End of Economic Stimulus?

After the recession in 2007, the world’s central banks used a variety of measures to stimulate economic growth. How do these measures work?

After the recession that followed the financial crisis in 2007, the world’s central banks used a variety of measures to try to stimulate economic growth, with varying degrees of success. These included quantitative easing (QE), the lowering of interest rates and combinations of the two. But how do these measures work?

Low interest rates are intended to encourage individuals and companies to borrow money. The premise is that when more cash is available, they are more likely to spend it on goods and services than to save it. This in turn, boosts the economy.

Central bankers also need to control inflation (the rate at which the prices of goods and services increase). Inflation that is too low can lead to a stagnant economy as everyone knows that prices are falling, so they wait for them to continue falling before spending money. If prices are rising too quickly, then wages have to be hiked rapidly to keep pace with higher prices. The Winter of Discontent in the late 1970s demonstrated the negative consequences of rampant inflation.

Central bankers can raise or lower interest rates to manage inflation, but it is a delicate balance in which the effects of interest rate changes tend to take around six months before their effects can be seen in the rise or fall of prices.

Since 2007, central banks in Japan, the UK, the US and the Eurozone have reduced interest rates and deployed QE in order to stimulate growth and provide sufficient cash for lending and investment to continue.

Now that much of the bad debt and economic contraction have been reversed, the stimulus measures are being wound down and reversed.

Changes in Europe

In June, the European Central Bank (ECB) announced that its QE programme would conclude in December 2018. The ECB has had a unique set of challenges to deal with. Economic growth has been variable across the Eurozone, recovering quickly in countries like Germany, but taking much longer elsewhere. Currently, the ECB is still buying assets worth around €30bn each month, but this will reduce before stopping completely in December 2018. Meanwhile, the ECB plans to keep underlying interest rates at zero for some time, stating its intention to leave them on hold “at least through the summer of 2019”.

Global stimulus reduction

US economic growth has recovered more quickly than in other countries, reaching 2.3% in 2017. The Federal Reserve (Fed) bought assets worth $4.5tn over six years, ending monthly purchases in October 2014. More recently, it has been able to raise interest rates slowly from record lows. The most recent increase took place in June and left the main underlying rate at 2%. The Fed expects to lift it twice more before the end of 2018.

Meanwhile, the Bank of England (BoE) is yet to pull the plug on its QE programme and is still buying bonds every month. To date, it has spent nearly £500bn buying assets, the equivalent of around one sixth of the entire UK’s annual economic output. The BoE has, however, started returning UK interest rates to more normal levels. In November last year, it raised underlying interest rates for the first time in a decade, leaving the main UK rate at 0.5%. However, this was more a reaction to rising inflation than to strong economic growth. At the end of 2017, UK inflation hit a five-year high, breaching the BoE’s target level of 2%. Prices were driven up by higher import costs because sterling declined in value against the currencies of many of the UK’s trading partners after the country voted to leave the European Union.

Unlike the UK, Japan has been struggling with little or no inflation for many years. This is partly because Japanese people prefer to save rather than spend. Nevertheless, Japan also endured a recession after the financial crisis, so the Bank of Japan (BoJ) was left with the problem having to stimulate both economic growth and inflation. It embarked on a huge QE scheme accounting for the purchase of assets worth around ¥537tn (about £3.6tn). It has also introduced negative underlying interest rates, meaning that commercial banks receive a small interest payment on money that they borrow from the BoJ. The BoJ’s governor has said it will “keep expanding the monetary base until inflation is above 2%”. Currently, Japanese prices are increasing at a modest annual rate of around 0.7%, though there is increasing speculation that this could increase over time as the country’s ageing population leaves fewer people working and saving.

Implications of less stimulus

The US is leading the process of reversing its QE programme by selling some of the bonds that it accumulated. The central banks in London and Strasbourg are winding down their stimulus programmes as they seek to reduce interest rates and bring asset purchasing to a close. Chronically low inflation levels mean that Japan is a little way behind this and has yet to reduce stimulus. But the general trend is clearly one of less economic stimulus, and that has implications for investors.

Rising interest rates can make bonds less attractive as the regular annual coupon payments that they provide are usually fixed. By contrast, a savings deposit account can increase interest payments as underlying interest rates rise, which could attract some investors out of bonds. Lower demand for bonds means lower bond prices. Those bonds with a long maturity date (long duration) would be most at risk, because interest rates are more likely to change substantially over the longer term than in the short term. So the overall market value of a bond portfolio could be reduced as interest rates rise. However, this is less important to investors whose strategy was to buy bonds and hold them until they mature as they are less affected by changing market values. For other investors, the need to include a variety of bonds perhaps with different remaining lifespans or different issuers (companies or governments) could become increasingly important.

Meanwhile, as the amount of cash circulating in the broad financial system is reduced, economic growth might become harder to sustain. And if companies struggle to maintain robust profits, share prices could fall. This will depend in part on how quickly inflation and interest rates rise. Once again, there is considerable pressure on central banks to make the right decisions before inflation gets out of control but without stifling growth.

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