Like John Ralfe, the pensions consultant well known to these pages, I was sufficiently struck by the Bank of England’s claims about the impact of quantitative easing to take a deeper look at their calculations, and in particular at their estimates of how the first two rounds of QE have affected the performance of the stock market. Given the attention that is currently been given to the next moves by the Federal Reserve and the issue of whether the European Central Bank is going to join in the QE business more wholeheartedly than it has done in the past, the subject could hardly be more topical.
That QE has helped to prop up the stock market is widely believed and evidently true, to some extent. But how important an influence has it really been over equity prices? The figures in the Bank of England submission to the Treasury Select Committee are certainly striking. QE1, the paper suggests, was responsible for raising equity prices by 20% and QE2, the paper assumes, lifted share prices by a further 12.5%. Bond yields were 1% lower as a result of QE1 and 0.6% lower during QE2.
In aggregate, the paper calculates, the cumulative £325 billion of QE the Bank has so far engaged in has produced a £600 billion increase in household wealth in the UK thanks to rising asset prices, a near 100% payoff for less than two years of keyboard stroking at the Bank’s computerised dealing desk. “Nice work if you can get it” seems to be the obvious first reaction.
The figures in the Bank paper raise some questions however. Can such a simple mechanism really be responsible for such a dramatic movement in equity prices? And secondly, if QE is so effective at increasing household wealth, should not we be taking more of the medicine – why not, in fact, make it a permanent policy instrument? In practice we all know that QE is a dangerously addictive policy whose use can only be justified at times of deep economic crisis, to stave off potential deflation.
At the very least the Bank’s figures surely deserve further independent scrutiny. One obvious caveat is that the figures may not, in practice, be right. If you go back to the original Bank paper on which the estimates are based, the authors honestly acknowledge that the estimates are “subject to considerable uncertainty”. Counterfactual history is always difficult to corroborate and the data set for QE is by definition both too recent and too short to allow definitive conclusions.
The Bank is effectively claiming that QE was the single biggest factor in the equity market’s recovery from March 2009. From an actuarial perspective it is surely open to question whether a temporary decline in long term yields, if induced by market manipulation, is really a sufficient ground for marking up the value of a competing asset class whose value derives from its long term earning power, as the Bank figures imply.
A second reason for caution is that the effects of QE on the real economy appear to be far more limited than they are effective in changing the psychology of professional investors. And of course the effects of QE are also transitory and finite: with the Bank of England already owning more than 40% of the UK government bond market, there is clearly a limit to how often the trick can be repeated. The Bank itself admits that the policy has costs as well as benefit, not all of them easy to track. (The paper incidentally states categorically that the Bank never expected its gilts purchases to stimulate bank lending, as many still seem to think it was designed to do).
QE in the UK has, they estimate, kept GDP 1% above where it would otherwise have been, but at a cost of keeping inflation higher by between 0.75% and 1.5%. It has also, palpably, produced a palpable loss of liquidity in the country’s sovereign debt market, with as yet unknown longer term consequences. You don’t have to be a fully paid up member of the Austrian school to believe that the long term costs of distorting price signals in the bond market may turn out to be very high, and by inducing the misallocation of capital ultimately potentially every bit as damaging as the short term benefits are positive. QE is a path that leads eventually to zombie banks, zombie property companies and zombie businesses.
What cannot be denied is that it seems to have become an article faith among investors that QE will boost stocks and commodities, at least in the short run. As long as that belief persists, the harder it will be for policymakers to resist using it again. These days, as the ECB’s president Mario Draghi has demonstrated in the last month, it is not always even necessary to implement monetary stimulus to achieve an effect. Merely hinting at it seems often to be enough to produce a Pavlovian reaction.
Even if it turns out to be a placebo rather than a potent drug, QE is certainly addictive and you can’t be surprised if central bankers continue to dole out the medicine as long as the patients keep asking for it. The potential impact is diminishing with use, however, and the financial markets are surely right to harbour a growing suspicion that the effects are in reality something of an illusion – helpful in the short term, but damaging in the longer term.
Jonathan Davis 