On Saturday we once again explored the question of whether central banks are creating deflation. The idea that post-crisis DM monetary policy may be causing disinflationary pressures to build is somewhat counterintuitive on its face but in fact makes quite a lot of sense. Here’s how we explained it:
The premise is simple. By keeping rates artificially suppressed, the central banks of the world effectively make it impossible for the market to purge itself of inefficient actors and loss-making enterprises. As a result, otherwise insolvent companies are permitted to remain operational, contributing to oversupply and making it difficult for the market to reach equilibrium. The textbook example of this dynamic is the highly leveraged US shale complex which, by virtue of both artificially low borrowing costs and the Fed-driven hunt for yield, has retained access to capital markets in the midst of the oil slump and has thus continued to drill contributing to the very same price declines that put the entire space in jeopardy in the first place.
Expanding upon that a bit, we might say this: those who have access to easy money overproduce but unfortunately, they do not witness a comparable increase in demand from those to whom the direct benefits of ultra accommodative policies do not immediately accrue. Meanwhile, as WSJ notes, governments are reluctant to spend in the face of heavy debt burdens and increased scrutiny on fiscal policy in the wake of the European debt crisis while China, that all important source of voracious demand, is in the midst of executing the dreaded “hard landing.” Here’s more:
The global economy is awash as never before in commodities like oil, cotton and iron ore, but also with capital and labor—a glut that presents several challenges as policy makers struggle to stoke demand.
“What we’re looking at is a low-growth, low-inflation, low-rate environment,” said Megan Greene, chief economist of John Hancock Asset Management, who added that the global economy could spend the next decade “working this off.”
The current state of plenty is confounding on many fronts. The surfeit of commodities depresses prices and stokes concerns of deflation…
Meanwhile, public indebtedness in the U.S., Japan and Europe limits governments’ capacity to fuel growth through public expenditure. That leaves central banks to supply economies with as much liquidity as possible, even though recent rounds of easing haven’t returned these economies anywhere close to their previous growth paths.
“The classic notion is that you cannot have a condition of oversupply,” said Daniel Alpert,an investment banker and author of a book, “The Age of Oversupply,” on what all this abundance means. “The science of economics is all based on shortages.”
But as we first highlighted early last month, signs that continued access to capital markets were triggering overproduction and oversupply in the oil market were readily apparent, as the US looks set to run out of oil storage capacity in just a few months' time.
At Cushing, Okla., one of the biggest oil-storage hubs in the U.S., crude oil is filling tanks to the brim. Last week, crude-oil inventories in the U.S. rose to 489 million barrels, an all-time high in records going back to 1982.
And it’s not just oil:
Around the world, about 110 million bales of cotton are estimated to be sitting idle at textile mills or state warehouses at the end of this season, a record high since 1973 when the U.S. began to publish data on cotton stockpiles.
Huge surpluses are also seen in many finished-goods markets as the glut moves down the supply chain. In February, total inventories of manufactured durable goods in the U.S. rose to $413 billion, the highest level since 1992 when the Census Bureau began to publish the data.
And as we recently discussed in “Chinese Economic Outlook ‘Skewed Heavily’ To The Downside” and in “Chinese Economy ‘A Lot Worse Than You Think’”, China's appetite for metals has abated as demand for steel is now below levels last seen in 2008 which has in turn had a devastating effect on an iron ore market which had come to depend on Chinese demand:
Central to the problem is a cooling Chinese economy combined with tepid demand among many developed countries. As China moves away from its reliance on commodity-intensive industries such as steelmaking and textiles, its demand for many materials has slowed down and, in some cases, even contracted…
For nearly a decade, producers struggled to keep up with the robust demand from China. But with Chinese output now slowing—its gross domestic product is expected to rise 7% this year, down from 10.4% five years ago—no economy has emerged to take up the slack.
In the end, central banks continue to keep conditions loose, seemingly oblivious (or perhaps willfully ignorant) to the fact that low rates and booming equity markets are contributing to the supply glut without effectuating a concomitant increase in demand. Meanwhile, producers — such as heavily indebted US shale companies — are forced to keep producing in order to keep what little revenue is still coming in flowing, a dynamic which is exacerbated when companies take on debt (and thus more interest expense) to stay alive:
Even if governments have the capacity for more fiscal stimulus, few have the political will to unleash it. That has left central banks to step into the void. The Federal Reserve and Bank of England have both expanded their balance sheets to nearly 25% of annual gross domestic product from around 6% in 2008. The European Central Bank’s has climbed to 23% from 14% and the Bank of Japan to nearly 66% from 22%...
Producers have their own share of the blame. In a lower commodity price environment, producers typically are reluctant to cut production in an effort to maintain their market shares.
In some cases, producers even increase their output to make up for the revenue losses due to lower prices, exacerbating the problem of oversupply.
Here is the vicious cycle visualized:
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For those wondering how this will play out, consider that sooner or later, in order to avoid liquidation and stave off severe disinflationary pressures, someone will have to call in "Helicopter Janet" and once the cash paradropping begins well, we'll see you in the Weimar Republic.