Inflation has been declining steadily in the developed world since the peak reached in the mid-1970s. This drop can be attributed to central bank policies and globalisation. For example, moving production to areas with lower labour costs resulted in a decline in the price of goods. However, deflation has now become a major concern for developed markets.

To counter this, central banks in the USA, Europe, Japan and the UK have been running large “quantitative easing” programmes. This means that central banks are “printing” money to buy financial assets, see the explanation by The Economist. If there is more money chasing the same number of goods, then the price of those goods should rise – the monetary inflation theory. So why has quantitative easing not given rise to inflation so far?

Monetarist Explanation

Even though developed market central banks are creating additional money, this is not causing an increase in money in their economies.  The central bank buys assets with newly printed money and the seller deposits the proceeds with commercial banks.

Commercial banks use these deposits, along with a regulated portion of their capital, to extend loans. This then injects new money into the economy.  However, since the financial crisis of 2008, new regulatory policies aim to make banks safer, so the percentage of own capital required in loans made to non-financial institutions have been increased.

This has forced banks into shrinking their current loan book relative to their capital and also to be more selective with regards to new loans. In doing this, banks are extracting money from the economy. Refer to a post at for a detailed explanation of how commercial banks create and destroy money.

Any new “unwanted” deposits at a bank, for example, deposits received due to quantitative easing, are held as reserves at the central bank. Here the money is safe and does not require the use of own capital.

The argument above has been put forward by Charles Goodhart from Morgan Stanley, see Buttonwood’s notebook. That the banks are not lending out the new money created from quantitative easing is supported by the fact that broad money supply (credit in the wider economy) has not increased, while bank reserves at central banks have indeed increased.

Keynesian Explanation

The world has an excess of supply over the demand for goods and services. This is the result of over-investment in China, where for the past 20 years, gross capital formation has been on average 47% of GDP. Similarly, the suppliers of raw materials and products to China have over-invested. This misallocation of capital has resulted in an oversupply of goods. Refer, for example, to the article “Gluts for punishment” by The Economist.

In addition to this, demand is also lacking as households are not consuming, either because they are paying down personal debt as required by the banks, given the regulatory changes in the wake of the 2008 financial crises, or they are increasing savings.

Given the current low real bond rates, increasing savings is a very rational decision as households do need to save more to be in the same situation at retirement as before. In addition to this, due to inflation being low or even the prospects of deflation, households are more inclined to delay consumption — the same products will be at the same prices or even cheaper in the future. See, for example, Tim Bond’s Odey Odyssey fund’s Feb 2016 manager’s report.