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Time for a national inquiry into the impact of lower interest rates.

13 September 2016

  • Time for a proper national debate about the impacts of Monetary Policy
  • Government should launch an inquiry into the effects of lower interest rates

 Main points:

  1. QE was an emergency policy to stave off depression – it is a huge monetary experiment which must not be considered as ‘normal’ policymaking
  2. The latest round of rate cuts and QE may well have been a mistake – in August 2016 we were not facing economic collapse and the negative side-effects need to be considered
  3. Monetary policy may not be working as theory predicts as banks have failed to pass on lower rates to many borrowers, while savings rates have fallen sharply
  4. Credit card, overdraft and even SVR mortgage rates have RISEN over the past 5 years
  5. Lower rates and QE are supposed to be expansionary but also have deflationary effects as they reduce disposable incomes for both households and some corporates
  6. QE has damaged UK Defined Benefit pension schemes and placed higher costs on firms
  7. QE has increased annuity costs significantly which also damages Defined Contribution pension income
  8. Distributional effects of QE may have political implications as ordinary savers and renters suffer while QE helps the wealthiest, perhaps feeding public dissatisfaction

 This paper presents an alternative view of monetary policy to that which has been used by the authorities.  I suggest that monetary measures have impacts that are rather like a tightening of fiscal policy, which may offset the expected expansionary effects.  I hope you will find this of interest and that it may stimulate more detailed debate of the real impacts of the unprecedented policy experiment which is underway.  The Bank of England believes its latest rate cuts and QE expansion will boost growth.  The Governor says he is serene about its policies.  However, the full impact of the QE experiment will not be known or understood for many years, while its negative side-effects may have been underestimated.

No economic emergency:  QE was originally introduced as an emergency measure to boost growth and stave off economic collapse. However, with record employment levels and no recession (let alone depression as was feared a few years ago) it is hard to argue that interest rates in August 2016 were ‘too high’ or were stifling spending and investment.  Indeed, economic indicators have recovered somewhat, the economy is certainly not facing imminent collapse, so aggressively pushing rates lower from already exceptional levels may not be an appropriate policy.

QE is not normal:  It is worrying that this massive monetary experiment of printing money to artificially distort long-term interest rates may now be considered ‘normal’ – it is certainly not normal at all.  Indeed its effectiveness is unclear.  It may do more harm than good and if any post-Brexit economic weakness is structural, rather than cyclical, monetary easing is unlikely to help.

The combined impact of low interest rates and more QE reduces the disposable incomes of savers and pensioners.  In some respects, monetary policy is acting like a tax increase, so attempts to ‘ease’ monetary policy have effects that resemble a tightening of fiscal policy.  Soaring house prices and rising rents have reduced younger people’s spending power, while savings and pension income for older groups have been cut. In an aging population, the expected income, substitution and wealth effects may fail to work as theory predicts.  The table below is a quick summary of the relative balance of impacts.  The net effect of the Bank of England’s policies depend on the strength of each of these effects.

Reflationary impacts expected by Bank of England Deflationary effects that may offset expected expansionary impacts
As interest rates fall, net savings fall and savers are expected to spend more Lower savings income may lead savers to spend less
As borrowing costs fall, corporate borrowing for capital investment is expected to increase QE increases pension deficits, so higher company pension contributions may lower corporate investment
Lower borrowing costs for households are expected to help them afford to spend more Lower pension income may mean less spending as annuity income falls for new pensioners
As QE increases asset prices (e.g. house prices), a wealth effect is expected to boost spending as asset owners feel wealthier Higher rental costs as house prices rise  may reduce spending and higher house prices may lead to higher savings to afford to buy homes
Income effects of lower rates for both savers and borrowers are expected to reduce saving and increase spending As savings income falls, savers may actually spend less or save more to afford housing
A Substitution effect is expected as rates fall and households or corporates are expected to bring forward spending plans which will boost growth Households and corporates may believe QE and falling rates signal economic problems ahead and reduce spending.  There are also concerns that continually bringing forward future growth cannot continue indefinitely


The monetary policy transmission mechanism is not working as theory predicts:  Let’s look at the impact of the Bank of England’s policies.  The first part is the fall in short-term interest rates as bank rate has fallen closer to zero.  The second policy element is the Bank’s Quantitative Easing programme designed to lower long-term interest rates too.

