Last week’s US economic data was generally weak with durable goods declining 5.1% in December, Q4 GDP coming in at just 0.7% and Dallas Fed Manufacturing collapsing to -34.6. On the other hand, the Chicago Fed Purchasing managers Index surged to 55.6 from an expected 45.3. The weak data on balance helped boost US Treasuries with the 10-year yield dropping 13 basis points to 1.92%. Credit also performed well with the BofA Corporate Master (average rating A3) gaining a fraction over one third of one percent over the week.
Elsewhere, the Bank of Japan (BoJ) unexpectedly cut the rate on excess reserves to minus 0.1%. Japanese government bonds now have a negative yield for all maturities up to 8 years with 10-year bonds yielding just 9.5 basis points.
Japanese short rates reached a high of 8.625% in 1991, but dropped to under 1% in late 1995. In the twenty years that followed, Japan’s growth rate averaged 0.78% and inflation averaged just 0.12%. The BoJ was the first central bank to embark on quantitative easing back in 2001 and given that this policy has failed to boost either growth or inflation in Japan, it is hard to describe the results as a success. Could the reason be that Quantitative Easing (QE) is actually deflationary?
One of the principle aims of QE is to stimulate investment in an effort to boost growth. There is no doubt that low rates have prompted many firms to boost investment with the result that oversupply is visible in everything from oil and metals, to air cargo and freight. On Friday, the Baltic Dry Index, which covers prices for transported cargo such as coal, grain and iron ore reached the lowest level on record when the index dropped to 317 points.
The other critical requirement for QE to be successful is that demand must exceed supply, otherwise we would be faced with a world of falling prices. The standard assumption is that individuals faced with low interest rates will elect to spend more, rather than save more, as lower interest rates make saving less attractive. However, this idea seems back to front. People saving for retirement for example will have in their minds a certain level of income they will need to achieve in order to live comfortably. Faced with lower interest on their savings, and in Japan’s case no uplift in rates for 20 years, surely individuals would save more, not less?
If QE were to result in both oversupply AND reduced demand then we would expect the world to end up with low growth and low inflation at the same time. However, this would appear to go against economic theory. Or does it?
In 2014,Yie Wen and Maria Aria at the St. Louis Fed published a paper which may provide the answer to the question, “Is QE deflationary?”. Their paper, “What Does Money Velocity Tell Us about Low Inflation in the U.S.?” explored what has happened to velocity since 2008.
Velocity is a nebulous concept as it cannot be measured directly but is a key component of the “monetary theory of money” that states that MV = PQ where;
M stands for money.
V stands for the velocity of money (or the rate at which people spend money).
P stands for the general price level.
Q stands for the quantity of goods and services produced.
According to the authors, if this theory holds, inflation in the U.S. should have been about 31 percent per year between 2008 and 2013, when the money supply grew at an average pace of 33 percent per year and output grew at an average pace just below 2 percent. In fact inflation was under 2% during this period. So what happened?
By rearranging the formula to V=PQ/M we can “measure” velocity which the authors presented in a fascinating chart (reproduced on our website) that shows that rather than being constant, velocity has collapsed since 2008. Put another way, rather than being induced to spend, individuals have chosen to hoard money instead.
So what would individuals do faced with negative rates? Would they go out and spend? The evidence suggests not. Would they leave their money in the bank or hide their savings under the mattress? If short rates are negative, or in Japan’s case negative for bonds up to eight years maturity, surely the best source of capital preservation is cash itself. Taken to extremes, this would result in deposits leaving the banking system en masse with all the negative consequences for growth and inflation.
The chart produced by Wen and Aria, provides the most compelling evidence yet that QE is indeed deflationary, and that efforts by central banks to stimulate their economies using QE are doomed to fail. If this is the case, we can expect high grade bonds yielding 5% to provide substantial gains over the next few years as investors in the West come to realise that the two lost decades experienced by Japan provides the best blueprint for the direction of bond yields.