The Bank of England (BoE) statutory monetary policy remit or mandate since 1998 has been to secure price stability in a way that supports the government’s economic policy objectives. The Chancellor’s November 2017 annual letter to BoE Governor defined that as the achievement of ‘strong, sustainable and balanced growth’. The same letter, however, underscored the government’s ‘absolute’ continuing commitment to price stability. That BoE mandate is operationalized by a forward-looking ‘medium-term’ inflation target of two per cent, as measured by the Consumer Price Index (CPI).
The primary monetary policy instrument open to the BoE to achieve that target is through influencing short-term interest rates by changing the rate – the Bank Base Rate (BR) – that it levies for the near-term use of its own funds. But, BR, has been close or at its effective lower bound (ELB) – where reducing it further is expected to have little or insufficient impact on domestic real economic activity – for nearly ten years.
BR was reduced to a historic low of 0.5% in March 2009. It was then that the introduction of QE was also announced, in effect, to give a second string to the BoE monetary policy bow, in recognition that conventional monetary policy – changing BR – in the wake of the Great Financial Crash (GFC) had been rendered too weak to be effective on its own.
QE involves the BoE creating new money electronically and expanding its balance sheet massively in order to purchase financial assets, predominately longer-dated (5-25 years) government bonds (gilts), mainly from insurance and asset management companies, pension funds, and other non-bank institutions, https://www.bankofengland.co.uk/monetary-policy/quantitative-easing. £375bn of such assets were purchased between March 2009 and July 2012, across three phases:
- £200bn between March 2009 and January 2010 (QE1);
- £125bn between October 2011 and May 2012 (QE2);
- £50bn extension announced in July 2012 (QE3).
There was then a lull until August 2016, when in response to Brexit uncertainty, the MPC announced, on top of a further cut in Bank Rate to 0.25%, another £70bn of asset purchases including a limited tranche of £10bn corporate debt (QE4).
For purposes of simplicity, post-GFC UK monetary policy (MP) can be defined as MP = BR+QE, with both acting in concert. The acronym, MP, in this post, is used in accord with that meaning. References to monetary policy relate to its more general non-time-bound meaning.
The impacts of MP, in practice, over time, have been and are affected by the complementing or offsetting impact(s) of fiscal policy (FP), as well by a raft of other macro-economic factors, some endogenous (internal) to the economy, such as productivity, others exogenous, such as changes in internationally-set energy prices impacting upon the domestic inflation rate.
Since 2010, with interest rates remaining at their ELB, and with discretionary fiscal policy contractionary in impact, and thus acting in an opposite direction to that of MP, QE has provided the primary, if not the sole, active policy mechanism or instrument to inject additional discretionary demand into the economy to sustain output and employment.
The Chancellor’s November 2017 letter confirmed that the QE asset purchase facility would remain in place during 2018-19. The BoE had still not sold back into the financial system any of the £435bn worth of the bonds that it has purchased under QE since March 2009. Maturing bonds are replaced or rolled-over. Such sales would take liquidity out of the financial system, tending to push up short-term interest rates, thus acting as a drag on expansion within the economy, all other things being equal.
The BoE jealously protects, however, its flexibility to reverse QE in the future, if its Monetary Policy Committee (MPC) considers that would be consistent with its primary price stability remit. The post-GDC QE programme remains very much unfinished business.
How QE works in theory
The honest answer is that even the central bankers don’t really know for certain (see Table 1, https://www.bankofengland.co.uk/working-paper/2016/qe-the-story-so-far ). The main identified transmission mechanism assumes that asset-holders, following changes in longer-term interest rates induced by QE, switch from lower-yielding and safe assets into higher risk asset classes more associated with increased real economic activity: the ‘portfolio re-balancing’ effect.
In that light, a Speech by Deputy Governor of BoE in 2012 suggested that as an immediate effect, QE1 had lowered long-term gilt yields by around 1% (100 basis points) between March 2009 and January 2010, and a 20% increase in their price. Investment-grade corporate bond yields, in turn, were lowered by about 0.7% (70 basis points), and high-yield corporate bonds somewhat more, by 150 basis points. Later QE rounds appeared to have been more muted in their impact on gilt yields, but this may have been due to other influences within the wider macro-economic environment, such as the intensification of the Eurozone crisis.
