Quantitative Easing and the UK Economy

Quantitative Easing works by digitally pumping new monies into the system which is then used to purchase government bonds, commonly referred to as gilts.  The increased demand for gilts in turn pushes down the interest rate paid on the loans, known as the yield.  Quantitative Easing  as such involves pumping liquidity into the market via quantitative easing.

Quantitative Easing = Printing more money = falling £v$ = higher commodity prices = inflation = erosion of savings = less consumer spending = lower GDP. The cycle used to be broken by higher wages with the inflation bit. That used to to inflate our debt away as wages went up. The problem now is that we have to hold down public sector wages and the private sector is now competitively linked to to unemployment and global labour rates. Expect higher fuel prices and imported foods. On the plus side the lower £ is good for exporters such as service sector and manufacturing, so they should be able to employ more which should add to GDP. So, bad for retailers but good for financial services and manufacturers.

Quantitative Easing: 40 years ago when we studied this at university as (open market operations) two things stuck in my mind:

1. It was done in secret.
2. It had to be done in secret as the distinguishing mark of this policy is that it all gets reversed as soon as the market bounces back.

The Fed has in the past intervened a number of times during times of financial turmoil  including 1987, 1994, 1998, 2001 to 2003 and 2008, via interest rate cuts.   Since 2009 the USA Federal Reserve has also launched two quantitative easing programmes costing a total of $2.3 trillion. It has also injected a further $400 billion in Operation Twist, a tool that was used to push down bond yields and borrowing costs. This programme was then expanded further from $40 billion to $85 billion a month, for QE-IV, once Twist expired in December.

The Bank of England has likewise added a further £50 billion to its Quantitative Easing scheme bring the total to £375 billion in July 2012 while the European Central Bank launched an Outright Monetary Transactions programme in the summer. Meanwhile the Bank of Japan keeps boosting its QE schemes amounting to a total of ¥101 trillion so far.

Quantitative Easing Programme 1 was implemented to help put out the fire and remove the possibility of a meltdown in the financial system = SUCCESS

Quantitative Easing Programme 2 was implemented with the goal of  driving down borrowing costs so as to stimulate the economy = FAILED (it has only served to drive asset prices higher while improving  banks balance sheets..which have not been passed onto the end consumers/small businesses)

Quantitative Easing Programme 3 same as above = Isn’t likely to boost the underlying economy but any additional liquidity should keep assets from falling.

In theory QE programmes are designed to boost confidence and create a wealth effect by supporting risk assets and boosting investors portfolio values so as to give us higher spending power. The aggressive action is somewhat helping to calm the markets with companies and people paying off debt and saving as opposed to spending.

What has happened to the old fashioned infrastructure boost spending – utilise the money to build big projects and create jobs – as opposed to bailing out banks that are effectively bust, allow them to fail and send any corrupt bankers for hard time!

On the one hand, the US Federal Reserve, Bank of England, Bank of Japan and European Central Bank are all trying to keep inflation down by keeping interest rates at record lows.  Chairman Bernanke’s theory seems to revolve around driving down yields forcefully on instruments that are traditionally considered safe holdings such as USA Treasuries (and cash and bonds) in a bid to get investors to seek better returns elsewhere (such as equities and property). The theory is that the extra cash will then help drive up stock prices and create extra wealth encouraging people and companies to spend more. In reality this has only led to a modest recovery but one can’t deny that each round of monetary stimulus has driven down bond yields and provoked a rally in share prices.

On the issue of writing off household debt – debt’s biggest enemy is inflation, and as some have pointed out, the majority of the West is doing everything to provoke that. Allowing the indebted to refinance at record-low rates and restructure their debt is as relevant to households as it is to businesses and countries, they just need the tools and help to do so.

On that, there are a few issues. Firstly, the Fed and ECB’s action has never been designed to lower indebtedness – inadvertently, it may create an environment in which inflation eats into that debt, but I’m puzzled on how they come to the conclusion that “QE isn’t helping indebtedness, therefore a global recession is coming”. I’m not sure if I’m missing something but that’s a pretty big conclusion to jump to!

