Review & Outlook

Our take on the investing, financial, & economic themes of the day

What if Quantitative Easing is Deflationary?

In the Wall Street Journal today economist Allan H. Meltzer argues that as a consequence of the Federal Reserve’s easy money policies, “Inflation is in our future. Food prices are leading off, as they did in the mid-1960s before the ‘stagflation’ of the 1970s. Other prices will follow.”  The danger of coming inflation has been the drumbeat of critics of the Fed since Chairman Ben Bernanke began his unprecedented intervention into the bond market.  As Meltzer notes, the Fed has now financed nearly $3 trillion worth of government debt from the Treasury, in addition to buying huge amounts of mortgage-backed securities from the Federal housing agencies.  Apart from directly buying government debt, the Fed’s actions have indirectly supported government borrowing by suppressing interest rates.

Price inflation risk is a real one, and Meltzer may eventually be proven right.  There is good reason to be dubious about the official inflation statistics as represented by the Consumer Price Index, since it fails to capture many real price increases that ordinary middle class consumers feel.   But it seems to me that the effect of quantitative easing might just as well be deflationary, and the warnings about inflation may  be idle.  This would of course be highly ironic, since deflation is just what quantitative easing is supposed to counter.  (The European Central Bank is presently considering its own new round of quantitative easing precisely in order to ward off perceived deflation.)  Quantitative easing could be deflationary, because it has the effect of flooding the market with artificially cheap debt and thereby enabling companies to stay afloat that would otherwise go bankrupt.  By breeding a whole sector of such “zombie” corporations that go on selling their products, as their businesses are sustained by ever-increasing debt instead of profits, the market would be oversupplied with goods and services.  This oversupply would suppress prices and prevent otherwise healthy companies from prospering.

Consider companies like J.C. Penney (JCP), Sears (SHLD), RadioShack (RSH), Best Buy (BBY), and Barnes & Noble (BKS).  These retailers have failing business models and have been selling assets, yet easy access to the corporate bond market, in spite of junk credit ratings, allows them to borrow at rates of 6-7%, which in the 1980s is what you could get on a one year certificate of deposit.

There are demographic trends, quite apart from central bank policy, which suggest that developed economies, and increasingly developing economies as well, are structurally deflationary.  Fewer births mean smaller and older populations, and thus less demand and fewer opportunities for growth and investment.