QE is not inflationary, but is it deflationary?

By Frances Coppola

I’ve suggested previously that QE could actually be deflationary. I looked at it from several perspectives – collateral effects, the monetary transmission mechanism, distributive effects, even Peter Stella’s “deadwood” inhibiting bank lending. But I have to admit that the evidence in support of my deflationary hypothesis was thin and the case not proven. All I could demonstrate was that QE is not directly inflationary and whatever stimulative effect it has is weak at best.

Until now, that is. Soc Gen have looked at QE…..and they have concluded that its effects may indeed be deflationary. Their reasoning is somewhat different from mine. Here’s their argument in full (their emphasis):


QE is by design set to be inflationary, yet we were asked several times last week whether the opposite could hold true; i.e. that QE is in fact proving deflationary.

* No credit = no recovery

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 $2tn of Treasuries held by the Fed would also offer a quick fix to the debt ceiling issue.

This somewhat tongue-in-check 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.

*An unintended consequence of QE’s external channel

It can reasonably be argued that QE in advanced economies generated significant capital inflows to emerging economies, boosting credit. In China, this liquidity combined with a further boost from domestic government policies found its way to fixed asset investments. This led initially to a welcome demand boost for commodities and a wide variety of capex goods. Today, however, 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. 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.

While in China, the impact of QE was observed mainly on the supply side, other economies such as Brazil and India saw the effect concentrated on the demand side, via consumer credit channels. Initially, local currency appreciation masked this inflationary aspect of QE. When Fed taper talk earlier this year hit the tapes, however, a new dilemma appeared for central banks in these economies as local currency depreciation added to domestic inflationary pressures at a time of slowing growth momentum. Contrary to China’s deflationary impact on the global economy, we do not expect to see these inflationary forces to be exported. As households struggle to deleverage balance sheets, the end result, however, could prove deflationary.

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.

In effect, Soc Gen argue that the expectation that QE will be unwound in future negates the “inflationary” effect of the temporary increase in base money. This is a sort of Ricardian equivalence. I’ve long thought that Ricardian equivalence is too narrowly defined: it is perverse to assume that temporary tax cuts don’t work because of the expectation of future tax rises, but temporary interest rate cuts DO work despite expectation of future interest rate rises. And it is equally perverse to assume that temporary increases in base money have a stimulatory effect when temporary tax cuts apparently don’t. Kudos to Soc Gen, therefore, for pointing out that temporary increases in the monetary base due to asset purchases might simply be ignored and therefore ineffective.  

Cancelling the assets would make the increase in the monetary base permanent and therefore impossible to ignore. However, I’m personally unconvinced that cancelling the assets currently held by central banks would necessarily be inflationary, since central banks have a range of tools for controlling inflation even without the presence of large amounts of readily saleable assets on their balance sheets. 

But I do think Soc Gen’s argument that unproductive investment is deflationary bears consideration. For whether temporary or permanent, if the money created by QE is not productively invested, it is useless. And if corporates don’t want to invest productively – perhaps because as Soc Gen says, they lack the confidence to do so – then no amount of QE will make them do so. 

Furthermore, QE money that is not productively invested in the countries where it is issued but is diverted into over-investment in other countries will ultimately prove deflationary. Soc Gen’s argument is that China’s overcapacity problem arises from such over-investment. They further argue that as QE is withdrawn, other emerging markets will be forced to defend their currencies at the expense of their domestic economies. If they are correct, then Western QE can be said ultimately to have deflationary effects in emerging markets. 

Whether QE is “intrinsically” deflationary remains unproven. But the argument that it can indirectly have deflationary effects seems now to be well grounded. 

Related reading:

Inflation, deflation and QE – Coppola Comment

There’s a problem with the transmission – Coppola Comment

QE myths and the Expectations Fairy – Coppola Comment

Exit-path implications for collateral chains – Peter Stella, Vox

The QE Debate

Thanks to Tom Bowker for providing the Soc Gen research.

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