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Is Quantitative Easing leading to tighter monetary conditions in the United Kingdom?

Summary

  • Quantitative Easing (QE) is generally understood to work primarily via the 'portfolio balance effect', i.e. it boosts asset prices, and thus pushes down yields.
  • However, the literature on the impact of QE is curiously silent on the assumptions regarding the term structure of the private sector balance sheet upon which the portfolio balance effect is implicitly dependent.
  • In the US, the portfolio balance effect can be understood to be economically positive, if politically divisive.
  • In the UK, it is unclear whether the portfolio balance effect brings positive economic dividends, given that the corporate sector has held against it the present value of defined benefit pension liabilities, which are effectively marked-to-market using market rates that have been driven down by QE.
  • Conventional measures of understanding the monetary conditions attached to bond market yields may need to be reassessed to take account of the term structure of the private sector balance sheet.

Chancellor George Osborne indicated in the 5 December Autumn Statement that the way in which the value of companies' defined benefit pension assets and liabilities is assessed will be open to review.  This will no doubt be seized upon by the Chancellor's critics as yet another example of his tinkering with accountancy measures, after he has failed to deliver on either economic growth or hit debt reduction targets. But it would be folly to miss the importance of the announcement, given that it addresses a key deficiency in the transmission mechanism of the current unorthodox monetary policy. This deficiency reflects the absence of the notion that the term structure of the private sector balance sheet (in the conceptual framework by which QE is judged) of a means to provide an easing in monetary conditions.

The literature that explains the case for QE rests almost entirely on what is called 'the portfolio balance effect'. This is true in both the UK and the US.[1] Put simply, the portfolio balance effect is the idea that as central banks buy a large number of assets, the price of these assets is pushed up. The sellers of these assets subsequently deploy the proceeds of these sales into other assets, thus pushing up other asset prices. This process helps the economy by: a) increasing total monetary wealth and; b) lowering the cost of new fixed rate and existing floating rate borrowing. Consequently, debts are easier to service and people and companies are more likely to spend and less likely to save.

In the United States, this framework for understanding the policy (as a means of delivering an easier monetary environment) sounds intellectually coherent. QE, as a result of the portfolio balance effect, results in higher asset prices and lower bond yields. The resulting lower bond yields are a determining factor in the setting of corporate and household borrowing rates. The reason why this is the case is partly due to the level of disintermediation of the banking system (thus, a large amount of corporate borrowing is done on a long-term basis), and partly due to the structure of the US mortgage market. US households borrow at long-term fixed rates, and have the option to refinance at a lower rate, if long-dated mortgage rates fall (due to a rally in the bond market). Consequently, in addition to any wealth gains associated with assets rising in value due to the portfolio balance effect, there are important benefits that impact across the economy when long-dated bond yields fall.

In the United States, as a result, QE has been labelled as 'monetary policy for rich people', an accusation not without foundation. After all, QE most directly benefits two groups: those who are invested in assets (proportionately to the size of their assets), and; those who are sufficiently creditworthy to effect new borrowings or refinance old borrowings (proportionately to the size of those borrowings). The hope is that in helping these people, new investments and risk-taking will be encouraged, leading to the creation of jobs for those not directly benefitting from asset inflation.

In the United Kingdom, the framework for understanding QE as a means of delivering an easier monetary environment is more open to question. The portfolio balance effect increases asset prices and reduces bond yields, but it is not clear whether a fall in long-dated bond yields serves to loosen monetary conditions. This is because the UK corporate sector has a large legacy defined benefit pension book, the liabilities of which have a high duration, and the mismatch between liabilities (high) and assets (low) actually means that the overall corporate sector is in a position whereby it seems effectively to be short rather than long in terms of financial assets. Consequently, a policy which is designed to boost asset prices may actually have negative implications.[2] Before turning our attention to this possible outcome, we should consider the way in which falling long-dated yields might have helped to lower private sector borrowing costs.

Lower long-dated yields do have positive implications for some companies. If we look at issuance patterns since the end of 2008, for example, we can see use has been made of the lower yields that QE has delivered. Chart 1 shows cumulative total issuance in the sterling non-financial corporate bond market divided into different maturity buckets. It shows that more than half of the over £110bn of borrowing that has occurred in the bond market, has taken place with a term of over 15 years. However, only very large companies can access the bond market. The scale of this new borrowing in the context of the overall stock of outstanding borrowings, as shown in chart 2, is small.[3]

Chart 2 illustrates the term structure of UK non-financial private sector borrowing, and places in context the size of fixed-rate corporate bond borrowing versus intermediated credit - which we have assumed is made overwhelmingly on a floating rate basis or on fixed rates that are adjusted every five years or less. Using this assumption, chart 2 shows that in reducing the Bank of England Base Rate, and removing financial stress from the system (thus removing barriers to banks serving as credit intermediaries), the Bank of England would have achieved a meaningful and direct easing of monetary conditions for the overwhelming majority of borrowers. By purchasing gilts with maturities up to ten years to execute QE, monetary conditions have arguably been eased further than would otherwise have been the case. But it is not clear that buying gilts with longer maturities might have eased monetary conditions, and in the next section we will see how falling long-dated yields may actually be associated with tighter monetary conditions.

