Deflation Defeats Impotent Central Banks
Central banks are deadly fearful of deflation. That’s why the Federal Reserve, the European Central Bank, the Bank of Canada, the Bank of Japan and Sweden's Riksbank, among others, have 2 percent inflation targets. They don’t love rising prices, but they worry about the consequences of a general decline in consumer prices, so they want a firebreak. Unfortunately, they seem powerless to meet their targets in the current economic environment.
The guardians of monetary policy are riveted by Japan, where consumer prices have declined in 48 of the last 83 quarters. This pattern of deflation long ago convinced Japanese buyers to hold off purchases in anticipation of lower prices. But the result is excess inventories and too much productive capacity, which force prices even lower. That confirms expectations, resulting in yet more buyer restraint. The result of this deflationary spiral has been a miserable economy with an average growth in real gross domestic product of just 0.8 percent at annual rates since the beginning of 1994.
Central banks also fret that in a deflationary environment, debt burdens remain fixed in nominal terms, but the ability to service them drops along with falling nominal incomes and waning corporate cash flows. So bankruptcies leap, while borrowing, consumer spending and capital investment all weaken.
As I argued on Monday, deflation remains a clear and present danger. Worryingly, the remedies central bankers are using aren’t working. First, in reaction to the financial crisis, they knocked their short-term reference rates down to essentially zero, and bailed out their stricken banks and other financial institutions. That may have forestalled financial collapse but it did little to stimulate borrowing, spending, capital investment and economic activity. Creditworthy borrowers already had ample liquidity and few attractive spending and investment outlets; slashing borrowing costs to record lows stimulated asset prices such as equities, with little economic benefit.
Furthermore, banks were too scared to lend. And as they resisted attempts to break them up and eliminate the too-big-to-fail problem, regulators bereaved them of profitable activities such as proprietary trading and building and selling complex derivatives. That forced them back toward less lucrative traditional spread lending -- borrowing short-term money cheaply and lending it for longer at a profit -- just as the shrinking gap between short- and long-term funds made that business even less attractive. With the amount of capital banks are obliged to set aside against their trading activities also leaping, they're now regulated to such an extent that many of them probably wish they had been broken up.
For their next move, central banks introduced quantitative easing, purchasing massive amounts of government debt and other securities. As the Fed bought trillions of dollars’ worth, the sellers plowed much of the proceeds into equities. That hyped stocks but didn’t induce economic growth (equities are primarily owned by rich folk who don’t spend much more on goods and services as their portfolio values rise).
The Fed called a halt to QE in October 2014; but the ECB and the Bank of Japan are still extending their programs, and have turned to negative interest rates out of desperation. They know full well that borrowing costs at or below the so-called zero bound cause multiple financial distortions as investors’ zeal for yield drives them into hedge funds, private equity, junk bonds, emerging-market equities and debt and other risky asses. But they're praying that negative rates will spur investment and spending as borrowers, in real terms, are paid to take the filthy lucre away. Against a deflationary backdrop, nominal rates must be even more negative than the rate of consumer price declines to create negative real rates.
Central banks have tried almost everything, but in the current deflationary climate monetary policy is impotent and policy makers are proving the ineffectiveness of pushing on a string. That's good news for Treasuries and the dollar, but bad news for equities and commodities.
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