Has Bank of England backed itself into a corner – frightened of falling gilt prices it feels obliged to continue with QE!

Bank of England medicine ignores dangerous side-effects

Gilts are no longer ‘risk-free’ assets

by Dr. Ros Altmann

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Sadly the Bank of England has failed to see sense after all. Announcing a further £50bn purchase of gilts is not the right medicine for our economy. In fact, it is more likely to damage growth than boost it. The sums of money involved here are so huge, but this is still just an experiment.

QE has not worked. The jury is still very much out on whether QE is actually providing an economic stimulus. Despite the billions of pounds of new money, consumer lending fell last year, growth weakened and inflation sapped consumer confidence. And, even if initial gilt-buying did provide a boost, it is clear that the lower gilt yields fall, the less effective the policy becomes. I believe, at current levels, no further stimulus will be achieved by continuing with QE in the same way.

Has Bank backed itself into a corner – frightened NOT to do more QE in case gilt prices tumble? The Bank of England may, in fact, feel it is in a bit of a fix, frightened that, if it does not keep on buying gilts, yields on Government bonds will rise, which will make the fiscal deficit harder to finance and damage the economy. But this is just a vicious circle.

Gilts are no longer ‘risk-free’ assets. This would mean that gilts are no longer ‘risk-free’ assets, because their prices are being propped up by official purchases, rather than reflecting economic fundamentals. At current yield levels, gilts simply do not reflect our fiscal deficit situation and our inflation rate.

Bank rationale for QE ignores domestic fundamentals. The rationale released for sanctioning more QE is that European economies are weak, so the UK could be harmed! The new money-printing measures are ignoring some crucial economic factors. With long-rates already so low, inflation still way over target, economic indicators showing more positive signs and a massive imbalance of supply and demand in the gilt market, the Bank has still decided to buy more gilts.

Bank already owns over a third of outstanding gilts. The Bank already owns over a third of the outstanding stock of Government bonds, institutions are desperately in need of holding on to gilts to shore up their solvency ratios, and yet the Bank is buying up more of the market. This smacks of panic measures, not knowing what else to do, markets expecting QE, and theBank frightened of NOT meeting those expectations in case gilt prices tumble!

This is, in my view, dangerous for all asset markets and all investors, as well as causing further damage to pensions, pension funds and annuities. The balance of risks is that QE will not help growth, but will cause economic damage. Consider the following:

How can QE help growth? This is the theory:

1. The Bank buys gilts with newly created money
2. Sellers of gilts deposit that money in banks
3. Banks lend that money to help boost the economy
4. Gilt yields fall, making interest rates lower across the economy
5. Borrowing becomes cheaper so more economic activity occurs

What about the reality?

1. Sellers of gilts often buy overseas assets, so the money does not boost the UK economy
2. Banks are not lending at rates that are attractive to small companies so the money is just stuck in bank balance sheets to help banks become stronger
3. Institutions need to hold gilts, pension and insurance companies have to pay even more to buy their gilts, diverting money away from more productive investments
4. Low interest rates do not boost lending because banks are still charging too much for loans and large companies are flush with cash so the falling gilt yields are of no help

How does QE damage growth?

1. With a record number of people reaching age 65 this year, there will be more annuity purchases and anyone retiring now will receive a permanently lower pension as a result of falling annuity rates, thus giving them less money to spend, which harms growth
2. Company pension scheme liabilities rise as gilt yields fall, forcing companies to divert money into their pension funds instead of using it to build their business, which harms growth
3. Inflation stays high, which damages consumer confidence, which harms growth
4. Anyone with an income drawdown policy will face a fall in their income, because the amount they are allowed to withdraw falls as gilt yields fall, so they have less money to spend, which harms growth
5. Falling interest rates damage savings income so savers have less money to spend, which harms growth

Conclusion:

QE is not the medicine our economy needs now. It is a desperate measure that has dangerous side-effects and the Bank needs to urgently find more intelligent ways of using any newly created money than buying gilts.

What else could we do? Creating so much new money and then wasting it by buying gilts is not sensible, there are far better things to do with this £50bn

1. Lend directly to small companies- this would create jobs
2. Underwrite new small company lending by banks – this would create jobs
3. Underwrite infrastructure projects that would boost growth and jobs
4. Drop pound notes from a helicopter and let people spend them!

All of these are better than the current policy!

 

ENDS
Dr. Ros Altmann – 07799 404747
9 January 2012