When it comes to using QE to justify arguments that massive inflation is being provoked by Fed action – let’s look at it another way.

Oil today is $90. Oil after QE2 was about $90. In October 2008, before QE1 began, Oil was $90. Before most people began talking about things like Quantitative Easing, Oil was on a steady march up to $147. The numbers can be bent into different shapes, but speculative moves aside, there hasn’t been definitive proof that real inflation is really taking place as a result of QE. At least not yet.

In any case record-low interest rates, quantitative easing (QE) and currency market intervention will remain the order of the day for the near to medium term although trusting the bankers to put it right does seem futile to say the least…

Hmmm? So they have to print money? But won’t that devalue the euro? And doesn’t that mean each Toshiba TV costs more, so even more euro’s flow East? The East continue to get richer while the West continue to get poorer then? And if it was that easy why didn’t they do it before?

Funny, you should mention that, the biggest concern amongst the hedge fund community isn’t Europe now, it’s China. After fairly aggressive stimulus, growth prospects continue to be revised down for China, the latest suggestion being 5% growth.

Why? Globalisation. Money flowing east isn’t the problem, the Chinese economy remains heavily reliant on Europe and the US consumer. It’s not a game of “West is in trouble, evil East gets the jobs and money”, unfortunately we all tend to suffer together and grow together in cycles.  Meanwhile the International Monetary Fund doesn’t seem impressed and has slashed global growth forecasts for 2013!

As the Dow makes multi-year highs, I believe the Hang Seng is making multi-year lows, such has been the shock of how much Chinese growth is slowing in this cycle. And my biggest concern is how much of the data can you believe coming out of China, they have a habit of being a tad enronesque with their figures, I have a feeling there are a few more sino-forest type companies that could rear there head at any time!

Having said that I think the structural China story is one that may take thirty, forty years to properly play out – meanwhile the market tries to place a value multiple on that in the present. I’m not sure how high that multiple was in 2007, or how much growth it was anticipating going forward, but you can bet it was inflated by so many of us wanting a piece of the action.

Moodys downgrade our banks. Moody’s have effectively stuffed the UK. Disgraceful. Government pumps in £75bn, Moody downgrades banks by 3 notches…..money goes up in puff of smoke. Sometimes I feel ratings agencies should be closed down, not least because of their role in causing this crisis in the first place. The timing of their pronouncements is extremely suspect. While we are at it, can we add the BBC to that least of “come the revolution”? Yes it’s grim out there but people are intent on pushing agendas.

The downgrades were as follows:

• Lloyds TSB and Santander UK were downgraded one notch from an Aa3 ratings to an A1
• Royal Bank of Scotland and Nationwide were downgraded two notches from Aa3 to A2
• Co-Operative bank was downgraded from A2 to A3.
• Newcastle building society, Norwich and Peterborough building society, Nottingham building society, Principality building society, Skipton building society, West Brom building society and Yorkshire building society were all downgraded between 1 and 5 notches each.
• Barclays Bank PLC was not downgraded but left at Aa3

Why were the Credit Ratings Cut?*

The ratings were cut because Moody’s now considers these banks to be at a higher risk of defaulting than they were before. However, Moody’s were quick to point out that the downgrade did not “reflect a deterioration in the financial strength of the banking system,” and went on to say that ‘The downgrades have been caused by Moody’s reassessment of the support environment in the UK which has resulted in the removal of systemic support for seven smaller institutions and the reduction of systemic support… for five larger, more systemically important financial institutions.’

In short, Moody’s is of the opinion that the British government has removed some support to the banking sector making a default slightly more likely if things go wrong. Elisabeth Rudman, senior vice president at Moody’s said after the downgrade: “Compared to their European peers the UK banks are well positioned from a capital perspective. But the environment they are operating in is still very tough and there’s an awful lot of uncertainty out there in the euro zone.” Banks and building societies involved in the downgrade were quick to emphasise this point. A spokesperson from the Building Society Association commented: “It does not represent any change in financial strength and it is business as usual across the sector”. The Chancellor of the Exchequer George Osborne, in an interview with BBC Radio 4’s Today programme said that he was ‘confident that British banks are well capitalised, they are liquid, they are not experiencing the kinds of problems that
some of the banks in the eurozone are experiencing at the moment.’

