EDITOR'S LETTERCris Sholto Heaton
Well, that was quick. Last Tuesday, on only its second day, the Bank of England’s latest quantitative easing (QE) programme hit a snag. The plan was to hoover up £1.17bn of long-dated gilts. Unfortunately, not enough bondholders wanted to sell. The bank was offered just £1.12bn worth – even though it was prepared to pay prices significantly above market levels.
So what’s the problem? These investors – pension funds and insurance companies – are desperate for the yield on those bonds. They are really keen on long-dated paper because it helps them to match their income streams to their long-term liabilities. They could, in principle, sell the bonds and book a capital gain, but then they would be forced to reinvest that money at historically low, and consistently falling, interest rates and bond yields. They worry that if they do that, they will end up with too little money to cover their future payouts.
In other words, the latest QE programme has run into difficulty because of a problem caused by… QE. The low interest-rate environment, of course, is a result of previous purchases of bonds with printed money. The Bank of England bought £435bn of bonds, around 15% of GDP, in the years after the crisis. The US Fed did three rounds of QE, while the Bank of Japan has pressed the pedal to the metal. Its QE is worth 80% of GDP.
Tuesday’s hiccup is just a microcosm of how central banks have trapped developed economies in a vicious circle. Ever since the 1980s, central banks led by the US Fed have tended to respond to every wobble in the economy and market by showering both with liquidity. Cutting interest rates, however, simply blew up a series of bubbles. When they burst, policymakers would inflate another one to avoid a nasty downturn. We have gone from tech bubble to credit bubble to post-credit crunch bubble. So much for the received wisdom that central bankers were clever enough to abolish the boom-and-bust cycle.
Now look where we are. The negative side-effects of QE, the next step once interest-rates reach zero, easily eclipse any benefit it may once have provided in cushioning the downturn.
It’s not just that rates are so low investors are being forced to chase risk, blowing up bubbles in markets. Lousy banks and companies are being kept alive, preventing capital being allocated to promising new ventures. Long-term growth and productivity will dwindle, no doubt prompting yet more central bank activism.
Where will it end? We could see helicopter money and a sharp jump in inflation, which will at least finally raise interest rates, but implies a nasty crash in bonds. Inflation jitters are one key reason to hold gold, but another is more basic and has been highlighted once again by this week’s events. More and more investors may soon come to realise that not only do central banks not have a plan – they don’t have a clue.