Have we reached the limits of Quantitative Easing?

We are more than six years into a recovery in the developed world and official interest rates are still at emergency levels, growth remains weak and output gaps are generally high.

Governments had generally assumed that ultra-low interest rates coupled with unorthodox monetary policies, as well as being convenient in allowing them largely to avoid unpalatable spending decisions, would eventually induce a sustainable growth cycle with accompanying levels of inflation that would help to mitigate high overall debt burdens.

In reality, the track record of quantitative easing (QE) and the favoured central bank policy of low interest rates has been decidedly mixed, and there is a growing disillusionment amongst politicians everywhere about the ability of monetary policy to solve their economic problems.

It is certainly the case that such policies were essential in offsetting the sharp contraction in money supply growth that occurred in the period immediately after the global financial crisis.

It has also played a role in facilitating currency weakness, first in the case of the US dollar, then the Japanese yen and finally the euro, helping each of their respective economies (admittedly at the expense of others).

However, recoveries have been lacklustre at best and the side effects increasingly unmanageable.

Ultra-low rates have helped fuel bull markets in both financial and real assets, dramatically widening social inequality and resulting in significant capital misallocation.

Savers have been forced into owning riskier assets or their funds have simply been reallocated for the ‘greater good’.

It seems that markets have become like junkies waiting for their next ‘fix’ of QE, threatening a deflationary collapse if they don’t get what they think they need.

The boom in the developing world, itself partly the product of poor monetary policy setting in the developed world in the 2002-2008 period, was certainly exacerbated by ultra-low interest rates post the global financial crisis, and in turn led to even more pronounced levels of domestic credit creation in those economies.

The so-called ‘vendor financing model’ (the lending of money by a company to its customers so that the customer can buy products from it) was turned on its head to become a producer financing model.

The result is the current emerging market bust, along with renewed concerns about deflation and a global recession.

So, is QE part of the problem rather than the solution? Central bankers remain fixated on inflation targeting and, as the recent debacle concerning the Federal Funds rate starkly illustrated, are extremely reluctant to normalise interest rates.

As well as perpetuating many perverse incentives, the lack of normal yield curves provides little incentive for financial institutions to lend, as evidenced by the reserves piled up at the same central banks.

Large-cap company managements across the developed world continue to engage in financial engineering by borrowing at giveaway long-term interest rates to buy back their shares, in preference to investing in their own businesses.

The uneasy awareness that the current environment is not ‘normal’ is in itself promoting collective risk aversion. Central bankers must remain true to their mandates and will continue to pursue policies aimed at improving ‘stability’ which do exactly the opposite.

This is the law of unintended consequences writ large. We believe this will perpetuate the current ‘wall of worry’ and promote market volatility as well as doing little to promote growth.

Governments, on the other hand, are beginning to realise that they have to be a lot more proactive if they want to achieve their growth objectives.

Japan, in our view, is a good example of this and, just when market participants had given up on Abenomics, things could be about to change.

The long-awaited Trans Pacific Partnership trade agreement opens the door to an overdue reform of that country’s agricultural sector. As well as supply-side reform, we suspect that spending on infrastructure is about to boom and that fiscal policy will start to take much more of the strain.

Better late than never.

by Philip Saunders, portfolio manager for the Investec Diversified Growth Fund (reproduced with permission)

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