Impacts of the Downgrade*

In truth the immediate impact shouldn’t be too extensive. The most recent round of quantitative easing announced by the Bank of England should inject enough cash into the banks to counteract the rising cost of the banks borrowing money thanks to their new lower credit ratings. Any effects are likely to be seen in a drying up in credit for smaller businesses. There have been calls from the Lib Dems to nationalise RBS completely so that they can sidestep this problem by forcing the bank to lend to smaller businesses and encourage economic growth. This however is unlikely.

The greatest and most immediate affect the downgrade will have is summed up by Jason Riddle, founder of campaign group save our savers: “The downgrade of 12 banks and building societies will further undermine savers’ faith in the banking system.” With the memory of 2008 still fresh in everyone’s memory and dissatisfaction with banker’s wages and bonuses; people are beginning to lose patience with the problematic banks.

* with some excerpts from SVS CFD Securities report

Having said that I think Moody’s have a point to downgrade UK banks. The Bank of England is giving the banks monopoly money to pump into the economy and strengthen their balance sheets. The government are deliberately devaluing the £ to make our exports more competitive and our imports more expensive. They are trying to inflate our way out of debt. You can’t expect to devalue your currency without devaluing your assets – in this case banks. I believe it was Harold Wilson who devalued the £ and said ‘This won’t effect the £ in your pocket’ – except when you go to the supermarket or pay your fuel bills hmm

And its not just the United Kingdom…In the USA we have an Armageddon looming and the debt bomb keeps ticking…

The US debt to GDP increase shows me that they are dying a slow death from a cancer called debt, which has spread to 100% of GDP and become terminal. imo USA is no better than Europe, globalisation has wrecked ALL western economies together.

It took the USA 219 years to accumulate $8.6tn of national debt up until 2007. In the last 5 years alone, they have accumulated a staggering $7.1tn (up 82.5%) almost doubling the national debt to $15.7tn. In 1980 US debt was just $1 trillion, GDP was $2.7 trillion.

US GDP has grown 470% since 1980

US Debt has grown 1470% since 1980

Long term debt to GDP increase ratio = 3.12:1

2007 – 2012 GDP increased from $13.9tn to $15.4tn up by 10.7% or avg 2.1% pa

2007 – 2012 Debt increased from $8.6tn to $15.7tn up by 82.5% or avg 16.4% pa

Short term debt to GDP increase ratio = 7.71:1

This tells me that the speed the debt disease is spreading and has increased by 148%. The runaway train has increased speed from 70mph to 174mph.

In 2009 US debt was $12 trillion, it has grown 23% to $14.8 trillion in just 2 years. If it grows at the same rate it will hit $18.2 trillion in 2 years, (almost double the 2008 level) their new debt ceiling is set at $16.4 trillion and maybe hit in just 12 months if my calculator is right? If they are spending $1.3 trillion more than they are earning how can they reduce debt? Tick tock!

Comment from Henry: The US debt isn’t a problem going forward. They will be energy self sufficient within 5 years which will address their balance of trade and debt. They are the world largest food exporter and technology exporter. They hold the greatest proportion of intellectual property in the world and they are still the dominant global economy with a currency that everyone rushes for in uncertain times. These factors plus inflation will be capable of bringing their debt under control.

Update: November 2012: Goth the European Central Bank (ECB) and USA Federal Reserve have now launched open-ended monetary easing measures. The ECB hasn’t set a limit to its Outright Monetary Transactions while the Federal Reserve’s third round of quantitative easing (QE), will see it spend $40 billion a month until further notice. This follows the lead of the Bank of England which has launched its own third round of quantitative easing making the total spent to-date amount to GBP375 billion.