Friday 27 October 2017 by Craig Swanger Opinion

How the world’s largest fund managers got it wrong when Quantitative Easing did not cause global inflation

In 2008, in response to the collapse of Lehman Brothers and start of the Global Financial Crisis, the US Fed responded by slashing interest rates and then introducing “Quantitative Easing”, otherwise known as QE

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In hindsight, the Fed’s move to QE coupled with China’s stimulus policies, probably saved the world from a far more severe recession than the one we experienced.   Yet at the time, the outcry was loud.  Warren Buffett said, “I think QE opens up certain dangers in terms of people worrying about the United States printing money”.  The world’s largest bond fund manager, PIMCO, warned the world that inflation was about to explode.  Our RBA predicted inflation would rise beyond the top end of its 2-3% pa target range.

Years later, inflation failed to explode as PIMCO predicted and it hasn’t risen to the top end of the RBA’s target band as they predicted. In fact, global inflation fell as QE ramped up.

Looking back, it is quite likely financial markets would have been worse without QE. Regardless, the predictions of hyper inflation turned out to be wrong and in PIMCO’s case, it was horribly wrong.  Its prediction meant that PIMCO, led by “bond-king” Bill Gross at the time, was positioned for a rise in long term bond yields whereas they actually fell. 

Each passing year the number of the predictions for rising inflation and bond yields increased from PIMCO and other global fund managers as columns in the AFR attest. All assumed that either QE would push up inflation or conditions would ‘normalise’. Even today, low yields persist.  Many are therefore asking why “printing all that money” did not produce hyper inflation as it always has in the past. 

The theory

Printing money (a common euphemism for making more money available) per se doesn’t cause inflation.  But if a government prints more money and puts it in the hands of consumers, either through easier lending conditions, lower taxes or social security, eventually they create too much demand for goods relative to supply.  Because there won’t be enough goods to meet demand, the businesses selling those goods naturally put up prices, hence the link to inflation. 

Germany’s response to the massive debts it faced post WW1 created the term “printing money”.  Forced to pay massive reparations to their European neighbours, Germany started printing Marks to buy foreign currency to cover those debts.  But by printing more currency, they drove down the demand which resulted in the value of the Mark falling from 4.2 Marks to the USD in 1918, to 320 Marks to the USD by 1921.  Yet printing continued to accelerate, the Mark continued to fall, prices rose and unfortunately more printing was ordered.  Eventually, hyper inflation kicked in and the currency fell until one needed 4.2 trillion Marks to buy one USD. 

So when QE was announced in response to the GFC, it was seen as printing money because it involved guaranteeing banks a buyer of last resort should they need liquidity.  Because the central bank had announced it was buying such large volumes, the banks knew they would have access to practically limitless liquidity.

The action was supposed to encourage banks to lend more money to consumers and businesses, safe in the knowledge that they could always sell assets to the central bank if another credit crisis like the GFC striked.  In theory, more lending meant more “printing” of money that should eventually lead to more inflation – the basis for hyper inflation and rising rate forecasts

Why it has been different this time

There are three compounding reasons why all that “printing” did not wind up creating excess demand and therefore inflation:

  1. Loose credit in the early 2000s had to be repaid During the early years of 21st century, the western world was facing a natural economic slowdown due to years of slowing productivity and baby boomers retiring.  In response, the western world eased monetary conditions not through lower rates at first, but through more flexible banking regulations which allowed more consumer lending, particularly in the form of mortgages.  Higher consumer demand meant higher demand for the production of goods and services, which meant more businesses investing in capacity.  Consumer credit bought forward spending, but eventually it had to be repaid, slowing demand.  That occurred dramatically with the end of the housing bubble in Europe and the US and consumer spending was replaced by increased savings. 
  2. Surplus industrial capacity China’s economic miracle of the 1990s turned the country into a very powerful industrial engine by the early 2000s.  It invested massively in industrial capacity and created jobs for the world’s largest underutilised labour force.  By the time the GFC struck in 2007/08, global production capacity was already facing significant surpluses, particularly in China, Japan, South Korea and the US.  The sharp drop in demand in Europe in (2007) and then the US in (2008) meant that surplus capacity could only be addressed by lowering factory prices or shutting capacity altogether.  The US and Europe shut capacity often because the debt used to finance production could not be met.  China, on the other hand, responded to the GFC by encouraging a massive increase in new capacity. For example, China’s steel production capacity doubled in five years from 2008, with China accounting for 73% of the world’s total capacity increase through the 2005 - 2015 decade.  Those surplus capacities, at a time of very weak demand for the US, Europe and Japan, meant severely depressed producer prices and therefore lower consumer inflation.  Shuttered manufacturing and retail in the US and Europe meant lower demand for labour resulting in lower wage growth and less inflationary pressure. 
  3. The digital economic revolution, or “Amazon Inflation” Today the digital economic revolution, lowering costs and thus working against inflation has created new headwinds.  This impact has only really taken full effect since 2014-15 according to our numbers, but it has stepped up where the deflationary impact of China’s low cost labour has left off.  This impact will last for many more years, as we have suggested previously in this article.

It is probably untrue to say that QE did not cause inflationary pressure, however one can equally argue that QE did not cause hyperinflation for the simple reason that there was a very unusual combination of exceptionally weak demand and exceptionally high supply. 

Now as we near the end of 2017, Australian inflation data continues to weaken.  Utility prices and tobacco added more than 50% of total CPI in the past year, and what’s worse, tobacco was actually a greater contributor than utilities.  One could possibly argue that utilities inflation relates to economic health (and not government inaction), but tobacco’s impact on inflation is nothing but tax increases given that demand is actually falling sharply.  

Conclusion

Hindsight tells us that some of the world’s most renowned investors, like Warren Buffett and PIMCO, got it completely wrong when forecasting the impact of QE on inflation and interest rates.  Year after year, most economists and forecasters continued to predict QE would eventually bring inflation back and lead to rising interest rates.

Meanwhile, a smaller but growing voice has suggested that “this time it is different” due to the disinflationary pressures of falling demand from retiring populations, China maintaining and even encouraging excess production capacity, and the impact of the digital economy. 

Lower inflationary pressures are likely to become a feature of the global economy until industrial capacity eases back in line with demand and the peak impact of the digital economy has passed.  Industrial capacity could ease when China’s credit boom ends, but the digital economy will still provide at least a decade of major economic structural changes.

Without inflation to get in the way, and with record levels of government debt in the US and Europe and household debt in economies such as Australia, central banks will likely leave rates much lower than historic levels for at least the next 10-20 years.

Lower-for-longer, according to this argument, is a feature of interest rate markets for several years to come and investors should position themselves for such conditions before the bulk of financial markets catch up.

 

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