Deflation is the big bad wolf threatening monetary policy. The logic of QE
Public enemy number one for central bankers in the developed world is deflation. When the CPI declines we have deflation, when it rises we have the opposite, inflation. Prices in general fall, when aggregate demand in the economy exercised by households, firms and governments, fails to keep up with potential supply. Prices rise when demand exceeds supply in general. The economic problem in the developed world and in much of the less developed world (including SA) is too little rather than too much demand that has called for highly unconventional monetary policy.
These central bankers, with modern Japan very much in mind where prices have been falling and economic growth abysmally slow since the early nineties, are convinced that deflation depresses spending and by so doing serves to prevent an economy from achieving its growth potential.
They are therefore doing all they can to stimulate more spending to arrest deflation or a possible decline in average prices. What they can do to encourage reluctant spenders is to create more money and reduce interest rates. Inflation, as they used to say, was too much money chasing too few goods. Deflation may be said to be caused by the opposite – too little money chasing too many goods. Inflation calls for less demand and so less money creation. Deflation calls urgently for the opposite – more money creation.
But while these central bankers have the power to create as much extra cash as they judge appropriate they have had to overcome a technical problem. The extra cash intended to encourage more spending may get stuck in the banking system. And when it does there may be no additional demand for goods and services and the extra money created (at no cost) may not encourage spending or lending and provide no relief of the unwanted deflationary pressures. The banks may hold the extra cash as additional cash reserves or use the cash to pay off loans they may have incurred previously with the central bank.
The mechanics of money creation go simply as follows. The cash the central banks create (or more specifically the financial claims they create on themselves called deposits with the central bank) when buying securities from willing sellers in the financial markets (typically pension funds or financial institutions of one kind or another) reflects immediately as extra privately owned deposits with private banks. In the first instance, as the proceeds of a sale of securities by a private bank customer are banked, the private bank will have raised an additional deposit liability and will receive in return an asset in the form of additional claim on the central bank. That is, the asset to match their additional deposit liabilities will take the form of an increase in their (cash) reserves at the central bank. Normally the banks will make every effort to convert this extra cash into a loan that earns them more interest. Such loans would then lead to more spending. Normally banks keep minimal cash reserves in excess of the regulated requirement to hold cash reserves in fractional (say 5%) proportion to their deposit liabilities.
But ever since the Global Financial Crisis of 2008 this has not been the case at all. The central banks, led by the US Federal Reserve Bank, have bought trillions of dollars worth of financial securities and the private banks have added trillions of dollars to their cash reserves. In the figure below we show how the assets of the major central banks have expanded over the years. Their extra assets have consisted of securities issued by governments of government agencies- for example in the form of mortgage backed securities issued by government backed mortage lending agencies Fannie Mae and Freddie Mac in the US.
It should be noted that the ECB balance sheet has been shrinking in recent years, unlike those of the other central banks. This decline in ECB assets and liabilities (mostly cash reserves of the banks) has represented additional deflationary pressure on spending in Europe. The European banks have been repaying ECB loans previously made to them and the ECB has now responded by initiating a further programme of QE, that is to say security purchases, intended to inject an extra EUR60bn a month into the banks of Europe over the next 21 months. That is to encourage bank lending and spending to counter deflation.
The important point to note is that creating money in the form of a deposit with the central bank by buying securities in the market costs society almost nothing. Creating money that is an asset of the banks and an addition to the wealth of the community does not require any sacrifice of consumption or savings, as would any other form of wealth creation. It is literally money for nothing. But in normal times too much money means too much spending and inflation. Hence the resistance in normal times to creating money – because it normally leads to inflation.
But the times have not been normal. The extra supplies of money have been accompanied by extra demands by the banks to hold money and too little rather than too much spending has remained the economic problem. Hence the case for creating still more money until deflation is conquered and central banks can get back to worrying about too much money and inflation.
The extra liabilities issued by the central bank matching the extra assets were mostly to private banks in the form of cash balances in excess of required cash reserves. In the US the banks have received 0.25% p.a on these cash reserves.
It should be notie that the US banks have begun marginally to reduce their cash reserves with the Fed and that the assets of the Fed are rising more slowly with the end of QE in October 2014. QE ended because the recovery of the US economy is well under way and presumably does not need further encouragement in the form of further increases in the supply of cash. The banks presumably have more than enough excess cash to meet the demands of borrowers from banks. It could be argued that QE at least in the case of the US – the economy is recovering – the dangers of deflation have receded and the danger of inflation taking over is judged to be absent.
There is very little inflation priced into the yields offered on 30 year US Treasury Bonds that offer yields below 3% and less than 2% more than inflation protected US obligations with the same duration. Japan and Europe, it may be presumed, will be doing still more QE or as much as it takes to get the banks to lend out more of their cash.
The problem of deflation is complicated by very low or even negative interest rates. Cash has one advantage over other assets. The income return on cash can only fall to zero. Other assets, for example government securities or bank deposits, may only offer negative interest rates. The German government, for example, can now borrow for up to 10 years, charging rather than paying interest. In other words, it can take about 105 euros from you and promise to pay you 3 euros interest and repay you 100 euros in a year’s time. In other words the transaction will have cost you 2 euros and this, alas, is the best risk adjusted return you can get, though, if prices in general decline by 2% over the year, your 100 euros will be worth as much as 102 a year before adding to your real return. But you would have done better holding cash. 100 euros in cash will still be worth 100 after 12 months and will also buy you more.
Hence deflation forces down interest rates and encourages the demand for cash (and safe deposit boxes) and discourages the demand for bank deposits and for goods and services that may be expected to become cheaper. Deflation also encourages banks and other lenders to hold cash rather than to lend it out. Hence further reason to fight deflation (and too little rather than too much spending) by flooding the system with additional cash so that the supply of cash can eventually, even with very low or negative interest rates, overwhelm the demand for cash.
Until Europe succeeds in overcoming deflation and stagnation we can expect interest rates in Europe to stay low and for the euro to stay weak; and the US dollar (offering higher interest rates) to stay strong. We may also expect deflation and low interest rates in Europe to help hold down long term rates in the US and elsewhere as European lenders seek higher yields abroad. The weak euro and stronger dollar (and perhaps also stronger emerging market currencies, including the rand) may also help restrain any increase in short and long interest rates globally. It may take some time before we can say with any confidence: goodbye to deflation and welcome back inflation.