Tuesday, February 28, 2012

Charlie Bean Strikes Again - The Impact of Rock-Bottom Interest Rates

England's famous Mr. Bean (not THAT Mr. Bean although sometimes one wonders), Deputy Governor of the Bank of England, has once again, opened his oral orifice and waxed philosophical about the state of the economy. Recently, he gave a speech to the Scottish Council for Development and Industry in which he pontificated about the Bank of England's program of quantitative easing and how what an unmitigated success it has been, in fact, it has been so successful that the Bank has had to implement the third attempt at prodding the United Kingdom economy back to life.

In its most recent meeting, the Bank of England voted to make a further £50 billion purchase of gilts, the sovereign bonds issued by the British government.  Once this purchase is complete, the Bank will own £325 billion worth of gilts, roughly a third of the entire stock of UK government debt of £1033 billion or one fifth of the annual economic output of the United Kingdom.  Basically, the Bank of England is now the major shareholder in the debt owed by the British government; for your information, all overseas gilt holders only held 30.7 percent of all gilts at the end of the third quarter of 2011, less than what is owned by the Bank of England.

After all of this fun and games, this is what has happened to the balance sheet of the Bank since 2007:


Prior to the Great Implosion, the Bank's assets totalled £85.213 billion at the beginning of 2007; this has risen to £313.518 billion in February 2012, an increase of 247 percent over five years.

The Bank of England began its program of QE back in March of 2009 by purchasing £200 billion worth of gilts from pension funds and insurance companies; at that time, the bank rate was as low as it could go as shown on this graph:


On top of that, the country's GDP was shrinking at a record rate as shown here:


Basically, the Bank of England was out of ammunition and was seeking any means that would push consumers back to their spending ways, banks back to loaning to consumers and businesses and corporations back to expanding employment and making capital investments.

By purchasing gilts, the Bank increases the demand for these bonds resulting in a rise in prices and a drop in yield since the two factors work in opposition.  By pushing yields down, the Bank suggests that other investors will sell their stock of gilts because they are paying nothing and purchase corporate bonds and equities as replacements.  This is supposed to boost the value of people's wealth and will result in more spending.

But, did it work?

Charlie goes on to say the following:

"Our analysis of the first phase of quantitative easing suggests bond yields were around one percentage point lower than they would otherwise have been. And UK equity prices rose 50% during the programme, though only a small part of that is likely to be down to quantitative easing. That made it cheaper for companies to access finance through the capital markets and issuance was indeed strong during 2009. But the ultimate aim was to sustain demand. Though we cannot be sure what would have happened in the absence of our asset purchases, our internal work suggests that the first phase of quantitative easing boosted the level of activity by around 11⁄2-2%." (my bold)

Notice Mr. Bean's use of qualifiers including "suggests", "around" and "though we cannot be sure"?  Hardly a ringing endorsement of quantitative easing, is it?  Basically, the increases in the price of equities was likely due to outside factors; the oversold condition of the market as the economy tanked among other factors.  As well, a one percentage point drop in bond yields may also be a statistical blip; there are many market factors outside of central bank policy that impact bond yields, just ask Greece, Portugal, Spain and Italy!

Mr. Bean continues to explain that, although the first round of QE was not exactly a resounding success, the Bank of England has now decided to implement two additional bond purchases, largely because recent economic growth was modest at best as shown here:


Isn't it interesting to see that, even if the effects of the first round of QE were basically unquantifiable, the Bank of England still persists with its experiment?  Certainly, economic growth rose in the first half of 2010 but fell sharply to very low levels by late 2010, indicating that any impact of QE on the United Kingdom economy was very short-lived.

Enough of that.  Let's move on to how all of this impacts U.K. pensioners, a topic that Mr. Bean seems particularly fond of as shown in this speech from September of 2010.

As the Bank's asset purchases pushed interest rates down, the yield on annuities has dropped by about one percentage point.  A pension pot of £100,000 would have yielded about £7000 annually three years ago; this has dropped to about £6000, a decline of 14.3 percent.  Mr. Bean notes that "...that is a rather substantial income loss.".  But the "glass is half full" central banker goes on to note that the pension funds will most likely have invested in a mixture of bonds and equities; the rise in the value of these bonds and equities as a result of QE will have raised the value of the annuity, providing an offset for the loss in income due to lower interest rates.  Magic, right?  That is, as long as the managers of those annuities pick the right equities and bonds and buy and sell them at the right time.  He neglects to add that the risk involved in equity investment in a desperate attempt to increase yield is also far higher and that capital losses are not uncommon. 

What's not so wonderful is the impact of near zero interest rates on senior savers who have invested their life savings in savings accounts or other bank-issued deposits.  Savers like these are now seeing negative real returns (after inflation) on their investments.  Here's what Mr. Bean has to say about that:

"More generally, the current extended period of rock-bottom interest rates has impacted heavily on those holding most of their savings in deposit or short-term savings accounts, who have seen negative real returns. Savers have every right to feel aggrieved at losing out; after all, they did nothing to cause the financial crisis. But neither did most of those in work, who have also seen a substantial squeeze in their real incomes. And unemployment, particularly among the young, has risen as output has fallen. This is all a reflection of the hit to output from the financial crisis. Output is still some 4% below its previous peak and more than 10% below where it would have been if the economy had simply continued growing at its pre-crisis historical trend. There have been few winners over the past few years." (my bold)

Apparently, misery really does love company!  And, apparently, the Bank of England's policy has led to neither a return to reasonable economic growth and employment prospects for young adults.  Way to succeed!  Yes indeed, there have been few winners, despite the Bank's acquisition of £325 billion in bonds.

A study by the American Institute for Economic Research actually shows that this decreased investment income has a rather profound impact on economic growth.  As I posted here, in the United States, every one percentage point decrease in yields results in a $75 billion drop in consumption or 0.51 percent of GDP.  It also results in a loss of 715,000 jobs.  While the U.K. economy is smaller than the United States, the drop in interest rates on investments would likely have a proportional impact on economic growth, a factor that Mr. Bean seems to completely ignore.

Mr. Bean has proven himself to be rather unconcerned about the plight of retirees in the United Kingdom.  His comment that everyone, including the employed who have not seen raises and the young that are experiencing record high levels of unemployment, is suffering through this "soft patch".  That is, everyone excluding those at the top of the heap at the Bank of England as shown here:


Just in case you wondered if Mr. Bean's pension would make it difficult for him to make ends meet once he retires, here is a look at his pension entitlements:


Something tells me that he won't be struggling to make ends meet.

I find Mr. Bean's entire analysis wanting.  He provides little evidence that the third round of QE is going to improve upon the very modest impact that rounds one and two had on the economy, in fact, he admitted that "...there were few winners in the past few years".  As well, his rather dismissive attitude toward the plight of senior savers and retirees is appalling, however, I guess when your personal compensation package is in the top one percent of the wages earned by your fellow citizens and you have a hefty and secure pension, you can afford to be more than a bit smug about the impact of your decisions on your fellow countrymen and women.



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