A bold step into the unknown – are we heading for hyperinflation?
QE has done very well at heading off depression. But continuing with it now risks disaster. So what should investors do? James Ferguson reports.
I have long argued in these pages both that quantitative easing (QE) is not inflationary, and that MoneyWeek readers should buy government bonds: gilts, bunds and US Treasuries. This advice has served those who followed it well.
Last year, the best-performing asset class in the world, beating even gold, was developed-world government debt. Since February last year, the yield on the benchmark ten-year US Treasury bond has fallen from 3.8% to 1.8% (when bond yields fall, prices rise) and the ten-year gilt yield has dropped from 3.9% to 1.9%.
However, I am now fearful that QE has gone too far. Both America and Britain now finally face genuine inflation risks. In the US, QE3 looks particularly inflationary now that US banks are lending again. That means US Treasuries are no longer a buy, and may even be at risk of collapse. So what's triggered this 180-degree switch in my thinking? To explain, we first need to look at what QE is, what it does and why we need it.
What is QE?
Last week, Bank of England governor Mervyn King was in Cardiff, warning the South Wales Chamber of Commerce that our banks are effectively still sitting on large hidden losses, and that a full recovery from the banking crisis could take a generation to achieve. He also suggested that QE might be losing its ability to smooth the required adjustment to the economy.
Not only that, he even wondered whether it was really a good idea to keep such a short-term policy going for four years after it was first conceived.
All typically uplifting stuff. However, King also gave a brilliantly succinct summary of his role as a central banker: "When banks extend loans to their customers, they create money by crediting their customers' accounts. The usual role of a central bank is to limit this rate of money creation, so that an excessive expansion of money spending does not lead to inflation. But a damaged banking system means that, today, banks aren't creating enough money. We have to do it for them. And as private-sector balance sheets contract, public-sector (government and central bank) balance sheets have to take the strain. The way in which the Bank of England expands the money supply is to purchase government gilts from the non-bank private sector and credit the bank accounts of people from whom the gilts are purchased. Please note that we are not giving money away."
Here's what King is saying. When banks have over-extended themselves, they have two choices. One is to raise new capital but that's very hard to do once markets are suspicious and share prices have plunged. The alternative is to shrink their lending activity.
But because money is created in the capitalist system mainly through increases in bank lending, when lending falls it can result in deflation and depression. So the Bank of England, similarly to the US Federal Reserve (Fed), has artificially created more money to refill the hole in the money supply that is being dug by the banks.
So, instead of broad money supply shrinking a lot the textbook definition of deflation in both countries it has been growing a little instead. This is the main reason why the recession and its aftermath, although hard to rebound from, have not been far more severe.
But King now worries publicly that QE, while saving the economy from depression, has also slowed the necessary rebalancing away from credit, consumption and imports, and back towards savings, investment and exports. This he calls the "paradox of policy".
In short, we have QE because banks are shrinking their loan books and destroying money in the process. Too little QE and the money supply will still shrink as banks deleverage, and the economy will enter depression. But too much QE leads "to accelerating inflation and ultimately the collapse of the currency", as King himself explained. So QE is a tightrope walk, with neither too little nor too much being desirable.
How do we get the balance right?
The problem is that central bankers don't have a great track record when it comes to the self-discipline needed to stay on the tightrope. They're usually charged with stopping inflation from getting out of control. Recessions typically happen when central bankers fail to do this, and so have to raise interest rates sufficiently to slow the economy and choke off inflationary pressures.
The trouble is, central bankers often let inflation get out of control, and so recessions happen all too frequently. So experience tells us that it is always a good idea to watch the Bank of England and the Fed closely, and to monitor how aggressively they are acting.
And you could argue that they've been very aggressive indeed. US QE has now amounted to around 16% of annual gross domestic product (GDP). Money printing in the UK has been proportionally even greater, at 24% of GDP. Yet until now there has been very little sign of a pick-up in core inflation (that is, excluding volatile components such as energy and food).
Indeed, at just 2.1% in the UK, core consumer price index (CPI) inflation is at its lowest level for nearly three years. This is because the size of the hole' that money-printing (via QE) was re-filling was equally large. M4 data for net lending to the private sector in the UK shows a £343bn drop in the stock of loans since January 2010, while US commercial bank lending fell by $1trn peak to trough. Without QE, broad money supply growth would have shrunk and both countries would surely have entered depressions.
