Central Bank inflation may take some time at arrive
Quantitative easing will lead to higher inflation…eventually
By Steve Blizard
Quantitative easing (QE) is an unconventional monetary policy used by central banks, such as the US Federal Reserve, to stimulate the economy when conventional monetary policy has become ineffective.
During the early 2000’s, QE was used unsuccessfully by the Bank of Japan (BOJ) to fight domestic deflation (falling prices).
Since 1999, the BOJ has maintained short-term interest rates near zero percent.
With QE, Japan flooded commercial banks with excess funds to promote private lending, leaving them with large excess reserves, and therefore little risk of a liquidity shortage.
What increasing the money supply tends to do, however, is depreciate a country's exchange rates versus other currencies.
This QE feature directly benefits exporters residing in the country performing QE and also debtors whose debts are denominated in that currency.
As the currency devalues, so too do their debts.
However, QE directly harms creditors and holders of the currency as the real value of their holdings decrease.
Devaluation of a currency also directly harms consumers and importers, since the cost of imported goods is inflated by the devaluation of the currency.
The most recent QE event transpired on June 20, when the U.S. Federal Reserve expanded its "Operation Twist" program by $267 billion.
Operation Twist is name given to a Federal Reserve monetary policy operation that involves the purchase and sale of bonds.
The operation involves selling an amount of short-term bonds to buy longer-term ones, with the aim of keeping long-term borrowing costs down.
When delivering this latest round of monetary stimulus, the Federal Reserve said it was ready to do even more money pumping to help an increasingly fragile U.S. economic recovery, in the lead up to the rapidly approaching US presidential election.
Operation Twist, which was due to expire this month, will now run through the end of the year.
Federal Reserve Chairman, Ben Bernanke, said the central bank was concerned that Europe’s prolonged debt crisis was dampening U.S. economic activity and employment.
Seasoned investors watch the activity of the Federal Reserve closely, since the popular theory is that its activities can produce inflation, thereby boosting growth in investment market returns.
And so, as Australia’s share market nears the end of its fifth year as a bear market, investors are constantly looking to any prospect that may stem their flagging investment portfolios.
Until recently, many believed stock and housing asset prices mostly rose.
This was because it was what they had witnessed during their investing lifetimes.
Even when house and stock prices fell, it wasn't long before they recovered and rose to a higher plain.
Take the 1987 and 2001 stock market crashes.
Or the early 1990’s housing bust.
Soon prices stopped falling - levelled off - and then soared higher.
But as the Japanese experience showed, stock and housing prices don't always go up, and they don't always recover after a crash.
Endless investment newsletters have been written, warning of the dangers of money printing.
The argument goes like this – QE involves a central bank creating money as a book entry to buy, generally speaking, government bonds.
This in turn dramatically increases the money supply and can lead to inflation down the track.
The reason it hasn’t created inflation to date is because monetary velocity has collapsed, as the banks won’t lend out the money.
Instead, the banks have just left it on deposit with the Federal Reserve.
But when confidence returns, lending will explode, and fuelling inflation along with it.
Central to this thesis is the idea that the restraining factor behind bank lending is having enough cash to lend out.
However, this is plainly wrong.
Rather, what appears to be limiting bank lending at present, is lack of confidence.
Domestically, the continued prospect of a minority government in Canberra simply adds to investor woes.
Banks are struggling to find sufficient credit-worthy borrowers who actually want a loan.
The confidence issue runs both ways – both borrowers and lenders need it before the loan takes place.
But let’s assume confidence does return and both borrowers and lenders are happy to do lot of business again.
Now we come up against a second hurdle.
Do the banks have sufficient equity capital to meet the Basel III capital adequacy requirements?
Basel III is the third of the Basel Accords developed in response to the deficiencies in financial regulation revealed after the 2008 Global Financial Crisis.
This latest accord strengthens bank capital requirements, introducing new regulatory requirements on bank liquidity and bank leverage.
However, if the banks do not meet the required terms, they will be forced to go into the capital markets and raise equity to support a huge expansion in the volume of loans.
If the capital markets are feeling good about the banks, the banks can raise sufficient capital to do as much lending as they wish.
Now here’s the twist.
None of this requires cash created by QE.
In a non-QE world, the process works in exactly the same way.
If the banks can find enough suitable borrowers to dramatically expand lending, they go to the capital markets and raise equity to support that new lending.
And, due to the nature of the fractional reserve banking system, the required money supply is created within the banking system.
Therefore, QE just is not relevant to the volume of lending.
So how can governments create seemingly unlimited amounts of money without creating inflation?
The key is what they do with the new money created.
If they use it to buy assets, and in particular, buy their own bonds, they are simply swapping one form of government debt for another.
It is as if the US government decided that the currency should be red rather than green, deciding to pay $1.01 in red bills to buy back a dollar of the old green currency.
True, they have doubled the cash in the economy by printing a vast quantity of the new redbacks.
But in releasing it, the government has taken away all the old greenbacks.
Everyone is one percent richer and prices will probably rise by one percent – but that’s it.
Consider how different it would be if the government simply gave away the new redbacks to all and sundry.
We would really be facing the potential for high inflation.
But this is not what is going on.
And this is why QE doesn’t, and will not, of itself lead to inflation of anything other than the value of government bonds or whatever asset it is being used to buy.
Steve Blizard is an authorized representative of Roxburgh Securities.