  • Lower short-term interest rates

Low short-term interest rates are meant to boost household spending:   Households are expected to increase their borrowing as loans become cheaper and savers are supposed to reduce net saving as their income falls.  In fact, the pass-through of low short rates has been weak, as banks have not reduced borrowing rates much, if at all, but have lowered savings rates more significantly.  In an aging population, savers facing falling income may not just increase their spending.  They may look for better returns on their savings, or even save more for the future.

 Though short rates have been near zero for years, many household borrowing rates have actually risen:  Over the last five years, credit card interest rates and bank overdraft rates have actually increased, despite low base rate.  Indeed, credit card rates and overdraft rates are 2% higher than they were in August 2007.  Clearly, banks have not been passing on the benefit of low interest rates to these borrowers.  Therefore, low rates will have less impact than theory predicts.

Even mortgage rates have failed to properly reflect the base rate cuts:  In August 2016, average 2-year fixed rate mortgages had an interest rate 1.17% lower than five years ago.  However, rates for an average Standard Variable Rate mortgage were higher than in August 2011.  Lenders are also charging households higher fees and imposing tougher conditions on loans.  Therefore, ordinary households have not really felt as much benefit from the ultra-low interest rate environment as might be expected.  And even though fixed rate mortgage costs have fallen, the rise in house prices means the size of a mortgage required for house purchase has increased.  For many people the costs are so high relative to their income that they cannot get a mortgage at all.


Date Credit Card  %




Rate %

Standard Variable Rate Mortgage % 2-year fixed


75% LTV %

Aug 2011 16.73 19.38 4.11 2.69
Aug 2012 17.26 19.53 4.27 3.54
Aug 2013 17.87 19.54 4.36 2.8
Aug 2014 17.39 19.67 4.52 2.74
Aug 2015 17.91 19.67 4.48 1.72
Aug 2016 17.96 19.68 4.33 1.52
Interest rate change over past 5 years +1.23% +0.3% +0.22% -1.17%

Source:  Bank of England

Of course, over the past five years, savers’ interest rates have fallen sharply:  While the above table shows the low interest rate environment has not fully fed through to borrowing costs, the average interest rates for savers have fallen quite significantly over the past five years.  Banks do not need savers’ deposits as the Bank of England gives them plenty of cheap funding, while the latest Term Funding Scheme helps further.  .  Thus, interest rates on Cash ISAs, fixed rate ISAs and fixed savings deposits were significantly lower in August 2016 than five years ago. Banks have cut saving rates by more than the base rate fall and cut borrowing rates by less, to boost margins



Date Cash ISA 1 yr fixed ISA 2 yr fixed Deposit rates
Aug 2011 2.37 2.54 3.08
Aug 2012 2.52 2.53 3.08
Aug 2013 1.26 1.74 1.93
Aug 2014 1.09 1.5 1.52
Aug 2015 1.01 1.51 1.55
Aug 2016 0.6 0.94 1.02
Int. rate change -1.77% -1.6% -2.06%

Source:  Bank of England


  • Quantitative Easing

The second part of the Bank of England’s policy has been forcing long-term interest rates down, by creating billions of pounds of new money to buy gilts.  Buying more gilts forces up gilt prices which means lower yields, but also artificially distorts these supposedly ‘risk-free’ assets.

Bank of England suggests QE protects the value of savings and wealth, but higher asset prices are irrelevant to cash savers:  The Bank of England claims QE has boosted the value of financial asset holdings and that this ”protects the value of savings and wealth”.  However, asset prices are irrelevant to cash savers.  Most people’s savings are in deposits of less than 2 years’ maturity, so they do not benefit from increases in asset prices resulting from QE.  The majority of households hold their savings in bank or building society accounts, ISAs and National Savings which have been damaged by the low base rate policy and have not necessarily benefited from QE.