 

Chart 1: Non-financial Sterling corporate issuance December 31 2008 - September 30 2012, by maturity bucket

Chart 2: Term structure of UK private sector borrowing, October 2012[4]

quantitative_easing_1

Source: Morgan Stanley Research; Bank of America Merrill Lynch, Bank of England, December 2012

At a time when policy aims to inflate asset prices, being short assets is a bad position in which to be. Each month, the Pension Protection Fund (PPF) publishes what it calls its s179 valuation report. This report shows one measure of the estimated assets and liabilities of the UK's defined benefit pension book. It also shows the deficit on a monthly basis. Using this data we can see that pension assets have increased by 38% in value since the depths of March 2009, but - as shown in chart 3 below - the present value of liabilities have increased by an even greater measure. This is primarily because long-dated bond yields are used to discount the present value of those pension liabilities, and these yields have been driven lower by QE. Similarly, the accounting standards FRS17 and IAS19 use long-dated, high quality bond yields to calculate the present value of pension liabilities in company accounts. The collapse of corporate bond yields that is associated with QE in the UK (according to various studies by the Bank of England, the Federal Reserve, and independent academic studies) has served to raise the present value of pension liabilities and so increase company pension deficits as reported in company accounts. Chart 4 compares the over-15 year, AA-rated corporate bond yield with the PPF's measure of defined benefit pension liabilities. It can be seen that they are meaningfully linked. Importantly, the degree to which liabilities have increased is greater than the degree to which asset values have increased. Moreover, while there may be other factors other than QE, which are driving down yields, the aggregate pension deficit as calculated by the PPF sits near record levels, and QE has not helped this situation.

Chart 3: PPF's s179 measure of defined benefit assets, liabilities and balance

Chart 4: PPF's s179 measure of defined benefit liabilities and over 15yr AA-rated sterling bond yields

 quantitative_easing_2

 

Source: PPF ( http://www.pensionprotectionfund.org.uk/DocumentLibrary/Documents/PPF_7800_underlying_data.pdf), Bank of America Merrill Lynch, December 2012.

If we look at the defined benefit pension liability from an accounting perspective, we can understand it as analogous to the cumulative short position that UK PLC has accumulated in long-dated bonds. And - crucially - there is an annual mark-to-market and associated cash-call made on defined benefit schemes by the PPF to compensate for the very real and present risk of default among its insured members. The pensions and investment consultant LCP calculates that FTSE100 companies alone have diverted around £10bn a year into their pension funds in each of over the last three years in an effort to keep these deficits stable. LCP also calculates that the sensitivity of the present value of FTSE100 company defined benefit pension scheme liabilities to a 1 basis point fall in high quality long-dated yields amounts to -£800 million.[5] The economy-wide sensitivity of pension fund liabilities to falling long-dated yields will be somewhat higher than this.

The Bank of England associates a net positive impact on GDP associated with QE of between 1.5% and 2% relative to what otherwise might have happened.[6] We would accept that lower yields for bonds with maturities up to ten-years are associated with easier monetary conditions. But the Bank does not publish its assumptions regarding any positive economic or net wealth impact that they attach to reductions in long-dated bond yields, and the academic literature is curiously silent on the matter. It is not unreasonable to question whether the positive impact of lower long-dated yields is somewhat smaller than the negative impact recorded by defined benefit pension schemes. If this is true then the case that lower long-dated yields correspond to a net tightening of financial conditions (and thus the case for the Bank of England's Asset Purchase Facility buying long-dated gilts) would be undermined, to say the least.

Conclusion:

This leads us to an interesting and counter-intuitive conclusion.

  • In the United States, falling long-dated bond yields are associated with an easing in monetary conditions. Given the term structure of the US balance sheet, there is good reason to believe that this conventional wisdom is correct.
  • However, given the term structure of the private sector balance sheet in the UK, whereby companies and household borrowing is overwhelmingly skewed to either floating rate debt or 0-10yr fixed rate debt, and companies must mark their long-term pension obligations to market on an annual basis for the purposes of the Pensions Regulator assessing scheme viability and PPF scheme levies, it is more than feasible that monetary conditions are loosest when short-term bond yields are low, but long-term bond yields are high. This insight flies against the conventional and accepted understanding of how monetary conditions should be assessed, and leads to the conclusion that Bank of England purchases of long-dated bonds that depress their yields might serve to tighten rather than loosen monetary conditions.
  • The Chancellor's move to potentially change the way in which pension scheme viability is assessed may go some way to remove monetary tightening that we believe has been delivered as a result of the confluence of a regulatory environment for pension funds that effectively marks-to-market the present value of their liabilities. But this does introduce new risks for taxpayers in the event that the solvency of PPF is at some point in the future threatened, and political calculations force the taxpayer to come to its rescue.

Toby Nangle,

Head of Multi-Asset, Threadneedle Investments

6th December 2012


[1] See the canonical texts that assess impacts of quantitative easing in the UK (Joyce, Lasaosa, Steven, & Tong 'The Financial Market Impact of Quantitative Easing in the United Kingdom', International Journal of Central Banking, September 2011) and in the US (Gagnon, Raskin, Remache & Sack, 'The Financial Market Effects of the Federal Reserve's Large-Scale Asset Purchases', International Journal of Central Banking, March 2011), as well as other more recent assessments such as Joyce, Tong & Woods, 'The United Kingdom's quantitative easing policy: design, operation and impact', Bank of England Quarterly Bulletin Q3 2011, and Joyce, Miles, Scott & Vayanos, 'Quantitative easing and unconventional monetary policy - an introduction', The Economic Journal November 2012.

[2] Indeed, Charlie Bean recognised that the average pension fund had a deficit equal to 30% of total liabilities in his May 2012 speech 'Pension funds and quantitative easing'.

[3] M4 MFI net lending to the private sector is shown within the 0-5yr maturity band with the assumption that the vast majority of household and corporate borrowing will not be attached to fixed rates or will have a fixed rate term of five years or less.

[4] See note 2 above.

[5]LCP Accounting for Pensions 2012, pp17-19

[6] 'The distributional effects of asset purchases', Bank of England Quarterly Bulletin Q3 2012

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