BoE-financed asset purchases increase the demand for longer-dated government gilts and other securities (5-25years); other things being equal, this should push up their price and reduce their yields (interest as proportion of price). The financial institutions selling such bonds to the BoE can then use the resulting receipts to acquire equities and corporate bonds. That they should do so rests upon impact of the QE process suppressing safe-haven bond yields, thus improving the relative the risk-adjusted returns of equities and corporate bonds, as an asset class. Such portfolio rebalancing should lower the cost of capital for firms issuing new equity or bonds by increasing their price or value while lowering their prospective yield (increasing potential receipts at point of sale and reducing their interest cost over time), so encouraging business investment. The BoE back in 2012 noted that given that both UK new equity and bond corporate net issuance rose sharply in 2009 compared to the preceding 2003-2008 period, that this provided some evidence that this may have happened, not only as response to the cuts in BR (which made equities relatively attractive as an income-earning asset), but also because of the immediate effect of QE1 on raising the demand for equities relative to gilts through the portfolio balancing effect.
Rising equity and property asset values that makes their holders, whether they are Middle England homeowners, or owners of substantial equity holdings, or firms with such assets, feel richer and ‘confident’ than they would otherwise be, and so more inclined to borrow, to invest, and to consume more, can provide a related but indirect ‘wealth effect’ transmission mechanism into real economic activity.
The injection of liquidity into the financial system by QE should also increase commercial bank deposits. Financial institutions selling bonds under QE will tend to deposit their receipts with their banks and/or use them to purchase higher risk assets that, in turn, generate receipts for the selling counterparty to deposit with their banks. This increase in the short-dated liabilities of the banks should encourage them to expand their direct lending to firms and to individuals to secure a return exceeding the interest payable to depositors – the ‘bank lending channel’. Little evidence is reported, however, that this happened, or was even expected. Banks preferred in the wake of the GFC to increase their reserves to cushion future anticipated asset write-downs of bad debts, even if that impacted adversely on their profitability.
Bank lending to households and firms can, of course, in any case, be used to fund the purchase of existing assets for speculative capital appreciation purposes, rather than on new productive assets that can generate future additional output and income. As noted above, rising asset values can impact on real economic activity, largely indirectly, through the wealth effect.
The aggregate and distributional impact(s) of monetary policy (MP), as reported by the BoE
That very tendency of post-GFC MP generally, and of QE especially, to increase the prices of equities and property assets, has given rise to concerns about its distributional consequences and their possible impacts) on widening both class and generational inequality, with Conservative Cabinet Ministers expressing concerns about MP policy decisions made by unelected technocrats that reward the already-rich.
A growing sensitivity of the BoE to such claims is clearly discernible in recent speeches by senior staff and within its research output. A, March 2018, Staff Working Paper No. 270, modelled both the aggregate macro-economic and the distributional household income and age cumulative impacts of the reduction of BR from 5.5% to 0.5% between February 2008 and March 2009 with the introduction of QE1-3, claiming to be the first UK study to investigate the impact of monetary policy in such detail at the household level.
The methodology it applied, involved, first, modelling the aggregate impacts of MP on gdp, employment, wages, consumer prices, house and equity prices, using the main BoE macro-economic forecasting model. The counterfactual of what would happened if monetary policy had remained unchanged in response to the GFC was applied. Then the estimated macro aggregate impacts it generated were then mapped to the micro balance sheets of individual households. This was done comparing data from the government’s Wealth and Asset Survey (WAS) for 2012-2014 and the Family Resources Survey for household incomes to earlier surveys, covering household:
- interest payments and receipts;
- employment income;
- financial, housing and pension wealth; and on the:
- effect of prices induced by MP on household real savings and debt levels, fixed in nominal terms.
The impact of MP on different households was then further mapped, according to:
- tenure status;
- whether members were in or out of work;
- age cohort.