QE has distributional impacts as rising asset prices helps the wealthiest:  The Bank of England admitted in 2012 that ”those households with significant asset holdings will benefit by more than those without”.  It said it had boosted the value of stocks and bonds by £600bn and that this is ‘equivalent to £10,000 per person if assets were evenly distributed across the population’. But assets are not evenly distributed so gains have gone largely to the wealthiest 5% of households.  Further QE merely magnifies those effects.  The Chart below shows the Bank of England’s 2012 estimates of the redistribution of wealth resulting from QE.  The ongoing and further rounds of QE exacerbate this redistribution of wealth, with the wealthiest households becoming even wealthier.

QE has deflationary effects which may undermine its effectiveness:  QE is designed as an expansionary policy, but some of its effects are similar to a tightening of fiscal policy.  There are several ways in which QE has deflationary side effects.

High house prices can be deflationary:  The Bank of England has suggested that its policies have supported house prices and that this benefits the economy.  However, artificially boosting house prices is not necessarily reflationary.  The wealth effect of high house prices may not be strong enough to offset the income effects of falling disposable incomes for renters or those saving more to try to get on the housing ladder.  Housing wealth is not evenly distributed, with significant regional, demographic and income disparities.  The high cost of housing relative to salaries prevents younger generations getting on the housing ladder and forces up rental costs.  Rather than supporting house prices, policy needs to address the shortage of housing by building more homes.

 Lower gilt yields damage UK Defined Benefit pensions:  The Bank has underestimated the dangers of low gilt yields for company-sponsored pension schemes.  Artificially depressing long-term interest rates increases pension deficits and imposes extra costs on companies sponsoring pension schemes.  Deficits have soared to nearly £1trillion on some estimates.  All measures show rising deficits for UK pension schemes following the latest gilt yield falls.  The Bank of England itself is insulated from the effects, because its own scheme has ‘employer’ contributions of over 50% of salary which are funded by levypayers.  Private sector firms are struggling to meet these costs and addressing their ballooning pension deficits will weaken their business.  As firms put more money into their pension schemes, they have less money to spend on expansion and job creation.  For example, Carclo had to withdraw its planned dividend payment in order as a result of its pension deficit.  Pension funds are becoming locked in a vicious circle.  The more the Bank of England buys gilts for QE, the more expensive – and unaffordable – it becomes for trustees to buy assets to try to reduce risk.  If they compete with the Bank of England to buy more gilts, they drive gilt prices up more, which increases their deficits even further.  For many schemes, this can be a ‘death spiral’.  Some firms have been bankrupted as a result of their pension problems.  QE makes Defined Benefit scheme funding seem like a bottomless pit.  The Bank’s insouciance on pension issues is troubling.

QE has driven up the cost of buying annuities but Bank of England has ignored this effect:  The impact of QE on annuity rates has not been investigated.  This may be a serious omission.  Rising annuity costs have potentially serious implications.  QE has forced up the costs of buying bulk annuities, making it too expensive for companies to remove defined benefit pension liabilities from their balance sheets.

QE has damaged Defined Contribution Pension savers too:  In addition to the problems created by increasing annuity costs for employers running Defined Benefit schemes, annuity problems can affect ordinary households too.  Retirees buying an annuity will have lower incomes for life as a result of QE and will never be able to recover their losses.  In 2012, the Bank of England claimed: ”QE has raised the value of pension fund assets too.  Once allowance is made for that, QE is estimated to have had a broadly neutral impact on the value of the annuity income.”  This conclusion is flawed.  Most ordinary investors’ Defined Contribution pension savings are invested in with-profits or insurance funds which have not performed well enough to offset annuity falls resulting from QE.

QE artificially distorts asset markets – nobody knows what this means:  Gilts are supposed to be ‘risk-free’ assets, but by artificially boosting gilt demand, the Bank of England has distorted gilt prices.  Thus, QE has added risk to gilts, potentially creating an asset bubble in the very market that is supposed to be risk-free and on which other asset valuations are based.  This adds risk to all financial assets and nobody knows what the medium term impacts will be. Printing new money and debasing a currency may be politically expedient short-term political palliatives, but will usually fail to solve underlying problems and generally have damaging long-term consequences.


In summary, monetary policy may not work as the Bank of England’s theoretical models predict:  This paper suggests that the current stance of monetary policy and the most recent policy decisions may not work as intended and have damaging side-effects that could even offset any expected stimulus.  So what other measures might Government consider for boosting growth, with less damaging side-effects?

