Principal Danny Vassiliades said: “This latest round of QE may cause the double-whammy of driving down gilt yields and driving up inflation expectations, both of which increase the value placed on UK pension scheme liabilities.”

Rates on annuities – which give an income for life in exchange for pension savings – are also linked to gilt yields: lower yields are bad news for those nearing retirement.

In the aftermath of the QE announcement in 2009, there were 18 annuity rate cuts and just two rate rises, according to Tom McPhail, Head of Pensions Research at Hargreaves Lansdown, the financial adviser. “[QE2] will fuel expectations of further annuity rate cuts to come,” he said.

Investors approaching retirement should shop around, first for the right type of annuity, then for the best rate.

“Don’t delay buying an annuity in the hope of a short-term bounce in rates; it may happen, but there’s no strong reason to expect it,” said McPhail.

“If you want to minimise the risk of buying an annuity at the wrong moment or you hope that asset prices may recover, consider phasing your annuity purchase.”
 

Share prices

On the bright side, the restarting of quantitative easing should boost confidence and asset prices in financial markets. At first glance, the stock market loved it: the FTSE 100 index jumped by almost 4% on the announcement.

In the short term, QE2 is likely to encourage investors to move back into ‘risk assets’, as asset allocators rebalance portfolios by selling bonds (perceived to be expensive) and snapping up shares (seen as better value).

However, experts concede that we are unlikely to see a repeat of the rally seen in the fourth quarter of 2010: the same medicine never seems as effective the second time around.

Adrian Lowcock, a senior adviser at Bestinvest, the independent broker, said: “In theory, QE2 should help to drive up share prices as the ‘new money’ is used to purchase lower-risk assets, encouraging banks to reinvest in higher-risk shares.

“However the sums announced by the UK are relatively small compared to the amounts used by the US in quantitative easing. So, unless the US Federal Reserve or other central banks join in – the EU has to some extent – the impact on share prices will be muted.

“The Eurozone crisis is driving share prices lower in the UK and globally. Share prices will continue to be volatile, at least until there’s a solution to that.”

The views expressed in this article are those of the author and should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect personal opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.

This article contains information and opinion on investments that does not constitute independent investment research and is, therefore, not subject to the protections afforded to independent research.

Author: Jennifer Hill
Jennifer is an award-winning British financial journalist. She recently left The Sunday Times, where she was deputy Money editor, to set up her own company, mediahill Ltd. She is a previous personal finance correspondent of Reuters, the global news service, and personal finance editor of The Scotsman newspaper.

She has won or been shortlisted for six Headlinemoney awards, the ‘Oscars’ of personal finance journalism in the UK. She has also scooped or been nominated for accolades from the Association of Investment Companies, Ignis Asset Management, the Association of British Insurers and the British Insurance Brokers’ Association.