Are Central Banks Creating Deflation?

Last week we noted that with the start of Q€ just around the corner, the ECB finds itself in a rather absurd situation. In what we called the ultimate easy money paradox (or, alternatively, the ultimate Keynesian boondoggle), Mario Draghi and crew are doomed to trip over their own policies as they (literally) attempt to monetize twice the net supply of eurozone fixed income this year. 

The problem is two-fold: 1) the central bank’s adventures in NIRP-dom mean anyone willing to sell their EGBs would face the truly silly prospect of sending the proceeds right back where they came from, except at a cost of 20 bps (negative deposit facility rate), and 2) because the central bank’s easy money policies have compressed credit spreads, sellers who wanted to reinvest the cash they would theoretically receive for their EGBs would have to do so at ridiculously low rates, a scenario that would compound QE’s already negative effect on NIM for banks and would be absolutely untenable for insurers. So what we have “is one deflation-fighting policy stymying another [and] the central bank’s previous efforts to drive down rates thwarting its current plans to … drive down rates.” 

Now, courtesy of Citi’s Matt King, it’s our distinct pleasure to present yet another wonderfully ridiculous paradox inadvertently created by central banks who apparently aren’t capable of understanding when they’re just pushing on a string: manufactured deflation or, more poignantly, just what the doctor did not order. Here’s Citi: 

It’s that linkage between investment (or the lack of it) and all the stimulus which we find so disturbing. If the first $5tn of global QE, which saw corporate bond yields in both $ and € fall to all-time lows, didn’t prompt a wave of investment, what do we think a sixth trillion is going to do?

 

Another client put it more strongly still. “By lowering the cost of borrowing, QE has lowered the risk of default. This has led to overcapacity (see highly leveraged shale companies). Overcapacity leads to deflation. With QE, are central banks manufacturing what they are trying to defeat?”