‘All of a patter and a pitter’… from rebalancing to fingers crossed
The good news is that the Bank of England, under new governor Mark Carney, has demonstrated it cares about unemployment. Its ‘forward guidance’, published yesterday, means monetary policy, which is being used as an economic stimulus, will stay as it is until unemployment starts to come down.
The bad news, however, is that we are no closer to a coherent policy for kick-starting economic growth. The Bank is crossing its fingers in the hope that its current approach will start to bear fruit, in terms of employment, over several years.
Tolkein fans might have spotted that this article’s title is lifted from The Hobbit:
“Go back?” he thought. “No good at all! Go sideways? Impossible! Go forward? Only thing to do! On we go!” So up he got, and trotted along with his little sword held in front of him and one hand feeling the wall, and his heart all of a patter and a pitter.
As a step forward, the Bank’s plan isn’t very sure of foot. It is absolutely right that monetary policy has in mind unemployment as well as inflation. But a policy to ‘do nothing’ until unemployment goes below 7 per cent is hardly radical. Certainly, it gives no indication of any attempt to rebalance the economy, in the way we were promised by George Osborne in 2010, away from growth dependent on house price appreciation – it may even be counter-productive in this regard.
Instead it is more a case of the Bank putting its faith in the government’s increasingly incoherent economic strategy – and perhaps accepting that a very slow, stuttering recovery is the best we are going to get in the near future. The small print tells us that unemployment, which is currently 7.8 per cent, will remain above 7 per cent until 2016. Mark Carney might not have a great deal to do for the next few years, despite his £874,000 annual pay packet.
The huge problem that pension funds face in coping with current monetary policy not only typifies the incoherence of the government’s economic policy – it may actually be one of the key barriers to delivering a strong recovery. But despite the overwhelming economic logic in favour of action, the government cannot do very much about this problem without jeopardising the political capital it has staked on austerity, and electoral interest in persistent – but very weak – positive growth statistics between now and 2015.
I am trying very hard not to wander into a debate about whether quantitative easing has been a bad thing for pension funds. It is complicated and will remain so: defined contribution savers close to retirement have been badly affected by the Bank buying gilts, because they tend to be heavily exposed to gilts, and annuity rates are closely related to gilt yields. Defined benefit funds, which provide guaranteed pensions to their members, are (other things being equal) likely to have benefited as much from increased asset values among their equity stock as they have lost from increased liabilities relating to the impact of QE on gilt yields.
However, one issue that has received comparably fewer headlines is the impact that lower interest rates (which are of course partly sustained by QE) is having on pension funds, and the closely related impact of inflation (because sustaining low interest rates means tolerating higher inflation).
The forward guidance tacitly accepts a high-inflation environment. I think this leads to a triple whammy of negative effects for defined benefit pension funds. Firstly, their liabilities are greater because pensions in payment must be increased in line with inflation. This is not a benefit to members, because they’d be just as well off with lower pensions and lower living costs. Inflation is not necessarily bad for funds –but it is when we are seeing sluggish growth in the economy so their investment returns are not keeping pace.
Secondly, because liabilities are higher, the need to adopt liability-matching investment strategies is greater. This means investing in gilts – at a time when low interest rates make gilts unattractive. The stable returns offered by gilts makes them ideal for tracking inflation-linked liabilities, but because gilt yields are (artificially) low, funds are seemingly over-exposing their portfolios to this asset class and missing out on much-needed higher returns from riskier investments.
In fact, Buck Global Investment Advisors reported recently on the worrying trend of funds ‘investing’ heavily in cash – a practice that would normally be considered quite perverse (and even more negatively affected by low interest rates!), but a sure sign of the impact of low growth and relatively high inflation on funds.
Thirdly, because mechanisms for discounting liabilities are rightly linked to the assets held, over-exposure to low-yield gilts means that liability values have to be increased.
The forward guidance not only extends for at least three years the impact of this environment on pension funds; we might end up viewing it as an enormous missed opportunity to utilise pension fund investments in rebalancing the economy. Pension funds hold assets worth around 95 per cent of UK GDP (the vast majority in defined benefit, at the moment) – they could almost literally buy and sell the entire economy.
It is this immense size that found pension fund investments at the heart of the government’s 2010 National Infrastructure Plan (a centrepiece of recovery through rebalancing). Of course, the plan amounted to little more than a wish-list from the government’s perspective, with two-thirds of the funding expected to come from the private sector. The amount required for infrastructure investment to make a real difference to the recovery is debatable – but it is clear that we are talking about hundreds of billions. At the moment, the flagship Pension Infrastructure Platform has just £1 billion in ‘soft commitments’ from pension funds – and much of this from public sector schemes (i.e. local government), and the quasi-public Pension Protection Fund. Just to spell it out: not the private sector.
It would be wrong to conclude that pension funds are not interested in infrastructure investment. Many see this asset class as the ideal form of high-yield, long-term investment suitable for funds with long-term obligations. But most private sector funds are simply not in a position to take on the short-term volatility in returns that infrastructure investment also entails.
The government recently ‘updated’ the flailing infrastructure plan worth £40 billion in lending guarantees for ‘shovel-ready’ projects. But even this limited funding comes with so many strings attached it was clearly designed to generate headlines rather than new investment. As Stephanie Flanders remarked:
To qualify, a project has to be perfect in every possible respect, but somehow not quite perfect enough to get up and running entirely on its own.
A far more radical way of getting pension funds to invest significantly in infrastructure is for government to issue ‘infrastructure bonds’. They would presumably be higher-yielding than regular gilts for investors, but over a longer time-horizon. The government would use the cash raised for public infrastructure investment. I’m certain the Treasury have toyed with this idea – but must have concluded that it involves taking too much debt onto the balance-sheet, even though any half-decent economic assessment would demonstrate how valuable it could be for economic growth.
It is of course too simplistic to say that monetary policy must be transformed immediately for the sake of pension funds, even if the potential for wider economic good can be identified. Indeed, changes within pensions policy (for instance, reforming the way that pension fund deficits are valued and reported) would go some way to achieving the same ends. Yet it seems certain that low interest rates – arguably necessary for business but also fuelling house price inflation – is narrowing pension funds’ room for manoeuvre at the same time as directly harming their asset base.
As Ed Balls has pointed out, in the absence of stronger fiscal policy, monetary policy is being asked to bear an impossible weight. The Bank cannot do right for doing wrong.
Karel Williams’ response to the forward guidance is worth reading. Describing Carney as a ‘shaman in an uncontrollable world’, he concludes that:
Restoring the mechanisms of credit transmission is quite futile in the UK because our credit system is geared to lending on property, manufacturing is enfeebled and infrastructural investment comes via a private sector that wants high returns without risk. We need political reframing, not technical guidance to tackle those problems.
In essence Williams is saying that a vow to keep interest rates low, while ostensibly intended to help firms access credit, will not achieve this sufficiently because the UK’s ‘credit transmission’ system is oriented towards property –a source of inflation that does not create many jobs, at least not directly. Furthermore, we no longer have enough capacity in manufacturing and construction for lending to be targeted at the most productive forms of economic activity.
One solution might have been to empower the institutional investors, like pension funds, who could have been in a position to mitigate these structural flaws in the UK economy – but they will find very little comfort in the forward guidance.