Principal Investment Management

Quantitative easing - the impact on savers and borrowers - November 2011

02/11/11

Many investors were caught off guard by the timing and scale of the Bank of England's announcement of a second round of Quantitative Easing (QE) in the UK. While consensus grew over the summer that the deterioration of the global economy would lead to the Monetary Policy Committee (MPC) creating more money to stimulate the economy, many people expected them to wait at least another month before announcing it, and most expected a maximum of £50bn to be created, rather than the £75bn announced.

With markets still adjusting to the announcement, it seems an opportune moment to look at the impact of QE on consumers and borrowers. Some of the impacts are obvious; some more subtle; and some are downright insidious for savers and pensioners.

The amount of money involved in QE is large by any standards. The Bank of England has already created £200bn in the previous programme; bringing the overall total to £275bn, compared to the UK's annual Gross Domestic Product (GDP) of about £1,400bn and total government debt of £940bn. Common sense dictates that the release of so much money must have a material impact on the UK economy, and many people have asked us, specifically, what impact this will have on inflation and growth. From our perspective there are other considerations which are at least as important, the effect on: asset prices, the behaviour of banks and on pensions. It actually has a more profound impact on investors in both the short and the longer term than is immediately obvious, and certainly benefits borrowers at the expense of savers.

The impact on inflation cannot be quantified in a simple linear correlation between the amount of money created and the rise in the Consumer Price Index (CPI) or Retail Price Index (RPI). It is just not possible to draw a straight line which reliably shows the extent to which increasing what economists call the 'monetary base' increases inflation, or even the time in which it will happen. That is, above all, because the impact depends on what the banks and pension funds do with the cash that they receive in return for the gilts or other assets that the Bank buys.

When QE was tried in Japan in the 1990s, it actually had a pretty negligible impact on loosening deflation's grip, as undercapitalised banks simply hoarded the cash gratefully on their balance sheets. On the other hand, it does seem clear that the most recent programmes have had a material impact on commodity prices, perhaps more from the QE in the US than in the UK. Inflation in the UK is certainly higher than it would have been without QE, although the relative impact of the UK programme, and the much bigger (just over $2,000bn) US programme, cannot be clearly established.

The Bank of England's own research concluded that inflation is about 1.5% higher than it would have been without its own QE, and that GDP was increased by about 2%. Part of this is, of course, the result of the devaluation of sterling, as foreign currency speculators reacted to the increased monetary base and the evident change in the Bank of England's commitment to fighting short-term inflation. However, those numbers are essentially an educated guess and it is even more uncertain that the second programme will have the same proportionate impact on either inflation or GDP growth. The economy is sensitive to many effects, in particular: the less buoyant the broad international economy, the less impact new stimulus is likely to have. It also seems that the more that debt builds up, the more money is needed to have the same impact.

But there are undoubtedly other effects which have a more direct impact on many savers than just cutting the real purchasing power of their money, or the value of their pound abroad. Because QE involves introducing a new, artificial (but substantial) buyer of specific assets, it has a marked impact on the prices of those assets. Gilts are most affected as they are the chief object of the Bank of England's fancy - indeed the Bank of England could end up owning almost a quarter of outstanding Government debt. There is then an inevitable knock-on effect on other assets that are priced off that 'risk free' rate.

This particularly affects those saving for and purchasing pensions - most pressingly those that are buying annuities, but also those seeking ongoing returns from bonds and many other assets. Annuity rates are already at all time lows, and falling gilt yields have a direct impact on annuities. It is often said that a 1% fall in gilt yields cuts annuity rates by one-tenth, although the impact of the last round of QE was a little less severe - a 1.18% fall in gilt yields led to an 8.6% reduction in annuity values. But that still means that the capital needed to buy a £40,000 pension before QE will now produce only £36,500 - an extremely significant impact on the quality of life for the recipient.

The impact for savers is less drastic, but cash yields are negligible and longer term fixed deposits are essentially priced off gilt yields. So even those that are willing to tie up cash for long periods in the search for a return will find it more difficult to obtain a decent yield. For investors with long-term, diversified portfolios the problem is less acute, with corporate bond yields, as well as gilt yields, artificially depressed. Those that are used to pension projections based on annual returns of, say, 7% need to be aware that this may now only be achieved by taking much more risk than they may wish to take. Although, QE does tend to benefit share prices in the short term, as it aids the economy - however, there is no substantive evidence that the long-term effect of QE is beneficial to share prices.

It is, however, likely to have a clear long-term benefit for long term borrowers, especially mortgage holders, quite apart from the obvious point, that higher inflation reduces the real value of their debt. As banks are the chief recipients of the Bank of England's largesse, QE is likely to free up some capital for mortgage provision, and the fall in gilt yields mentioned above will certainly make it possible for all to borrow at abnormally low rates for longer than otherwise would have been the case. That is not to say that the days of 95% mortgage provision of six times salary are about to return, but 'QE1' did have a noticeable effect on mortgage availability and 'QE2' will be no different.

In summary, QE on the scale proposed by the MPC will have a real effect on the economy in the short-term, but the impact for investors goes beyond merely increasing both GDP and the rate of inflation. In the short term it is likely to be beneficial to share prices and certainly raises gilt prices, but beyond that immediate stimulus it materially disadvantages long-term savers and benefits borrowers.

Important information

Investing involves risk. The value of investments, and the income from them, may fall as well as rise and is not guaranteed. Investors may not get back the original amount invested.

The views expressed above are based on information which we believe to be reliable, but are not guaranteed as to accuracy or completeness by Principal, and any expressions of opinion are subject to change without notice. This article is for information purposes and should not be treated as advice to buy or sell any particular investment.