Why QE will be back

The wealth effects expected from QE haven't emerged, but in the process central banks have gotten themselves into a position where they have to expand their balance sheets to keep confidence in the market.

The Federal Reserve’s quantitative easing ended last week, not with a bang, but a whimper, and then – surprise of the week – the Bank of Japan picked up the QE baton and on Friday the markets went off – not with a whimper, but a bang.

The BoJ’s announcement that it will increase the growth rate of Japan’s money supply from ¥70 trillion to ¥80 trillion a year was prompted by concern that “inflation expectations” are too low.

BoJ governor Haruhiko Kuroda declared that he is determined to get inflation up to 2 per cent.

European Central Bank president Mario Draghi has also been saying the same thing, but hasn’t done anything yet.

The US Fed, in Thursday’s monetary policy statement, said it wasn’t too worried any more – to be precise, it said: “the likelihood of inflation running persistently below 2 percent has diminished somewhat…”

It’s now well established that central banks have become fighters FOR inflation, not against it, and this is due to the abundance of debt. Rising prices are needed to diminish the value of money so that debtors are rescued and the machinery of finance doesn’t fall apart.

The central bankers seem to be basing their despondency about inflation on the 5-year/5-year swap rate, which provides a measure of the financial markets’ betting about the CPI in five years’ time.

Their faith that money market punters have any idea whatsoever about the inflation rate in five years’ time is very touching indeed, but hardly scientific.

A while ago there was a widespread consensus that all this money printing would cause a repeat of the Weimar Republic hyper-inflation of 1922-23, when the Deutsche mark fell to a value of 4,210,500,000,000 to the US dollar by November 1923.

In fact inflation everywhere has been falling this year, not rising. Maybe the central bankers should forget about Milton Friedman.

In 1970, Friedman wrote: “inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output...” Note the word “only”.

That was just three years before inflation became always and everywhere an oil price phenomenon, and then it happened again in 1979.

Over the past six years the quantity of money has certainly increased more rapidly than output, but with no inflation.

Gerard Minack, in a note marking the end of QE last week, said that QE demonstrated that inflation is not a monetary phenomenon, but a credit one.

“The Fed could juice up the money base, but that could not spark the credit creation process required to accelerate broader monetary aggregates. Moreover, it seems that the principal channel that the Fed expected QE to work, over and above conventional policy, was via wealth effects.  Wealth effects are not working: households have barely reduced net lending as wealth increased.”

It seems to me that there is more to it than that. Fracking in the US, and increased oil production in the Middle East, are producing a reverse oil shock.

In addition to that, cloud computing, the rise of algorithms, automation and robotics are all reducing costs – on top of the consumer goods deflation caused by the entry of China, India and other emerging nations’ labour onto the world market.

The wealth effect from monetary expansion is not working because inflation is far more complicated than Milton Friedman postulated.

But QE did increase asset prices, and the Bank of Japan’s announcement did it again on Friday.

Maybe that’s the end in itself: if you can’t reduce the value of money through rising prices of goods and services, and thereby let debtors and off the hook, you can do it by increasing the value of what’s on the other side of their ledgers.

And the most interesting thing of all is that QE doesn’t work on the value of assets because the recipients of the cash (banks) use it to buy assets and bid up their prices.

It works because it makes investors believe in central banks. It’s all about confidence, not money.

And for that reason, QE will be back. The Fed and the Bank of Japan, at least, have got themselves into the position where, in order for markets to have confidence in them, they have to expand their balance sheet.

Having put their money where their mouth is for so long, the mouth alone just won’t do any more.

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