InvestmentsDec 4 2015

Fund Selector: Deflationary effects of QE

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Quantitative easing (QE), as well as boosting economic growth, is designed to stimulate inflation. Back in 2009-10 when it was first mooted, I wrote about the risk of incipient inflation from using such a mechanism. This clearly has not come to pass.

Since the global financial crisis, QE has been actively employed with varying degrees of success by the UK, US, China, Japan and the eurozone among others. QE tends to cause bond prices to rise and yields to fall. This injection of liquidity maintains downward pressure on interest and exchange rates while putting upward pressure on bond prices.

These inflationary pressures can spread to other related asset classes, most visibly equities and commercial property, as income-hungry investors seek alternative income streams to replace declining income from bonds.

However, we shouldn’t confuse asset inflation with economic inflation. The two are different. It is true that in lowering the exchange rate and thereby causing the price of imported goods to rise, QE helps stoke economic inflation. Nevertheless, it is just possible that QE may also produce deflationary effects that may actually undermine some of what central banks are trying to achieve.

QE and low interest rates go hand in hand. In the eurozone, for example, where the European Central Bank’s current QE programme is to buy €60bn (£42bn) of bonds every month until September 2016, the central bank deposit rate is minus 0.2 per cent (ie, depositors are being charged for lending money to banks, rather than being rewarded for doing so).

This is essentially ‘free’ money for borrowers, which means poorly performing or uncompetitive companies, which under any other circumstances would have most likely gone bust, are able to stay afloat using cheap credit. This maintains unproductive capacity in their industries and markets and puts downward pressure on prices. The most obvious examples are to be found in the commodities and energy industries, where otherwise uneconomic output is propped up by abnormally low rates despite the toxic combination of low prices and high inventories.

The downward pressure on yields in a low interest rate environment also has significant ramifications for savers, in particular pensioners. Given they are relying on investment income while trying to preserve capital, falling yields mean pressure on pensioners’ earnings. Lower spending power weakens demand, which in turn puts pressure on prices.

Low interest rates exacerbated by QE also absorb capital. Pension funds need larger capital pools than would otherwise be the case in order to meet their liabilities. Additional capital injections may frequently be significant and must be met from the company’s own financial resources. This diverts capital that could otherwise be used more profitably by the business – for example, in capital expenditure or by being distributed to shareholders, again undermining longer-term consumption.

So, while intended to be inflationary, QE has distinct deflationary undertones. Whichever of these conflicting pressures eventually dominates, it’s difficult not to argue that QE does at the very least create significant distortions.

John Chatfeild-Roberts is head of strategy in the Jupiter independent funds team