The Federal Reserve’s quantitative easing program of bond buying has, in its various iterations since it began in 2009, caused fears about runaway inflation as the Fed’s balance sheet has ballooned and base money has expanded.
“QE is by design set to be inflationary,” says Michala Marcussen, global head of economics at Société Générale. “Yet we were asked several times last week whether the opposite could hold true; i.e. that QE is in fact proving deflationary.”
In a note to clients, Marcussen writes:
In theory, a permanent increase in money supply results in a proportional increase in all money prices. Central bank asset purchases boost money supply, but this “inflationary” impact of QE is only temporary as the assets are in the future set to either be sold to private investors or redeemed to central banks, thus exerting a “deflationary” impact. For QE to be efficient, this argument would thus suggest that central banks (Fed, BoE, BoJ … and even the ECB!) should simply forgive their considerable holdings of debt (mainly government debt) thus making the increase in base money permanent. In the case of the US, cancelling the $US2tn of Treasuries held by the Fed would also offer a quick fix to the debt ceiling issue.
This somewhat tongue-in-cheek argument merits qualification. Indeed, there is base money and then there is broader money aggregates. While QE has boosted the former, the impact on the later has been modest to date due to still lacklustre credit channels.
This ties in with our long-held view that the key to sustainable recovery lies with corporates regaining sufficient confidence to borrow, to invest and to hire (and not to swap equity for debt via share buybacks).
Moreover, tempting as a cancellation (or a restructuring to perpetual zero coupon bonds) of government bonds held by central banks may sound; we are concerned that such a policy could ultimately prove inflationary in a bad way (think Weimar Republic). Indeed, this goes to the very heart of the argument as to why QE is not printing money.
Marcussen also points to the effect the Fed’s quantitative easing program has had on the Chinese economy. QE spurred capital inflows, causing a credit boom which many fear is now coming undone.
“The result is that China suffers significant excess capacity and poor capital returns, not to mention a shaky shadow banking system that China Economist Wei Yao has written extensively about,” says Marcussen. “Excess capacity is deflationary and the means to deal with it is to shut it down. Indeed, we expect China for now to exert deflationary pressure on the global economy.”
The bottom line, according to Marcussen: “Unproductive investment is by nature ultimately deflationary. This is a point also worth recalling when investing in paper assets fuelled by QE liquidity and not underpinned by sustainable economic growth.”