By debating the size of their balance sheets, central banks are showing the first signs since the crisis that they may be worrying about our growing addiction to QE, according to Group Chief Economist Neil Williams in his quarterly Economic outlook. After unclogging the system in 2009, QE has since been an imperfect remedy.
There are no counter-factuals, but the responsiveness of GDP to money-growth has been far less than one-to-one, as consumers and producers wary of unemployment and deflation became interest-rate insensitive and fell into a ‘liquidity trap’.
No matter how much QE is run, its reflationary impact also depends on how quickly the liquidity is pushed around the system. In reflation terms, it is no good throwing money ‘out of a helicopter’ if no one spends it. In practice, the velocity of money circulation has been slow to recover. So, by bloating asset prices, QE could be accused of getting to those that needed it least.
While QE got to those that needed it least, protectionism would trigger cost-inflation...
But, its impact may not have been properly picked up. By taking explicit account of QE and fiscal positions, our analysis suggests the true US policy interest rate may be as low as -4%, and -3% in the UK.
For the time being, this may be just as well. As, without care, an unhelpful jigsaw piece from the 1930s – retaliatory trade protectionism – might yet come crashing into place. However, the impact of protectionism this time could be far more complicated.
First, the economic and financial linkages suggest the knock-on would be more far-reaching. Global retaliation would activate second-round effects that later offset the initial growth-impulse from Mr Trump’s intended tax cuts.
A strong dollar would reinforce this, at a time when the UK is about to renegotiate its own trade deals. If US experience is a guide, new trade deals take an average four years to complete. Nonetheless, the UK cannot commit trade-deal ‘bigamy’ while still in the EU.
Second, the deflationary return to the US could therefore be much larger than anticipated. China’s commitment to US Treasuries would be questioned, supply chains for US corporates disrupted, and the US’s already shrinking labour supply and potential growth reduced further.
Third, should protectionist forces build, inflation would reappear. However, with the possible exception of the US facing labour shortages, it will be the ‘wrong sort’ – cost-push, led by tariffs, weaker currencies, and goods shortages, rather than demand-pull. Central banks would thus have to ‘turn a blind eye’ as economies stagflate.
This portends more to the inflation rises of the early 1980s and 1990s recessions, than the overheating of the late 1980s and mid 2000s. And, as chart 2 below for the US suggests, inflationary flames going into recessions – that is, not stoked by wage increases – tend to snuff themselves out relatively quickly.
By starting ‘QT’, the Fed may not have to raise rates as far as markets assume...
In which case, while reflation trades looked appropriate at the start of 2017, the spectre of protectionism, cost inflation, and dissipating growth may cause stimulus euphoria to fade.
The trade-off, though, is that policy rates stay lower than many expect, helped as the US Fed nudges the other monetary lever, ‘QT’ (quantitative tightening). Otherwise, if QE endures, financial assets will continue to be priced more on central bank actions, than underlying fundamentals.
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