In Thursday’s (October 13, 2011) Financial Times, Tim Bond, investment strategist at Odey Asset Management, wrote a column welcoming “a world without QE.” Acknowledging that equity markets around the world were disappointed by the failure of the Fed to restore a program of monetary easing, some form of QE3, Mr. Bond contends that the reaction was “myopic and mistaken,” calling QE2 “a mistake with problematic unintended consequences.” He explains:
The underlying defect in QE is that it stirred investors’ fears of monetary inflation, whilst stimulating the wrong sort of inflation in the wrong places. The early positive economic effects were subsequently overwhelmed by a negative inflationary blowback that played a key role in disrupting the recovery.
This is a rather different take from mine, which is that investors don’t fear inflation, they yearn for it, as evidenced by the strikingly positive correlation, since spring 2008, shortly after the downturn starting the previous December, between changes in the TIPS breakeven spread and changes in the S&P 500 . (I have presented evidence for this correlation, based on data through the end of 2010, in my paper “The Fisher Effect Under Deflationary Expectations” available here, and I explained why the stock market loves inflation in this posting.)
Intimating that the rise in commodity prices prompted by the QE2-induced expectation of rising inflation took everyone, especially policy makers, by surprise, Mr. Bond observes that “fears (my italics) of monetary inflation prompted a widespread portfolio reallocation into commodities.” However, a portfolio reallocation from holding cash to holding physical capital is a key element of a recovery from a sharp downturn such as we experienced in 2008, expectations of increasing returns from holding capital assets relative to returns from holding cash spurring investments in working capital (i.e., inventories, including raw materials, intermediate goods, and final goods) and in fixed capital (machines and structures). Why this salutary reallocation constitutes “negative blowback” is not explained, Mr. Bond apparently considering the adverse nature of any increase in commodity prices too obvious to require any elucidation on his part.
But the “more important flaw in QE,” according to Mr. Bond,was that it “stimulated large financial flows into China and other emerging market (EM) economies, as investors sought a higher-yielding, hard currency alternative to the dollar.” These hot money flows fueled an unwanted credit expansion in China, triggering a sharp rise in inflation and a real-estate bubble. Rising inflation in China added to the pressure on commodity prices, boosting global inflation. The increase in global inflation, in Bond’s view, is responsible “for the sharp slowdown in global growth since the start of the year,” presumably because “higher inflation eroded household incomes and demand at a time of very slow nominal income growth.” The credit bubble forced the Chinese authorities to tighten policy, producing a slowdown in Chinese economic growth.
Mr. Bond attributes large recent money flows into China to a desire to avoid a depreciating US dollar. That is a superficial view. Large quantities of dollars have been flowing into China for over a decade, especially from about 2002 to 2007. The primary cause of those dollar flows was a desire by China to accumulate foreign exchange and to promote Chinese exports (the two are closely related and it is not clear which desire is the more fundamental) by limiting the increase in Chinese consumption. Criticism of China’s exchange-rate policy of pegging the yuan exchange rate against the dollar mistakenly focuses on the fixed nominal exchange rate between the yuan and the dollar. That focus is misguided. A fixed nominal exchange rate did not force China to limit the growth of Chinese consumer demand and to accumulate huge hoards of foreign exchange. A more balanced Chinese monetary policy than that which has been followed (though the policy seems to have been moderated in the last couple of years) would, even with a fixed yuan-dollar exchange rate, have allowed Chinese wages to rise more rapidly than they did, fostering rapid growth in the non-tradable-goods sector in China rather than forcing all the growth into the tradable-goods sector. The rapid increase in Chinese property values, mistakenly called a bubble by Mr. Bond, reflects the underinvestment by the Chinese in their domestic housing stock, not an inflationary real-estate boom, and certainly not a boom fueled by the modest QE2 program pursued by the Fed for only about 8 months. To attribute recent hot money flows from the US to China to an increase in expected US inflation ignores the simple fact that if economic growth and, hence, real interest rates in China are much higher than in the US, cash will be drawn, one way or another, from the US to China pretty much irrespective of what the US rate of inflation is. Even if some of the dollar flow to China is driven by speculation on an appreciation of the yuan, it is hardly clear how much of a role QE2, or QE3 if it were to happen,would play in the decision to raise the value of the yuan.
Mr. Bond confidently posits an almost immediate connection between increased inflation and reduced growth since the start of 2011, but the closest he comes to providing an explanation for this connection, lacking any basis in economic theory detectable by me, is that “higher inflation eroded household incomes and demand at a time of very slow economic growth.” Obviously begging the question of how nominal income is determined, Mr. Bond evidently is suggesting that nominal income is determined by factors independent of monetary policy. But if monetary has no effect on nominal income, the question then presents itself : how is it that QE2 could have caused commodity prices to rise in the first place?
If Mr. Bond is prepared to assert both that QE2 raised commodity prices and that QE2 did not raise nominal income, he is a brave soul indeed. Bravery is undoubtedly a virtue, and compensates for many shortcomings. Defective logic, however, is not one of them. The audacity of confusion has its limits.