Deflation – so what?

Expansionary monetary policy - loose interest rate settings and quantitative easing - is fuelling asset price growth across global property, bond, equity and even art markets. According to The Economist, “the global art market is booming”, with sales at a record volume in 2014 while prices for contemporary and post-war art have risen by 19 per cent.

"We appear to be lulled into a false sense of security believing deflation is somehow containable."
Sally Reid, Global head of IIB Portfolio Management, ANZ

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In 2014, global commercial and residential real estate prices rose by 9.9 per cent, leading MSCI to express “increasing concerns over its stability”.

In the BofA Merrill Lynch Fund Manager Survey for April, the most widely watched gauge of investor sentiment,  a record number of participants (84 per cent) considered that bonds are overvalued while 23 per cent considered global equity markets (in particular the US) overvalued. Some equity markets, like the Shanghai Composite Index which has gained over 70 per cent since late November, are certainly candidates to be thought “frothy”.


In a recently published report, which has received nowhere near the attention it deserves, the Bank for International Settlements (BIS) argued it is asset deflation which triggers a deflationary spiral which then results in a growth crisis. It can be exacerbated by increased private debt levels, as the bubble deflates quicker when defaults enter the fray.

Essentially, the BIS found:

  • Goods and services deflation is only weakly associated with poor growth outcomes (good)
  • Asset price deflation has a more significant impact on growth outcomes (not so good)
  • High levels of private debt can amplify the impact of asset price deflation (bad)


The BIS findings in terms of goods and services deflation support the current dominant narrative: what we are witnessing in the US, and to a lesser degree in Europe, is ‘good deflation’. That is deflation which is really about productivity reset – lowering wages to increase competitiveness to initiate a virtuous cycle of lower priced goods, higher demand and higher employment.

However, the findings around the impact of falls in asset prices (in particular property prices) and the amplified effect of these falls when private debt is high, should give us cause to reflect more closely.

Maybe expansionary monetary policy (quantitative easing) will ultimately act as a catalyst for severe deflation if it fuels asset price bubbles and an increase in private debt?

Quantitative easing (QE) was first used by Japan in the 1990s. Theoretically a central bank creates money, uses that to purchase bonds, which reduces interest rates, which encourages businesses and individuals to borrow, which means more money is spent and more jobs are created, which results in growth!

Right now in a US and European context, we really only have evidence that QE results in inflated asset (although not consumer) prices, that it increases inequality (gap between the wealthy and the poor is rising) and that it continues to entrench leverage as the route to growth (didn’t we learn anything from the global financial crisis?).

Recent US jobs data has been seized on by optimists as evidence of QE working but, in the context of economics, job growth is only useful it results in increased consumer demand.

Meanwhile, it is worth looking at consumer sentiment (in the US this is soft, though not at recession levels), wage inflation (in US this is muted), consumer price inflation (in US in deflation territory) – none of these point to QE working.

And it is further worth noting that for every US indicator, European indicators are worse and show even less evidence that QE is achieving its objectives.


Post the financial crisis, European and American governments have substantial debts. Even short periods of deflation could materially increase the real value of these debts and have an enormous impact on the ability to service them.

In other periods of sovereign indebtedness, the fastest way out of the crisis is default or inflation. It is really hard to see an inflation outcome from where we are – asset prices (see stock markets, corporate bond markets and housing markets) are already pumped high by QE and consumer prices are muted by low input costs (for example commodity prices, wages, transport costs).

If you let the deflation monkey out of the cage, and you can’t put it back, sovereign defaults become the only adjustment mechanisms.

On the consumer demand side, and setting aside the low wage growth and the quality of employment (European zero hours contracts are not the kind of jobs growth that stimulate demand and improve sentiment), European and American demographics are not favourable.

So using consumers as the engine of future growth seems unlikely. This will be especially true if asset prices fall when qualitative easing rebounds, as this will further erode consumer confidence and have a downward impact on demand.


Notwithstanding all of the above, the global economy seems to be muddling through, with the fear of deflation creating only a passing interest. We appear to be lulled into a false sense of security believing deflation is somehow containable and, even in the face of the evidence, not that destructive.

Writing in 1923, John Keynes “A Tract on Monetary Reform” noted deflation is “not desirable” and “always harmful” because it redistributes wealth in a manner which harms both business and social stability.

Keynes talks about the “oppression of the tax payer for the enrichment of the rentier” but cautions the most problematic impact is modern business, carried out largely on borrowed money, is incentivised to turn everything into cash and to sit out on the sidelines.

He noted that while “a probable expectation of deflation is bad enough, a certain expectation is disastrous”, going on to say the world is more adept at managing price increases than price declines.

While the jury may be out on the impact of consumer and producer price deflation, the spectre of concurrent asset price falls (assuming that asset price bubbles are forming in light of QE) is serious as it has direct linkages to substantially decreased output.

As BIS conclude, “policy should first and foremost constrain the build-up of financial booms - especially in the form of strong joint credit and property price increases - as these are the main cause of the subsequent bust”.

Central Banks around the world cannot bury their “head in the sand” any longer – the most important focus must be on stemming the increase in asset prices and ensuring that we avoid the worst case outcome – that of a deflationary spiral.

Sally Reid is ANZ’s Global Head of Portfolio Management for Institutional Bank.

Photo: Adriano Castelli /

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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