With the unlimited asset purchase announcements by the Fed and ECB recently, the limits of balance sheet expansion will be put to the test. The current levels would have been seen as inconceivable a mere few years ago and now it seems business-as-usual as investors have become heuristically biased away from the remarkable growth. The problem is - central banks are missing inflation targets and credit growth is still declining - need moar easing, forget the consequences.
Balance sheet expansion resumes in advanced countries
Following the unlimited asset purchases announcements by the ECB and the Fed, the limits of balance sheet expansion will be put to the test once again.
Further balance sheet expansion is expected from the BoE and the BoJ, among others. The BoE’s asset purchase program will expire in November. For governor King, the MPC is “ready to inject more money” should the signs of a recovery fade.
A few years ago, it would not have been conceivable to go this far with balance sheet expansion. But, looking at where we stand now, it seems central banks could continue to expand their balance sheets further, as long as liquidity injections fail to spread to the economy via higher inflation.
People’s Bank of China and foreign reserves
The PBoC stopped expanding its balance sheet in 2012, as reserve accumulations ceased.
The bank has not responded to the recently announced global easing measures.
Even though inflation has been much lower in recent months (1.9% in September), the PBoC continues to pay close attention to inflation to avoid the formation of another asset bubble, as was the case in 2010.
The key challenge for the PBoC now is to stabilise the banking system as liquidity pressures intensify.
Main risks and opportunities: Inflation missed targets; credit growth declining
Risk 1: All central banks missed their inflation targets
After each round of QE from the Fed, inflation increased significantly. Applying past inflation gains from QE2 to the current level of PCE inflation (1.5% in August) means it could exceed 2.7% one year from now.
The absence of a well-defined exit strategy means inflation may not go down after central banks stimulus cease, despite efforts to reduce money supply.
In the eurozone, although inflation is somewhat higher, the risk in the short term is deflation, with austerity measures acting as a drag on growth.
Risk 2: Credit growth declining
Large liquidity injections by the Fed and the BoE did not succeed in promoting credit growth for the private sector. This market configuration is similar to the situation that took place in Japan after its bubble burst in 1990.
Overall, lending to the non-financial private sector in the euro area remains very weak and this is a genuine source of concern.
For China a potential slowdown in credit growth from its deteriorating banking system is a key risk for future Chinese growth.
Some inflation expectations
While the eurozone is implementing austerity measures adding deflationary pressures to growth, the situation is different in the US where GDP growth is moderate (2% annualized in Q3 )
A rebound in the US housing market is sparking some small improvement in employment and consumption, leading to higher inflation.
Current inflation expectations, as implied by the 10Y breakeven inflation rate, rose to an 18-month high on the day following the last FOMC meeting of September 2012 and now stand at 2.5%.