Sunday, 29 December 2013

Short-term thinking

I was wandering over a rather damp golf course yesterday, thinking about the rapidly-growing consensus that QE isn't inflationary because inflation is lower now in the US than when QE started. The golf course where I torture animals by sending balls into the undergrowth at regularly intervals responded to talk of global warming and a couple of dry summers almost twenty years ago, by digging a great big lake to increase irrigation. It now seems that global warming makes for wet summers.

I'm not an expert on global warming. But it does strike me as odd that a sample of one, and a period of just a few years, can be seen seen as proof  of anything - either the effect of global warming on the weather, or the effect of QE on inflation.

We don't really know what the long-term effects of massive expansion of central bank balance sheets will be. Personally, I reckon the effect of QE is mostly on the price of the assets that the central banks buy and everything else follows from that. The amount of money in the economy is determined by demand for loans, and banks' willingness to expand their balance sheets, more than by central banks' own balance sheets, but the effect on asset prices is simpler. A central bank buys bonds, drives prices up and forces other bondholders to buy something else. That is bad for the currency if there are a lot of foreign holders of the bonds and good for equities supposing they compete with bonds for investors' cash. And as long as there is a global excess of goods and labour and the currency effect is small, why should it send up CPI inflation?

But if the QE doesn't send up consumer price inflation, that doesn't mean it has no effect or that it isn't dangerous. Rising bond prices may be 'good' for borrowers but go shopping for an annuity and you could feel differently. Sit and decide what to put your pension savings into and the high level of the equity market won't be so attractive, either. But hey, pensions are not in the CPI index, any more than house prices are, so there's nothing to worry about, right?

Away from QE though, I still think the disparity between the cost of money and the growth rate of the US and global economies is simply causing mis-allocation of capital. The gap between  Fed Funds and US GDP growth is heading back towards 4%. It's a recipe for asset price inflation, and a recipe for excessive valuation of assets, somewhere. I've plotted the GDP/Fed Funds relationship below, in both nominal and real terms. There are four cases of rates being far too low relative to GDP growth and they have all had a different impact. Ignoring the present, in 2004/6 easy money caused a credit bubble. In 92/95 easy Fed policy caused a credit and asset bubble in Asia, and only the easy policy in 75/78 showed up in higher CPI inflation.

My point is a simple one - if rates are too low,  we should expect there to be an impact, but should not assume automatically that the impact will be felt in CPI inflation. And the same is true of QE. We should expect over-easy money to cause distortions that will come home to roost in the real economy - just not necessarily on the 1-2-year time horizon that suits most observers.

p.s.... if rates are too low for too long, of course someone becomes addicted to cheap money. The same would be true of what cheap beer prices do to alcohol addiction. The turkeys come home to root when rates have to go up, and we find out who the addicts are. In 2008, it was the banks. In 2006 it was the Asian banks and property developers. So, who is over-leveraged this time?

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