To see this in practice, just look at Ireland. As a eurozone member, it has no independent central bank. As its commercial banks went into decline and even receivership during the crisis, the M3 measure of broad money supply fell 28% peak to trough, taking nominal gross national product down by the same amount an almost inconceivable economic collapse. Not since the Great Depression have developed-world economies suffered peacetime implosions of this magnitude.
Thanks to QE, citizens of the US and the UK have been spared similar fates at least so far. Amazingly, some people even wonder if QE has had any impact, so finely tuned has its application been, and so benign its consequences.
A worrying development
But recently something worrying has been happening with our QE. Over the 32 months from the Bank of England's first asset purchases in March 2009 until December 2011, UK QE amounted to £200bn. In the last 11 months, there has been an extra £175bn of QE almost the same again. Only QE this year is running at about three times the rate it was previously (£175bn being printed over a year, compared to £200bn over almost three years before).
King explained last week that, because QE effectively brings forward demand from the next period into this one, now that we're living in the next period, it takes even more QE than before to boost demand by the same amount. However, if QE's primary role is merely to replace money supply, King's interpretation would result in the Bank doing too much and risking inflation. The consequences of this accelerated rate of QE are already visible in money supply growth, the exchange rate and GDP.
In the year to date, after barely growing at all over 2010 and 2011, UK broad money supply is now growing at a rate of 6.7% a year. That's even though bank lending (as measured by the M4 excluding intermediate OFCs' figure) is shrinking at a rate of around 6.5%. So QE is no longer merely neutralising the contraction in money supply resulting from the drop in bank lending it is now generating growth of its own.
This could swiftly become inflationary if left unchecked. QE dilutes the currency, causing weakness in the sterling exchange rate. Although other forces also come into play, from mid-2001 until last May, sterling was appreciating at an annualised rate of more than 10% against a trade-weighted basket of currencies.
Since May, however, it has fallen 1.5%. That's not a spectacular drop, but it is a complete change in direction. And third-quarter GDP surprised everybody with the fastest quarter-on-quarter growth in five years, nearly twice the rate expected. Maximum-strength QE seems to be doing the trick.
The only thing is, growth from QE isn't real growth. Instead, as King himself warned, it risks inflation and currency collapse, neither of which have historically been good for gilts. Bonds pay out a fixed coupon, so if inflation rises, the value of the unchanging coupon payments falls in real terms (that is, after inflation), so people sell bonds.
What's worrying on this front is that the ten-year benchmark gilt yield has been rising since the end of July. It has broken its prior two-year long downtrend. These are early signs that the long bull market in gilts may be over, unless the Bank of England scales back the rate at which it buys assets. But there's little sign that this is going to happen. Many City economists expect a further round of QE before the end of the year.
The two graphs above show what has happened to US ten-year Treasury (top) and British ten-year gilt (bottom) yields over the last two years. Both are now at historic lows below 2% but for how much longer?
The US goes for extreme QE
The story in the US is even more extreme. There is usually only one component to the creation of money, and that's credit. But when the banks throw that into reverse by shrinking lending, QE provides an alternative method of creating money, sufficient to prevent a deflationary contraction. With M4 lending in the UK shrinking at a rate of 6.5%, we're obviously a long way from normal broad money supply growth it is still only QE that's preventing depression.
But in the US, bank lending has been growing again for the last year. This means the monetary system is functioning again. When banks lend money, the borrower places the funds in their own bank account. Apart from cash, bank deposits are what constitutes money.
The bank that receives the deposit retains a small portion of the funds deposited as a required reserve. It then lends the rest out, repeating the process. As a result, the original loan is multiplied several times over.
Officially, we can't be sure of how fast the money supply is growing, because, back in 2006, the Fed ceased reporting the broad money measure M3. So now people have to estimate its rate of growth. These estimates suggest that broad money supply growth is currently around 4% a year. That's far too slow for a healthy economy, but it's a vast improvement on the bank loan contraction phase.
In an ideal environment, the Bank of England reckons broad money supply growth should be in the high-single digits, at a rate about 2.5% faster than nominal GDP (GDP before you adjust for inflation). In turn, nominal GDP should grow 2%-3% faster than real GDP, which ideally might grow at around 3%. So that gives you an ideal' money supply growth rate of roughly 7.5%-8.5%.
