Economic Crisis

Is deflation a bigger risk than inflation?

Consumer price inflation (CPI) has scraped itself off the floor in the past couple of years. In the face of tiny or negative real rates, ultra-low central bank policy rates and bond yields are now playing catch up. QE propped up the money supply when commercial banks couldn’t. As it’s wound down, money supply growth could even go into reverse. What are the potential implications for investors?

Bank of America Merrill Lynch, an investment bank, recently published its March survey of the biggest “tail risks” that global fund managers worry about.

The top concerns, in order of importance, were a trade war, inflation, economic slowdown, central bank policy mistakes (Federal Reserve / European Central Bank), market structure (whatever that means), and the tech bubble.

Inflation features prominently, at number two. I’m assuming “central bank policy mistakes” refer to causing a crash in stocks and/or bonds via increases in interest rates and/or the reversal of quantitative easing (QE).

QE is the process whereby a central bank creates new money from thin air and uses it to buy assets, most usually government bonds. It directly creates bank deposits at commercial banks, initially in the accounts of the bond sellers.

As such, QE bypasses or replaces, the normal process of money creation by commercial banks. Ordinarily, new money is created when a bank makes a new customer loan out of thin air (a bank asset), with a matching customer deposit created at the same time (a bank liability).

I’ve previously written about how these processes work in “Money and the missing link” (see Part I and Part II). Those articles explain where money comes from, why new supply is usually constrained, and why common theories of money creation are incorrect (including the idea of “fractional reserve banking”).

A lot of people thought that creating trillions of dollars (or euros) of new bank deposits via QE would lead to hyperinflation. That’s either directly or by allowing commercial banks to create massive amounts of new loans.

Clearly that didn’t happen. Instead, the last decade has been characterised by very low inflation, or even deflation.

The reason is that the lending capacity of commercial banks is constrained in two ways by regulations:

  1. Capital rules, which limit balance sheet assets in relation to capital (net assets after deducting bank liabilities), especially equity capital (net book value or shareholders’ equity).
  2. Liquidity rules, which say banks must have certain levels of highly liquid assets to cover sudden funding problems, like rapid deposit withdrawals during a bank run. These liquid assets include physical cash, highly rated government bonds (e.g. US treasuries) and deposits held at the central bank.

Immediately after the global financial crisis (GFC), commercial banks were woefully undercapitalised, as they struggled to deal with asset write-downs and multi-billion dollar fines for past misdemeanours.

This meant that money supply (deposits) from new lending collapsed for a few years. QE plugged the gap, albeit sending money to a different place (securities markets) than normal commercial or consumer loans (the real economy).

On top of the banks’ immediate GFC problems, regulatory capital and liquidity rules are far, far tighter now than they were in 2008. Governments and central banks understandably don’t want a repeat melt down. However, the negative, unintended economic consequences don’t seem to have registered with policy makers.

Put simply, the “normal” rate at which banks can create new loans is now much lower than before the GFC. At least, assuming that underlying bank profitability is the same (a big assumption, especially in the eurozone).

Consider a simple bank that used to be 40 times leveraged, meaning its assets were 40 times its equity capital (a fairly typical pre-GFC level). Say it had $400 billion of loans, $10 billion of equity and made $2 billion of net profit in a year. Also let’s say it paid out half of profits as dividends, and retained the other half to add to capital.

This bank made 20% return on equity ($2 billion divided by $10 billion), and grew equity by 10% a year ($1 billion divided by $10 billion). In turn, because it was 40 times leveraged, it could grow its lending by 10% a year, or $40 billion.

Now imagine that regulators say the bank has to have twice as much equity capital, leaving it only 20 times leveraged. Equity must now be $20 billion for $400 of assets.

Return on equity is halved to 10% ($2 billion divided by $20 billion) and the rate of equity capital growth also halves to 5% a year ($1 billion divided by $20 billion). As such, loan growth also collapses to 5% a year or $20 billion, half the previous level.

This is simplified. In reality the capital rules are highly complex. Also, banks have met the tighter capital rules both through shrinking their balance sheets and adding to capital, meeting somewhere in the middle.

But what has actually happened to lending growth is along these lines. According to figures from James Ferguson at Macro Strategy Partnership, bank loan growth was around 10% in each of the US, eurozone and UK just before the GFC hit in 2008.

Latest figures for bank loan growth are around 3% for the US and UK, and just 1% for the eurozone (where bank profitability, as measured by return on equity, is poorest).

In other words, a decade after the GFC, the rate of loan growth has collapsed. Far higher capital requirements than before will ensure the rate stays much lower than the highly-leveraged pre-GFC days, barring an unlikely profit miracle at the banks.

(This also explains why all the banks are so focused on automating away highly paid bank jobs to improve profit margins. But it’s unlikely that it will be enough to offset the stricter regulations any time soon.)

In short, in debt-saturated economies that rely on credit creation for growth, there’s no longer nearly as much credit creation capacity, in relative terms.

We’re in a low growth world, unless banks continually raise new equity capital to allow for faster loan growth. In turn, that requires investors to constantly pump more cash into the low return banking system (which itself would crowd out other sectors in search of capital).

That’s the baseline. But it gets worse.

 

Enter “QT”

Enter reverse-QE, or “QT” (Quantitative Tightening). This is the process whereby central banks, like the Fed and European Central Bank (ECB), wind down their accumulated trillions of dollars of bond holdings. That’s done either by allowing the bonds to mature or by selling them in the open market.

I’ll spare you the technical nitty gritty and skip straight to the result of QT. Bank deposits will reduce by trillions of dollars (or euros), and commercial bank excess reserves (the offsetting accounting entry) will fall by the same amount.

There are two implications to this.

Firstly, in a world where bank loan growth is already structurally slow, there will be a further drag on the money supply.

Secondly, any commercial bank that finds the draining of excess reserves pushes its total liquid assets below the legally required threshold (or minimum management target) will have to divert assets from ordinary business, such as lending. This has the potential to slow bank loan growth even more.

That said, that last part may not happen yet, and only in the latter stages of QT (assuming we even get that far, before central banks panic and relaunch QE). For now, excess reserves are so huge it may not be a problem. But I plan to look into it further.

In summary:

  1. Bank loan growth is already slow, due to much tighter bank capital regulations than before.
  2. QT will suppress money supply growth even more, as deposits are drained from the system.
  3. Newly tight bank liquidity requirements, combined with QT’s draining of bank reserves, could slow commercial bank lending to an even lower rate of growth (eventually).
  4. The net effect could be a contraction of the broad money supply.

A contraction of the money supply is the very definition of deflation…and it’s recessionary. In fact, even very weak positive growth of the money supply should spark a recession, being a contraction of real GDP.

Recessions don’t tend to be good for stocks, to say the least. Whereas deflation – or even disinflation (falling inflation) – would be good for bonds, as yields fall and prices rise.

Will any of this happen? I’m just putting out a scenario. But it’s something I plan to look into further, and will keep an eye out for new evidence.

For now, I continue to recommend holding plenty of cash and a modest allocation to long-dated US treasury bonds.

However, if inflation really is what we’ve got to watch out for, gold provides a hedge (as well as being a highly desirable item in the world’s large and fast-growing economies, such as China and India, with strong long-term prospects).

As a reminder, here’s a summary of my recommended asset allocations:

I’m still thinking through all the potential implications, and joining the dots with some other issues. In the meantime, I’d love to hear your own thoughts or questions.

Stay tuned OfWealthers,

Rob Marstrand

robmarstrand@ofwealth.com


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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.

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