The European Central Bank is starting QE this month in order to fight deflation, so it must be at least a little unsettling when Citi comes out with a new report titled “Is QE Deflationary?” While Citi analyst Mark King acknowledges that US and UK wage growth, positive economic surprises in Europe, and lending growth are all encouraging, but he’s not convinced that the news is as good as it seems.
“Lower oil prices, 18 central bank easings in the past three months, and record lows in bond yields. It all ought to prove highly stimulative. Yet we doubt that the sixth trillion of QE will succeed where the first five have failed,” he writes.
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QE doesn’t deal with overcapacity
If companies are turning deciding not to make productive investments because financing is too expensive, then pulling down that cost should lead directly to higher capex. But if companies don’t see anything attractive to do with their cash, record low interest rates won’t make any difference. Companies will still make use of the low rates for refinancing old debt, stock buybacks, and the like, but cheap credit can’t make interesting projects suddenly appear.
King takes this argument a step further. If the world is under deflationary pressure caused by overcapacity, then allowing weak companies that would normal go bust to refinance and scrape by actually makes the problem worse. As investors get ever more desperate for yield, risky companies find it easier to issue new debt. You can also see the effect of oversupply in commodities prices, which have been falling for the last two years even if you ignore headline-stealing oil prices.
“Investment will not pick up until the overcapacity problem has been dealt with – no matter how cheaply companies can fund,” he writes.
A race to the bottom for monetary policy?
In a comment that’s extremely similar to Bill Gross’s latest editorial, King says that central bank easing doesn’t seem to be increasing demand so much as moving it from place to place. If he’s right and we are looking at a race to the bottom in monetary policy, then asset prices could easily continue rising while long term damage is being done to the economy and QE becomes harder and harder to move away from.
“Even if QE does prove deflationary, until we start running into actual defaults, it is hard to see what stops this,” King writes.