In the US, nominal GDP has been growing at about 4% a year for the last two years and 2% in real terms. Importantly, there has been no substantive QE in the US since QE2 ended in June last year. At least, not until now.
What QE3 could mean for the US
If the US banking system is now working, then why is the Fed resorting to more QE? Unlike the Bank of England, the Fed is charged not just with avoiding inflation, but also with supporting employment. Despite evidence that the US economy is functioning again, the unemployment rate has remained stubbornly high at more than 8%. And that doesn't include the many people who have become discouraged from even looking for work, and so are no longer represented in the data.
The percentage of the population under-employed' (this is the U6 measure of unemployment, which adds in discouraged' workers and part-timers who'd rather be permanent) is around 15%.
Although this is below the high in late 2009 of more than 17%, it's still too high for the Fed's liking. So the US central bank has announced QE3, an open-ended programme targeting $40bn of asset purchases per month. On an annualised basis, QE3 is equivalent to more than 3.2% of annual GDP. Given that the best estimates of broad money supply growth suggest that it's already growing at around 4% to 4.5% a year, the combined impact is likely to see money growth of more than 7%.
Depending on the outcome of the so-called fiscal cliff', few economists expect much more than 1% real GDP growth next year in the US. But if the broad money supply is growing at a rate of 6% or so ahead of that, then there is little chance that US CPI inflation will remain as low as it was this August, at just 1.7%.
Although Ben Bernanke, the Fed chairman, has left himself the option of ceasing QE3 as soon as inflation risks appear, the chances are that he'll be too late in doing so. After nearly five years fighting deflation, he's likely to allow what he might see as a brief inflationary flurry' to get the economy back on track. Besides, with so much debt accumulated now, the temptation to inflate some of that debt away will probably prove irresistible.
The trouble is that inflation is a lagging indicator. In other words, by the time you see it coming, it's too late to do anything about it or at least, the only options you have left involve a fairly drastic tightening of monetary policy. That's because once it's established, inflation triggers demand for higher wages. This in turn forces companies, which are now spending more on their staff, to hike prices to offset rising costs. That stokes further inflationary pressure, and so on, in a vicious circle.
In the US, core CPI, which measures domestic inflationary pressure, hasn't registered above 2.5% since the crisis began. Unlike headline CPI, it has proved remarkably stable. But right now core CPI is already running ahead of headline CPI, and the inflationary impact of QE3 hasn't even been seen yet.
A highly inflationary policy
We know that QE is a very unconventional and highly inflationary monetary policy, but until now it has only been deployed against an extremely deflationary backdrop. As Ireland has proved, as well as Iceland, Greece and Portugal for that matter, if the contraction of bank lending is not neutralised by QE, then it can send the economy into a 1930s-style depression.
We can never know just how deflationary the last four years would have been in the US and the UK in the absence of QE. But we can make some fairly educated guesses and it's not pretty.
QE must therefore have provided a very powerfully inflationary counter force, in order to prevent such deflation from happening. Now that bank lending has been functioning normally and growing in the US for over a year, the backdrop is no longer as hugely deflationary. As a result, inflationary expectations as measured by the ten-year TIPS breakeven rate (that is, the rate of inflation expected by investors in index-linked US Treasuries) have risen close to a six-year high already.
What happens next is a bold step into the unknown. Applying a powerful inflationary tool to a deflationary environment is one thing but applying it to a perfectly normal one is likely to write a whole new chapter in The Law of Unintended Consequences handbook.
Will inflation shoot off at once, or will the economy seem at first just to be doing rather better than expected, much like the UK last quarter? It's impossible to tell but we do know that we don't know. It's never been done before and there's no theoretical hypothesis to make a forecast.
What we can say is that it looks decidedly irresponsible, and the inflationary risks are all to the upside. With ten-year US Treasuries returning no yield once adjusted for inflation, the risks to bond holders on the other hand are all to the downside. The one winner will eventually be the dollar. Rising inflation will ultimately mean the abandonment of any further QE and rising rates to bring CPI to heel, and that's always good for the currency.
In the meantime, what can you do to protect yourself? Well, you can start by reading the MoneyWeek overview on all the major asset classes: What to buy -and what to sell.