As QE operates indirectly and its transmission mechanism may not work, direct stimulus might be more effective:  QE creates new money which is intended to find its way into the real economy to boost growth.  However, the transmission mechanism is indirect and the Bank of England cannot ensure that this newly created money does go where it is needed in order to create growth and jobs.  There may be better policies to pursue, for example:

  • Temporary tax breaks for capital projects: Introduce temporary tax breaks for capital spending to encourage companies to bring forward investment plans.  The biggest benefit of QE is that it has allowed companies to borrow more cheaply and large firms are flush with cash.  However, they are not spending it, so an incentive to invest could help economic activity.
  • Boost construction:  Introduce incentives for new housebuilding or construction
  • Use pension assets to build new housing: The UK has billions of pounds in pension assets which could be used to build new housing, rather than trying to invest in gilts.  This can help to deliver better returns as well as overcoming the UK housing shortage.
  • Use pension assets to invest directly in infrastructure with Government underpin:  Using the billions of pounds of pension assets to bypass banks and invest in infrastructure or even lend directly to small firms would offer more direct stimulus.  It may require a Government to guarantee that the pension assets will receive at least a gilt yield return over, say, 1 years, if the project does not return more than the yield on 10 year gilts.  This would mitigate some of the risk for the pension scheme and allow pension funds to use these potentially higher return assets in the liability-matching portion of their asset allocation, while hoping to benefit from higher returns as well.
  • Consider ‘helicopter’ tactics:  It might be more effective if the Bank had sent a “time limited” cheque to all households, rather than letting low interest rates continue to squeeze people’s income. This would encourage spending directly.  The Bank of England rules this out, but it is possible that it would be more expansionary than QE.  In fact, the £25billion paid directly to households since 2011, in the form of PPI compensation, may have boosted growth more than the low base rate and gilt-buying program.


Conclusion:  QE, coupled with ultra-low rates, is supposed to be expansionary, but some of its effects are deflationary.  It is not yet clear whether the expected expansionary impacts are being more than offset by the contractionary side-effects.  Indeed, if any economic weakness following Brexit is structural, rather than cyclical, then monetary policy will not work as expected.  In some ways, QE and the base rate cuts have acted rather like a tax increase.  They have reduced current and prospective disposable incomes.  Savings income, annuity income and prospective pension income are all lower as a result of the Bank of England’s policies.  Monetary Policy can buy time for Government to introduce new demand-stimulus measures, supply-side reforms and reducing fiscal imbalances.  But, without other measures, buying gilts is unlikely to generate growth.


And finally, some politics…The Bank of England’s policies have distributional effects and the Government has perhaps not sufficiently recognized this.  The following table summarises which groups have largely benefitted from monetary policy moves and which groups are damaged by it, with the wealthiest gaining while ordinary savers, renters and younger households lose out.  Might it be possible that monetary policy could have contributed to the dissatisfaction among voters who feel left behind in recent years.  The rise of anti-establishment nationalist movements, epitomized by the Brexit result, may reflect anger at the financial difficulties facing some parts of the population, which policymakers have failed to recognize.  Politicians might like to consider how this balance of winners and losers fits with a desire to help the many, rather than the privileged few.

Groups benefiting from monetary policy


Groups damaged by monetary policy

Wealthiest asset owners

People trying to buy a home

Investment firms

People renting a home


Savers relying on interest income

UK Government

Pensioners buying annuities

Borrowers with large tracker mortgages

Companies with defined benefit schemes

Gilt traders or market makers

Pension scheme members whose schemes failed due to QE impact on deficits



1 Deb { 09.13.16 at 2:05 pm }

Timely, well observed and supported analysis of our unsustainable present.

2 Robert { 09.14.16 at 3:31 pm }

As monetary policy has unexpectedly become the major part of overall economic policy, then I think we need to establish some democratic control over the more extreme (both in terms of magnitude and duration) aspects of monetary policy.

A few days ago, I was interested to hear the Chancellor tell a Lords’ committee that the Treasury has to underwrite the BoE’s QE programme. So perhaps the first step in establishing some democratic control over the more extreme aspects of monetary policy could be via this route?

3 ekon { 09.21.16 at 9:49 am }

Thanks for sharing your analytics and detail explanation of quantitative easing.

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