Andy Haldane, the BoE’s current Chief Economist, summarised in his April 2018 speech, How Monetary Policy Affects your GDP, the results of that cumulatively across the 2008-14 period, graphically displayed across 24 charts. The headline results reported included that without MP, the:
- unemployment rate would have been four per cent higher, gdp eight per cent lower, and consumer prices 20% lower;
- overall impacts of MP income and wealth terms on different cohorts of society since the GFC proved positive and significant in overall; the average mean income household benefited by an estimated £1,500 a year, and £9,000, (charts 7, 8 and 9);
- overall distribution of income and of wealth, as reported by the 2012-2014 WAS, between the end of 2007 and 2014 remained broadly the same: in a nutshell, the UK’s unequal income and wealth distribution appeared to have remained largely unchanged by the combined impact of MP (see Charts 5 and 6).
Drilling-down on the distributional impact of MP:
- half of the total income gains in real cash terms was concentrated to the benefit of the top two income deciles; but, in percentage gain terms, Haldane advised, they were ‘reasonably evenly spread out, despite being slightly lower for lower-income households and negative for the lowest income decile’ (see chart 10 and 11, respectively);
- the young gained proportionately more from the positive modelled impact of MP on inducing lower unemployment and higher wages – an outcome related to the relative greater pro-cyclical propensity of the young to participate in the labour market compared to older age groups if provided with the opportunity, (see charts 14 and 15);
- households around retirement age, however, gained the most from the modelled impacts of MP on their total wealth (see chart 16);
- higher income decile households secured higher additions to their utility (welfare) than did lower-income deciles (chart 22), but the welfare benefits of having a job, and its associated job-satisfaction and self-esteem benefits, were concentrated in favour of the young (chart 23).
Haldane offered some additions. Notably, the social welfare benefit of enjoying improved levels of subjective satisfaction or happiness (utility) as result of having a job and/or improved job security, as well as from higher levels of income and wealth, was computed. Regression analysis was used to translate WAS-reported changes levels in household happiness into a notional-income equivalent. Reduced unemployment and arrears were found to have an especially statistically significant impact in explaining survey-reported changes in household happiness. Strikingly, a reduced probability of being unemployed was associated with a notionally deduced income-equivalent effect on household well-being of £7,300, compared to an actual reported average household income of £32,500.
Disentangling and quantifying the particular effects of QE must have presented an even more challenging task to the researchers. Charlie Bean, the deputy governor of the BoE the time, in the speech referenced above, noted that equity prices did rise substantially during both the periods covered by QE1 and 2. This was no doubt related to multiple reasons, including the continuing impact(s) of BR being cut to 0.5% that by reducing bond yields tended to make financial investment in equities relatively more attractive. His tentative conclusion was that equity prices probably rose by about 20% and 10%, as a direct consequence (my italics) of QE and Q2, respectively. This was on the back of the broad empirical fact that the introduction of Q1 and Q2 coincided with equity prices switching from a decline to growth trend, as well as on more analytic BoE econometric studies conducted at the time. The 2018-reported findings also stated that QE had the most modelled wealth impact on equities. Instructionally, lower income or younger households tend not to own equities (as they don’t tend to own housing wealth): the Bank of England quarterly-bulletin,2012, Q3, noted the richest 5% of households owned 40% of financial wealth held outside pension funds.
Only one chart (21) out of 24 in the latest 2018 BoE published research, reported QE-specific results. That painted a rather rosy picture, denoting that the overall impact of QE across the income distribution was positive, with all ten decile household cohorts enjoying an estimated c.20% average cumulative rise since 2007 in average real net income. There was some variation; the second to fourth deciles benefited from slightly under 20% gains, while the top decile enjoyed 30%. In that regard, the health warning that the direction of a modelled impact, rather than its precise estimated quantification, is more instructive, remains relevant. The translation of higher levels of household income and wealth attributable to MP to additions to their social welfare was appropriately captured by the near-logarithmic (constant percentage increase) across the distribution deciles that the survey reported, Haldane concluded, in preference to average cash increases per decile, invoking the diminishing the classical marginal utility of income principle that a unit increase in income is worth less to a rich person in marginal utility or social welfare terms than a poor one.
