Has QE failed, and if so why are markets clamouring for more?

Parmenion Investment Management

The aim of Quantitative Easing [QE] was to support global economic growth in the wake of the Global Financial Crisis, and help to push GDP growth back towards its trend rate, typically around 3.2 – 3.5% for the world and 2 – 2.5% for the UK.

This would allow the amount of outstanding debt to be managed and ultimately reduced over time. It was hoped that a virtuous cycle could be started: pinning interest rates down would boost investment, which would improve employment prospects, leading to increased consumption and a self-sustaining recovery where total demand would become strong enough to generate desirable levels of debt-reducing inflation. The problem has been that whilst the cost of capital for companies has been meaningfully lowered, it has not led to the hoped-for uptick in investment, so productivity, wages and consumption have all remained weak. Instead it has merely enabled weaker companies to survive, leading to excess supply at a point in time of sustained weak demand, which has acted as a further depressant on prices and therefore been a disinflationary force.

With soft growth and negligible inflation, the global debt mountain consequently remains as challenging today as it has ever been despite QE-driven central bank balance sheet expansion of almost four times since 2007 (the aggregate balance sheet of the US Federal Reserve, Bank of Japan, European Central Bank and Bank of England has grown from $3.5 trillion in 2007 to over $12 trillion today: source Wall Street Journal). As a result markets and policy makers are beginning to question the extended use of QE, though the alternatives appear potentially more disruptive and politically challenging.

The markets’ and society’s fatigue with QE stems primarily from the rising inequality that it has generated. Whilst “the few” have benefitted from the positive wealth effect of rising asset prices (bonds, equities, property etc.), “the many” have endured flat to falling nominal incomes. Corporations and their shareholders have profited at the expense of employees. Households have faced rising bills and the pain of austerity whilst governments have congratulated themselves on avoiding catastrophe, when in actual fact they have offered little to no leadership, failed to institute any growth-supporting fiscal policies and instead delegated all responsibility for repairing the economy to the central bankers.

Despite the relative calm that QE has brought, its primary goal of rekindling sustainable demanddriven inflation has been a glaring failure. Yes there are glimmers of ‘cost push’ inflation beginning to emerge, courtesy of a depreciating currency and commodity prices rising from a floor, but typically these pressures are transient and unstable. Until confidence is firmly re-established, the benefit of low interest rates is unlikely to manifest itself in increased investment and so the positive money multiplier effect the central bank craves remains elusive. This explains why markets continue to expect the long term natural rate of interest (the real, ie nominal less inflation, interest rate that supports non-inflationary GDP growth) to remain at historically low levels, see chart below.

estimated-natural-interest-rateThe problem is whilst rationally and intuitively many market participants believe a change is necessary, the prospect of moving away from QE raises uncertainty. As a result whenever central bankers have hinted at a reversal of QE, this has led to market weakness, ultimately leading them to withdraw their earlier intentions. This is effectively leading to a dangerous scenario where the counter-cyclical role of a central bank designed to deliver relative economic and financial stability through the cycle is being forfeited. Instead of central banks leading they are increasingly being led, and led by markets addicted to the QE drug, where the prospect of complete withdrawal is always going to be messy and full of unknowns.

So who would want to be a central banker, particularly now? Even after all their best efforts since the Global Financial Crisis (GFC) of 2008/09 to stimulate economic activity and restore financial stability, global GDP growth remains anaemic, inflation some way beneath target, and business confidence absent. The appropriateness, efficacy and relevance of QE is now being deeply questioned. Yet, at the same time there is a clear hesitancy about its withdrawal. As a result central bankers feel increasingly trapped, damned if they do and damned if they don’t. But that is why they have the position of responsibility they have, to take difficult decisions for the ultimate betterment of their respective economies. Let’s hope they are up to the task, as ultimately the addiction needs to be broken as QE cannot go on forever.

 


The above article by Peter Dalgliesh, Managing Director of Parmenion Investment Management, was first published by Parmenion Investment Management on 10th November 2016