Lessons from Japan: why quantitative easing won't lead to inflation

You don't need to have taken Economics 101 to be familiar with the demand curve. Everyone knows that if the supply of a product rises then, all other things being equal, the price will fall. The same goes for money. If there is growth in the stock of money (the money supply), then the value of money falls and you get inflation. So on that basis, quantitative easing (QE), which is nothing less than a substantial increase in the money supply, should mean inflation, right? Especially if the QE is likely to continue for as long as it takes to revive the economy. How could a rational person come to any other conclusion?

On a recent trip to New York, I was informed that the most crowded hedge-fund trade of all is to sell long-dated Treasuries short in anticipation of just such an inflationary outcome. This is in a country where QE has not even started yet. Here in Britain, where there are £53.25bn of notes and coins in circulation, the planned £150bn of new money creation (£75bn now and £75bn later if needed) is equal to nearly three times the monetary base. Inflation, even hyper-inflation, can be the only outcome. Or can it? There are many measures of money supply. The monetary base (M0) is by far the smallest. M1 is a wider measure, which includes demand deposits (such as the money in your bank accounts) as well as notes and coins in circulation. M1 far exceeds M0, at £1,060bn. But even this isn't the true, wide money measure, for which we might look at all sterling bank deposits, which total £2.6trn. That £75bn doesn't look so impressive now, at a mere 2.9% of this wider measure of money supply.

However, the Bank of England has left the option open to pursue QE more aggressively later, if needs be. Whether or not this proves inflationary depends initially at least on the strength of the opposing deflationary pressures. The Quantity Theory of Money states that money supply (M) times the velocity (V) at which money flows around the system, equals prices (P) times economic activity or transactions (T), or:

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M*V = P*T

Usually economists assume that V and T are pretty much fixed and stable. In this case, any growth in money supply (M) leads directly to a rise in prices (P) inflation. But as you've no doubt noticed, right now things are not normal. The velocity of money (V) is plunging as the economy slumps. This means that if governments fail to ramp up the money supply (M), prices (P) will dive. The trouble is we don't know exactly by how much the money supply needs to be ramped up, because while the slowdown is very clear, there are delays in measuring just how severe it is. Anyway, the velocity of money depends on banks' willingness to pass on any liquidity increases, and this they seem very unwilling to do.

So in reality, the magnitude of QE has been overstated and the severity of the collapse in the velocity of money may be too. In short, QE may be insufficient to lift us out of a deflationary spiral. Aha! I hear you cry. Surely growth in the stock of money, once velocity returns, will trigger a surge in inflation, perhaps a dangerously hyperinflationary one? If only we could try this in the lab and see how it turns out. Well, luckily for us, it's already been done in you guessed it Japan, and we can see exactly how it turned out. (To give you a clue, heard about the rampant hyperinflation in Japan recently? No? Exactly.) Japanese QE didn't start at once. First, the authorities ran a steady double-digit growth in money supply for over a decade, while the Japanese banks were initially in denial, and then the government injected nearly 10% of GDP directly into the banks' capital bases. Yet, even after money supply as a proportion of GDP had doubled, Japan's banks were still shrinking lending.

The Bank of Japan, believing it had perhaps just lacked imagination, doubled M1 money supply again, this time over the much shorter period of two to three years from 2001. This would be like the UK boosting QE not by £75bn or £150bn but by £1trn and then by the same again. Yet the impact on Japanese bank lending was... nothing. Bank lending continued to fall by 5%-6% a year, as it had done for the prior three years. Only a recovery in global demand for Japanese exports in late 2003 finally boosted GDP growth into positive territory, but money supply growth seemed to have nothing to do with it and the Japanese abandoned the strategy.

In 2006, Japan's banking sector finally raised loan growth backup to zero and then mildly positive, for the first time in almost a decade. Within months, the authorities were panicking that the return of the velocity of money would act upon the vastly inflated stock of money and boost inflation. But no such upturn took place. Now Japan once more faces the return of deflation. So attempts to look through the valley to the other side of this downturn seem very premature in the light of the Japanese experience. Anyone expecting inflation will be sorely disappointed, I'm afraid.

James Ferguson is chief strategist at Pali International and writes the Model Investor newsletter. Call 020-7633 3620.