Why Inflation is Falling Despite Quantitative Easing

Why Inflation is Falling Despite Quantitative Easing

We are likely to see economic data to take a backseat if the Ukrainian situation takes a turn for the worst, with European markets wobbling in morning trading (the FTSE 250 down 1.6 percent at noon GMT).

With a Monday 9AM deadline for ‘rebels’ (the BBC’s David Stern has said they bear some resemblance to the troops seen in the Crimea) in the East of Ukraine to disarm and move out of state buildings having now lapsed, it seems likely that the Ukrainian government will be moving security forces in to the region.

All this follows a weekend of remarks from the Ukrainian government indicating that escalation is likely following the death of a state security officer near Slaviansk, part of the region of Donetsk which is at the heart of the crisis.

It’s difficult to imagine the Ukraine will let the East of their country be carved up with as little protest following the Crimea’s departure, though a heavy handed reaction could be exactly the excuse Russia is after to disrupt gas supplies having already asserted that the Ukraine owes it $2.2 billion in unpaid gas bills.

Needless to say, with 40,000 Russian troops on standby on the Ukraine’s border the situation could quickly deteriorate and catch financial markets flat footed. It’s therefore unsurprising to see trading is subdued.

European markets will be looking particularly exposed given their heavy reliance on Russian gas, though the fact it isn’t happening in winter as it did last time the taps to the Ukraine were switched off would at least offset some of the impact of a gas price spike on consumers in the short term.

That said, there are still a few events for us to look out for:

Monday 14th April, 13:30 GMT: US Retail Sales for March (forecast 0.8 percent rise month on month):

With US consumer credit growth of 6.4 percent in February, the outlook for retail sales is buoyant following a slump in December and January following poor weather and the onset of tapering.

Tuesday 15th April, 09:30 GMT: UK CPI inflation (forecast 0.2 percent rise against a previous rise of 0.54 percent month on month with a forecast rise of 1.6 percent year on year):

The trend for UK inflation is, as I have mentioned previously, still on a downward trend (as illustrated below) and is a trend that is shared with the US.

How is this possible in the face of £375 billion of Quantitative Easing by the Bank of England?

Well, energy prices have stabilised and the pound has strengthened which has kept the impact of prices of imports in check. Given the UK’s continued trade deficit and strong demand for imports, this is significant.

What we’re also seeing is slowing growth in China, which is reducing the pressure on commodity prices. With Chinese growth figures due out on Wednesday potentially indicating another slow down to 7.3 percent from 7.7 percent GDP growth, this could well continue.

Another explanation is that the Central Banks have actually limited the impact of the growth in money supply following QE (otherwise known as ‘M2’) by starting to offer interest on excess reserves deposited by commercial banks with the central bank.

This wasn’t in place before 2008 and lends credence the notion that QE has been nothing more than a glorified bank bail out with purchases of Mortgage Backed securities by the Federal Reserve only acting to artificially prop up house prices.

This seems to be a more credible explanation given that both the UK and US are experiencing a similar trend and both their central banks have enacted similar policies with regards to QE and paying out interest on excess reserves.

Both have also seen lending to small businesses decline, again potentially as a result of paying out interest on risk free deposits. After all, why take risk lending to a fledgling business when you can still get a pay-out for taking no risk whatsoever?

The Federal Reserve has paid out $13 billion to banks by paying out interest on these reserves since 2008 with forecasts for the cost of this by the end of 2015 is as high as $77 billion (illustrated below)


Wednesday 16th April, 9:30 GMT: UK average earnings (forecast increase of 1.8 percent for the year against 1.4 percent previously):

This should be seen in conjunction with Tuesday’s inflation announcement and if both come in as forecast, this will be the first time in six years that wage growth will have outstripped inflation.

The increase in wages is still fairly tame, although falling inflation means that in real terms it represents an increase given the growth in wages is higher than the increase in prices (at least when measured against Consumer Price Inflation, which is lower than the RPI measure).

The political implications of the resulting feel good factor in the run up to a General Election in 2015 shouldn’t be underestimated and George Osborne will be hoping that real wages can continue to grow until then.

Thursday 17th April, 13:30 GMT: US Jobless claims for week of April 6th (forecast rise to 311,000 with continued jobless claims rising to 2.79 from 2.78 million):

With US jobless claims now at their lowest level in seven years, the obvious question is whether the trend can continue. Forecasts suggest that the latest figures will show an increase in claims and continued stagnation in the continuing jobless claims (i.e. those that are still claiming after a week).

A drop in claims indicates that firms are laying off less workers, though a large portion of the jobs being created remain those at the lower end of the spectrum & not requiring a college degree.