Home > Uncategorized > Domestic demand inflation and QE

Domestic demand inflation and QE

1. Inlfation

Eurozone inflation continues to be low, even in Germany where unemployment is less high (Graph 1, Eurostat, inflation defined as Domestic Demand Inflation, which does not just cover consumer prices but also investment and health care and education price and export prices). A country like Greece even experiences grinding deflation. Which seems nice: everything is getting cheaper. But which also means that it is getting ever harder to pay down your debts, as incomes and profits decline (Greece was the EZ country with the highest deflation in the Eurozone, Germany the country with the highest inflation).

Does this low inflation mean that QE (Quantitative Easing, i.e. a central bank which buys bonds) does not work? At this moment a lot of people tend to look at a graph like graph 1 and answer ‘It doesn’t!’. But are they right? I think they are, but for the wrong reason. Graph 2 shows the growth rate of Euro creating lending. As can be seen, borrowing (from banks) increased pretty fast before 2008.

2. Moneycreation

This high level of borrowing of course led to legacy debts, which people and companies try to pay down (see the decline of borrowing between 2011 and 2013). Siphoning off money from your stream of income to pay down debts however leads to depressed spending and acts as a drag on growth. QE tries to counteract that by decreasing the short and long-term interest rates (and, in the Eurozone, by equalizing the rate of interest between countries and banks), which has to stimulate new investment and lending. But do we really want more debt to solve the problem of these legacy debts by tempting people to borrow even more?(it might help of course, when these debts are refinanced in a way which decreases the average legacy interest rate).

But other kinds of QE are possible.

As far as I could figure out, national central banks have the right to define pension funds as ‘eligible counter parties’ (look here and here and here) which means that QE can also be used to buy bonds from pension funds instead of banks. And, contrary to banks, pension funds can use this money to invest in the real economy – or to pay pensions, which adds new money and purchasing power directly to the GDP economy. One can also think of some kind of ‘QE for the people’ which for instance consists of emitting transferable vouchers to each Eurozone citizen which can be used to pay down bank debt (mortgage debt, study loans) and which the banks can change into reserves at the ECB.

(the graphs are not entirely consistent, I’m working with a new version of Excel and I have not yet completely mastered the new graphing functionality)

  1. March 8, 2016 at 6:24 pm

    You say: “that QE can also be used to buy bonds from pension funds instead of banks”. Please correct me if you have access to the right data, but I don’t believe that asset purchase programs, either in ‘normal times’ or for QE, involve buying bonds from banks. If banks owned those bonds, they would hardly need QE liquidity support, would they? As I understand it the bonds are bought from non-bank financial institutions. Certainly, that is what the Bank of England Red Book says. Can it be any different for the European Central Bank?

  2. merijnknibbe
    March 8, 2016 at 7:11 pm

    Complicated. The bonds are bought from ‘eligible counterparties’, as they are called. I’ve not (yet) been able to find a list of these parties. In fact, the only real restriction mentioned for instance here https://www.ecb.europa.eu/mopo/implement/omt/html/pspp-qa.en.html is the fact that the ECB does not buy in the primary market. However, the intention of the purchases is clear from sentences like this one: ‘The amortisation does not alter the liquidity injected into the banking system through the purchases under the APP.’ and: ‘The ECB will buy bonds issued by euro area central governments, agencies and European institutions in the secondary market against central bank money (sic), which the institutions that sold the securities can use to buy other assets and extend credit to the real economy (not directly if these are MFI’s but via credit creation, M.K.). In both cases, this contributes to an easing of financial conditions’. and ‘The eligible counterparties for purchases shall be those eligible for the Eurosystem’s monetary policy instruments, together with any other counterparties used by the Eurosystem for the investment of its euro-denominated portfolios.’.https://www.ecb.europa.eu/press/pr/date/2015/html/pr150122_1.en.html I used the word ‘banks’ but I should have stated ‘eligible counterparties’. The point is that if these counterparties are pension funds they do not have to use the money to provide credit but can use it to pay pensions or to invest directly in the economy. Buying (also) from pension funds is what Bernanke did and what, as far as I know and as you indicate, is also what the BoE did. This is a much more direct kind of QE than QE which aims at ‘providing liquidity’. Pension funds can also, unlike MFI banks, directly use the money to lend, without ‘credit creation’.

    • March 8, 2016 at 8:05 pm

      Indeed, the BoE bought a range of corporate and other bonds in the early days, though that tapered off, and none now remain on their books, only British government bonds, some quarter of all government debt I believe (£375bn / £1,500bn, whatever that comes to). However, liquidity in the form of new reserves arrives at the private banks whatever the central banks buy and from whomever, except of course the banks themselves, so I am not sure why you say that buying bonds from pension funds is a more direct form of QE. Anyone who sells a bond could go on a spending spree, but most didn’t. The failure of QE to produce in the UK at least more than a guestimated 2% inflation (BoE figures) is because most bond sellers simply bought other bonds, i.e. rolled them over.

    • March 8, 2016 at 9:30 pm

      On another point you make: “institutions that sold the securities can use to buy other assets and extend credit to the real economy (not directly if these are MFI’s but via credit creation, M.K.).” MFIs don’t sell bonds to the central bank in QE via asset purchase, that we have agreed perhaps. But MFIs certainly gain huge reserves, as BoE and Fed figures show, but this only helps liquidity, not solvency. That is because for every billion of reserves as assets a private bank gains (covering loan defaults) it also is lumbered with a billion of new deposits, i.e. liabilities. This means that the ratio of capital to deposits drops, and unless investors come forward to buy shares (or bondholders are bailed in by converting bonds to shares, as with the Co-op) the capital ratio is now worse than before and so the last thing that the bank wants to do is to further extend its balance sheet via credit creation. As we have seen.

  3. Hepion
    March 17, 2016 at 11:38 pm

    “QE can also be used to buy bonds from pension funds instead of banks. And, contrary to banks, pension funds can use this money to invest in the real economy – or to pay pensions, which adds new money and purchasing power directly to the GDP economy”

    Why is it so hard to understand QE? QE is an asset swap where interest earning bonds are exchanged for money. It’s effect is deflatory as it cuts interest income from private sector. In other words it makes private sector poorer, and less able to spend.

    Those bonds held by pensions funds are easily convertible to money if and when they want to spend. That conversion is has never been a limiting factor in their ability to spend. They pay pensions based on their contractual obligations, that has nothing to do with how much money they have at hand. So what is QE going to accomplish other that cutting interest income from private sector?

    • merijnknibbe
      March 18, 2016 at 7:39 am

      The point is: MFI’s (Money creating banks) use the money as reserves which they need to be able to create new money by lending, taking the amount of reserves and interest rates into account. Pension funds can use the money to pay pensions and do not need to keep it as a reserve. I.e. pension funds can directly inject this money into the circular flow of the economy, banks have to wait till somebody wants to borrow.Which means that according to the statistical definitions QE directly adds to the stock of money in the case of pension funds but not in the case of banks.

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