London, 22 January 2015. In response to the European Central Bank’s (ECB) announcement of quantitative easing today, Paul Marson, Chief Investment Officer of MONOGRAM, argues the programme is unlikely to work:-
“The question is why the biggest private sector credit boom in history – prior to the financial crisis – did not generate consumer price inflation: at the start of the crisis, core inflation was just 2% in Europe and the US. The answer to this is crucial, and explains why quantitative easing in the US/UK has raised asset prices – but not consumer inflation – and why euro QE is likely to be unsuccessful in achieving the ECB’s inflation objective.
Graph 1: UK core inflation and five year annualised inflation following QE
“That underlying core inflation rates in the US and UK are lower today than when QE started is due to tide of disinflation originating from China. Chinese manufacturing goods supply is growing much faster than Western and Chinese demand for manufactured goods. This means a glut of supply which increasingly pushes down manufactured goods prices. Since China accounts for 17.1% of the total increase in world merchandise export (excluding the Eurozone) from 2002-2012, it is increasingly exporting deflation. Inflation is low, and getting lower, because the world is awash with supply – a “positive supply shock” is more powerful than the modest “positive demand shock” coming from QE.
Graph 2: Chinese manufacturing sector supply/ Western demand mismatch
“The problem confronting the ECB is that peripheral banks have substantially increased their holdings of [non-productive] government debt and substantially reduced [productive ] loans to the private sector, amidst ongoing balance sheet shrinkage: the ECB hopes to take those bond holdings down and encourage private lending, a policy that is unlikely to have meaningful effects from exceptionally low current bond yield levels. It is more likely that bonds will replace the bonds they sold with more government bonds!”
Graph 3: Change in PIIGS MFI Assets from 2008