WAS is collected only from private households, excluding people living in publicly provided housing. As the authors of the working paper recognised, using the household as the unit of measurement hides inequalities within households; for example, young adults living with their parents while saving to purchase their own home were not be separately identified in the results. This is relevant as although MP does appear – according to the research – to have particularly benefited some groups, such as the established homeowners; other groups, including, tenants, or, indeed, the increased number of young people having to still live in the parental home (and not separately recorded) due to unaffordable housing entry costs, were likely to be disbenefited by the impact of MP on the house prices and rents. For members of Generation Rent, such effects, could be very significant, indeed.
Putting on one side survey sampling issues and the sensitivity of the regression results to different assumptions and specifications, the specifications and assumptions of the BoE model, or any other model for that matter, may or may not have captured the interaction of MP with other macro-economic and other quite possibly unidentified influence and their (temporal) distribution over time. As the FT economics editor, Chris Giles, has pointed out with respect to the economic modelling of different Brexit options, economic modelling depends on a lot on things that we don’t know. The BoE model patently failed, to take a notable example, to forecast the GFC as its specification failed to capture the actual behavior and impact of the financial sector.
Nor should sight be lost that the BoE is evaluating its own conduct of MP. Take one possible instance of that: its Chief Economist chose to introduce (no doubt an important and welcome dimension to macro-economic analysis) the impact on individual social welfare of MP in his analysis of the distributional impact of MP, highlighting that these were positive, as reported above; but these welfare gains only partially offset and compensated for what must have been much larger losses in welfare that followed the GFC that could have, in part, been made worse by the prior pursuit of monetary policy combined with failings in financial system regulation.
That said, all policies will involve winners and losers, who, in theory at least, could be compensated. And, after all, the remit of the BoE is not to secure some desired abstract distributional result, but, rather, to secure a medium-term inflation target consistent with future sustainable non-inflationary growth.
When measured against that benchmark, how effective has MP been?
Understanding the wider picture
It is important not to lose sight that any modelled positive changes in aggregate macro-economic outcomes and in micro household circumstances that may be attributable to QE, at best helped to ameliorate – and not to reverse or to overcome – the deflating cumulative impacts of the GFC and the following Great Recession. A state of stagnation now shrouds the UK economy. Many individuals and households are worse-off than they were in 2007: an unprecedented post-war outcome.
That interest rates remain at their ELB nearly a decade later, reflects the empirical reality that the UK has still not had a proper recovery yet, nearly 10 years on from the GFC. Its muted, uneven, and incomplete nature was spelt out in Speech by Andy Haldane, May 2016, Whose Recovery? in some evidential detail. He catalogued that actual real per capita gdp has barely moved since 2007, while net national income (after taking account of remittances of income and profits to foreign countries) fell, and net disposable household income flat-lined. Real earnings remained five per cent below their 2009 peak in 2016, and, although the incomes of the poorest income deciles did rise, this was largely because of the redistributive impact of pensions and benefits.
Increases in income and in wealth over the course of the decade have been largely captured by higher income and older households; while the real disposable incomes of pensioner households rose by 9%, the incomes of working age adult households fell by 3%. The median income household enjoyed little benefit, mirroring a similar long-term trend in the US. Consistent with that, Haldane postulates that half of all UK households have seen no recovery in their real inflation-adjusted income since 2005 (although he was reporting in 2016 using BoE analysis of data available then, the economy subsequently has not showed signs of a material recovery, rather, if anything regressing further). Regional inequality – measured by gdp per head – also widened.
The real actual income of younger people fell further and recovered more slowly from the GFC than did older age groups. Although MP impacts on their employment income especially, as was reported and considered in the preceding section, may have helped them, in the sense that their economic position in its absence would have been even worse otherwise, that countervailing influence was not enough to prevent the economic position of that group worsening, when considered and measured over the course of the last decade. The growth of self-employment, part-time-working, and zero hours contracts within the labour market, no doubt, was connected to that outcome. Total employment levels recovering to record new levels conjoined with downward pressure on wages and job security.
The different presentational slants of these two speeches by the BoE Chief Economist are marked, no doubt related to the different purpose and target audience of both. They are not necessarily contradictory, but it takes quite an effort to reconcile them. The connecting thread between them is that MP served to prevent the economic fall-out of the GFC from being substantively worse than it proved, on ‘an umbrella doesn’t stop but protects from the rain’ basis. Economic conditions were maintained that allowed many to either return or to enter the labour market and so secure better incomes and enjoy welfare levels higher than would otherwise been the case in the absence of MP. What MP has not done is to put the economy on a recovered sustainable growth path.
