How central banks and governments impact your investments
Developed countries are usually described as free-market economies, where asset prices are set by supply and demand. But central banks can have a major influence on how markets determine prices. Today, their effect on the economy - and investment returns - is more important than ever.
What you’ll learn:Click to toggle accordion What you’ll learn:
Why central banks cut and raise interest rates.
Why quantitative easing (QE) was introduced.
What interest rate changes mean for your investments.
Before the global financial crisis in 2008-2009, the role of central banks was largely to adjust interest rates to manage growth and inflation. Since then, however, central banks have been forced to get more creative, deploying unconventional methods to pump money into the economy and encourage lending, with mixed results..
Along with central banks, governments also have a significant influence over the economy, and ultimately asset prices. This is due to changes in the level of taxation and public spending, described as fiscal policy. These decisions will often have a direct impact on households and companies, the so-called ‘real economy’, but also on the value of your investments.
Why interest rates have been so low for so long
Central banks are responsible for monetary policies, which control the amount of money in an economy. Their main concern is usually managing the level of inflation.
Generally speaking, cutting interest rates stimulates economic activity and should increase inflation, while raising interest rates has the reverse effect. Between 1997 and 2007, the benchmark interest rate in the UK, known as Bank rate, regularly moved between a range of 3.5% to 7.5%.
Following the global financial crisis of 2008-2009, central banks rushed to cut their benchmark interest rates close to zero in a desperate bid to avoid an economic depression. The Bank of England Bank rate was slashed to 0.5% in 2009, the lowest level in its history. Some central banks have even cut interest rates below zero.
In August last year, after the UK voted to leave the European Union, the Bank took out its scissors once again and trimmed the cost of borrowing to a fresh low of just 0.25%.
Low interest rates encourage banks to lend, and businesses and households to borrow – supporting economic activity and staving off deflation, or falling prices. In the case of negative interest rates, which are usually applied to the cash that financial institutions leave with central banks overnight (rather than being passed on to customers), they actually pay to store their funds.
However, when the cost of living increases, as it has in recent months, and inflation regularly exceeds the government’s target, this may trigger a moderate tightening in monetary policy. Central banks face a difficult balance as if interest rates are kept at very low levels, the risk is that inflation will get worse, but if they increase them, this could dampen economic growth.
What about quantitative easing?
In recent years, central banks have gone beyond low interest rates to resuscitate their economies. Since the global financial crisis, central banks in the UK, the US, Japan and the eurozone have all used highly unusual measures, such as quantitative easing (QE).
Under QE, a central bank creates new money electronically to buy financial assets like government or corporate bonds. If it buys lots of bonds, their price will rise, causing their yields to fall. Bond yields act as long-term interest rates, so as they decline, businesses and households should be encouraged to borrow. Businesses can borrow money at a cheaper rate to fund expansion, while consumers pay less on their debts. This frees up cash for spending on goods and services that boost corporate profits.
These bonds are bought from financial institutions, such as commercial banks, which can use the proceeds to make fresh loans to businesses and consumers, increasing the amount of money in the economy. QE also usually lowers the value of a country’s currency because loose monetary policy makes higher interest rates a more distant prospect; the higher the yield on assets, the more appealing the currency they are priced in. A weaker currency helps exporters by reducing the price of their goods in foreign currency terms. It also makes imports more expensive, bolstering inflation.
The US Federal Reserve has expanded its balance sheet to more than US$4 trillion in assets since the financial crisis under QE,1 until it ended the programme in late 2015. Following the ‘Brexit’ vote, the Bank of England upped its own QE package to £435bn.2 Yet economists disagree about the impact of QE on the economy. The US has returned to stronger growth, but Japan is still struggling, despite vast amounts of money-printing by its central bank.
These aren’t the only initiatives central banks have been using to try and boost economic growth since the financial crisis. Another specific monetary policy aimed at helping businesses and consumers was the UK’s Funding for Lending scheme. It let commercial banks borrow up to £70bn from the Bank of England cheaply, so they could pass this on in the form of cheap loans to firms and households.3 The scheme is due to end in February 2018.4
What interest rate movements mean for investors
Cutting interest rates and using QE to flood financial markets with newly created money has tended to boost asset prices, including equities, bonds, cash, property, commodities and currencies. The policies encourage investors to consider riskier assets in the hunt for higher returns on their cash.
For example, on 20 March 2015, the FTSE 100 index of the UK’s largest companies broke through the 7,000 barrier for the first time,5 having almost doubled in value in the seven years since the Bank of England cut rates to a historic low of 0.5%.
The prices of government bonds also tend to rise as they are seen as safe investments in times of low interest rates: they pay a fixed yield to investors, which is eroded when inflation is high. The same rationale applies to corporate bonds.
QE and interest-rate cuts have also boosted property prices. Indeed, the one real loser is cash, as low interest rates mean that investors who stash their savings in a bank or building society receive less income in the form of interest payments.
But investors should remember that hikes in interest rates or decisions to withdraw QE are likely to have the reverse impact on markets. Indeed, even the suggestion that central banks will raise interest rates again can be enough for stock markets to slide.
Spending stimulus v tax burden
While monetary policy is generally used to fine-tune the economy by speeding up or slowing growth to control inflation, governments can control the overall level and composition of spending in the economy.
By raising tax rates, the government takes money from households and businesses and keeps it for public spending or to pay down debts. On the other hand, governments can cut taxes and increase spending to offset a downturn and support overall demand, boosting the economy and potentially driving share prices higher.
Decisions on tax and spending can affect particular sectors and therefore influence the prices of specific shares and bonds. For instance, government investment to regenerate a rundown part of the country can lift property prices in the area. Equally, an R&D tax break for sectors such as pharmaceuticals can boost share prices of firms in that industry.
Some economists argue that if governments have to issue debt to fund the spending, the state-driven activity can ‘crowd out’ or deter private sector investment and push down stock prices. One study found that increases in tax receipts in the US from 1960 to 2000 led to a significant fall in expected annual returns from stocks, government bonds, and corporate bonds.
Investors need to be aware that changes in both monetary and fiscal policy can have significant impacts — both positive and negative — on the prices of their assets. Please remember that investments can fall as well as rise and you may get back less than you invested. Past performance is not a reliable indicator of future performance.
Remember, the value of investments can fall as well as rise and you could get back less than you invest. Seek independent advice if you’re unsure of this investment’s suitability for you.
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1 The Wall Street Journal, Fed Closes Chapter on Easy Money (October 2014)
2 Bank of England, Bank of England cuts Bank Rate to 0.25% and introduces a package of measures designed to provide additional monetary stimulus (August 2016)
3 Bank of England – Funding for Lending Scheme
4 The Daily Telegraph, Bank of England keeps interest rates on hold at 0.25pc - but hints they could rise within a year (August 2015)
5 The Independent, FTSE 100 breaks historic 7000 barrier for the first time (March 2015)