Yesterday the Bank of England (BoE) announced it was going to start printing money again (£50bn) in order to kick start the UK economy. Such drastic action will invariably affect mortgage rates, pensions, investments and value of the pound in your pocket.
So what is Quantitative Easing and how does it work?
In layman’s terms it is akin to the BoE turning on the money printing presses to flood the economy with new money backed by absolutely nothing (the gold standard is just a distant memory these days). With all this spare cash floating around the aim is to kick start the economy.
However, the reality is slightly different. The BoE doesn’t actually print money but instead buys swathes of assets, in this case government loans (aka gilts), from institutional investors with ‘new money’ created electronically. The effect is to drive up gilt prices due to the increased demand (and therefore drive down gilt yields – remember when gilt prices go up the yield goes down and vice versa). Banks selling these gilts will find themselves with bucket loads of cash earning next to nothing on deposit as the BoE has previously cut short term interest rates to next to nothing.
The theory is that banks will be encouraged to start lending more money to businesses and consumers who in turn will spend their new borrowed riches in the economy and get the wheels of the UK economy moving again.
Secondly, by driving down gilt yields the cost of borrowing should be driven down for banks and therefore borrowers. Cheap credit encourages people to borrower more and spend rather than save money and pay off debt. The former drives the economy while the latter slows it down.
So how will the QE2 affect me?
- Final Salary Pensions - The potential return achievable on gilts will now likely fall in tandem with gilt yields, gilts being the investment cornerstone for defined benefit schemes to match future liabilities. If investment returns are hit then schemes may fall into funding deficit.
- Annuity Rates - are based on long-term gilt yields. So when gilt rates fall so do annuity rates. So that means people nearing retirement will receive less income than they would have when they buy an annuity with their defined contribution pension pot (i.e. a personal pension plan)
- Investments - While risk assets (such as equities) rallied after previous QE efforts both here and in the US, markets have been pricing in the possibility of more QE in the UK for some time, although the timing of its implementation was uncertain. This bout of QE is smaller than previous efforts (£200bn in 2009 and another £75bn in October 2011) so its impact on investment markets will be dampened. Besides a lot of the previous (QE driven) equity and commodity gains were as a result of QE programmes in the US, so don’t expect to see equity markets shooting the lights out just because the bank of England have hit the panic button. But obviously current holders of 10 year gilts will benefit from price rises as a result of more QE. On the flip side gilt yields will fall meaning the income return on gilts will fall.
- Mortgages - most mortgage rates are based on short to medium term borrowing rates. So more QE is unlikely to impact your monthly mortgage repayments. But the application of more QE does suggest that the bank base rate will remain at 0.5% for the foreseeable future – which is good news for mortgage holders on variable/tracker rates.
- Savings - as the bank base rate and therefore savings rates are likely remain low for some time while inflation remains elevated savers will see the real value of their money deteriorate further.
- Sterling - quite simply, pushing more money into the economy makes the value of the pound in your pocket worth less. If this becomes reflected in currency exchange rates then your holiday spending money will get a bit more expensive. But exchange rates are influenced by a number of factors.
- Borrowing - the theory is that we should see signs of increased lending activity to businesses and consumers, as the cost of borrowing should fall. However, don’t hold your breath on this as if history is to repeat itself then increased lending may not materialise to the extent policy-makers are anticipating.