Even more seriously that sin of omission is linked to one of commission or agency. Where liquidity created by QE flowed into the purchase of existing land, housing, and equity assets, combined with the impact of low interest rates, it will have tended to pushup such asset values, along with the corporate profits of companies in the property and financial sectors. Many middle-income deciles saw their wealth rise, even while their incomes stagnated. The entry of the young into owner-occupation became much more difficult – at least without a contribution from the Bank of Mum and Dad. The richest households benefited disproportionately from rises in equity values. Leaving aside the broad distributional tendency for MP in general and QE in particular to maintain the status-quo of the wealthy staying wealthy, the poor remaining poor, and those in the middle, and the young in particular, having to run faster to maintain their position, comes the rub.
The palliative process and effect of MP risks creating conditions conducive to another asset bubble-induced recession, which are particularly prolonged and damaging, rather than helping to build the foundations and providing the wellsprings of future sustainable and balanced growth in line with the stated macro-economic objective of the current government.
Conclusion: a problem of political economy
Intuitively it seems safe and fair to conclude that QE acting in concert within the wider MP response may well have helped to prevent the GFC from turning into another Great Depression. Not an unimportant outcome, of course: at least, when taken on its own terms. On the other hand, its immediate effect in helping to stabilise an economy in systemic crisis may have initially served to obscure that BR+QE can be inherently inadequate to secure sustainable recovery when interest rates remain at their ELB for a prolonged period. The UK economy appears to be in a near-comatose state, where fitful recovery alternates with stagnation. MP appears to have become the economy’s ‘life-support’, which, if reversed, could tip it back into prolonged recession or worse.
This lends support to the growing body of informed opinion that the current macro-economic policy framework has been overtaken by events, and that it requires strategic reform if the economy is to provide the future growth, incomes and public resources that its population expects and will demand.
The centre-left leaning think-tank, the Institute of Public Policy Research (IPPR) in March published Just About Managing Demand. This proposed comprehensive reform to the BoE mandate, including raising the inflation target by up to two per cent to allow the economy to ‘adjust permanently to a higher rate of inflation’, which would then allow interest rates to settle at a higher resting point, giving greater space for a rate cut to be made in response to a future recession. The fiscal rules would also be changed allowing fiscal policy to be used as primary activist policy lever in place of the ‘uncertain and unreliable QE’ to restore and protect levels of aggregate demand when interest rates are at their ELB, and where ‘government fiscal policy is believed to be overly restrictive’. The independent remit of the BoE would be further extended to allow the MPC measured against its medium-term inflation mandate to decide when such a stimulus was necessary and its quantification. The BoE would also gain an added power to ‘delegate’ that economic stimulus to a new National Investment Bank (NIB) in effect, linking it the introduction of a more interventionist industrial policy.
Other more market-oriented economists, including ex-members of the Monetary Policy Committee (MPC), such as Andrew Sentance, argue that weaning the economy off the addictive, artificial and harmful prop of abnormal and ultra-low interest rates, requires that they should rise and QE be unwound. Capital could then gravitate and be allocated to where it could secure the best return; the historical process of ‘creative destruction’ could then re-exert itself. Zombie companies, such as many high street retailers, would exit the market, releasing resources to the growth sectors of the future, capable of creating the new sustainable jobs that could replace the zombie ones extinquished.
The BoE faces a MP policy double bind, where interest rates need to rise to provide it with some reserve power to respond to a future recession or shock, but given the reliance of the UK economy on debt-financed consumption and high and rising house prices – at least in London and the South-East – and the current context of Brexit uncertainty, such rises could risk precipitating a downturn turning stagnation into actual recession that may or may not be followed by either depression or by a new process of creative destruction and rejuvenation; or rather, by much the same. Who knows?
The macro-economic framework is in a state of limbo, therefore, where the BoE is unable to achieve its remit in an economically, socially, and, thus over time, a politically acceptable way, but alternatives are stillborn. Something sooner or later will need to give.