Overdosing on the Inflation Drug — Quantitative Easing
Do you take drugs?
It’s not because you’ll end up in the hospital from one pill, tab, snort or whatever it is. Many of us don’t take drugs because we’re afraid of getting addicted. A slippery slope and all that.
You can tell I became a dad last year, can’t you? This is very much the same speech I’ll be giving at some point in the hopefully distant future. The thing is investors need to hear it too. Just applied to inflation instead of drugs.
Quantitative easing (QE) in 2009 wasn’t important because of the inflation that QE inherently creates. It didn’t create much consumer price inflation, after all. But, just like a drug, it created a high — a high in the stock market, the property market and the bond market.
No bad consequences (consumer price inflation), but lots of good ones (asset price inflation).
Whoopee, so let’s do it again!
The problem is the same as with drugs. Now, every crisis gets a dose of QE. In fact, despite economies around the world being on the mend from the lockdowns and inflation running hot, QE is set to continue indefinitely. Just as drug addicts deal with every down by seeking an artificial high, only to go on to needing the drug all the time, we’ve become addicted to QE. Reliant on it.
The creators of the European Central Bank understood this risk of addiction. Well, the Germans did. That’s why they banned financing of governments by central banks and placed other restrictions on the ECB. It wasn’t about the inflation itself. After all, a little QE and deficit financing needn’t trigger inflation. It can have good effects.
The German fear was about the longer-term implications of governments being able to finance themselves with the printing press. And they knew that’s what made the short-term temptations so dangerous, especially in a democracy.
Once politicians’ cotton onto the opportunity of forcing central banks to use QE to finance outrageous fiscal deficits, anything goes. No cause is too big for the government budget. And that’s how things really do descend into an inflationary nightmare.
Here’s the reason the distinction between a little bit of recreational QE on the weekend and a constant dose matters: it’s only once you’re addicted to drugs that the bad effects really begin to emerge. It’s only when we’re reliant on QE that inflation kicks in.
Why? Because it’s going to be so hard to reverse the QE. It’s not like we can just quit now. Governments would go bust, and banks would go bust — the only question is, who would go first?
Once markets discover this truth, that’s when inflation takes hold. When QE is set to continue indefinitely, and a reversal would lead to something worse than inflation. In that scenario, central bankers will continue QE.
In Weimar Germany, inflation got out of hand because the government was trying to keep employment high, reparations paid, and the left-wing under wraps. The consequences of failing to monetise the government’s deficit were considered worse than monetising it.
In the end, they only succeeded on the last goal, at the expense of the value of money and the French occupation of the Ruhr — my birthplace. Ironically, they got a right-wing takeover instead of the left…
Today, we rely on central banks’ QE to finance governments, keep interest rates under wraps, rescue banks and keep house prices rising. An end to QE would put all that at risk. And there’s no question it’d be a catastrophe if they went into reverse.
This means QE is a one-way bet. It’ll reliably be rolled out at the faintest hint of trouble. And that’s what hints at inflation so strongly — the inability to withdraw QE if inflation rises.
One way of describing this is that we won’t find a Paul Volcker or Hjalmar Schacht. The chairman of the Federal Reserve was willing to rein in inflation at the price of undermining the economy in the early ‘80s. The German currency commissioner in 1923 was willing to do so as well. But things didn’t go so well for the Germans as a result because the Great Depression hit just when they’d achieved currency stability…
The warnings about QE in 2008 should’ve been about where this leads in 10 years, not about any immediate surge in inflation. Being able to turn to QE reshuffles the incentives of central bankers and politicians radically. It’s only QE that made the pandemic fighting policies possible.
It has often taken a decade for inflation to break out after loose monetary policy begins. In the meantime, times were very good. As they were in Weimar Germany, and other nations turned to the printing press to solve their government deficit problem.
Where are we in this timeline? ECB President Christine Lagarde explained that in May:
‘We are committed to preserving favourable financing conditions using the PEPP envelope, and to do so until at least March 2022. It’s far too early and it’s actually unnecessary to debate longer-term issues.’
Government financing will continue because it is needed. But over the past few weeks, inflation data has begun to spike. In Germany, it’s already above the ECB’s mandate of 2%.
This week, even the Federal Reserve began to acknowledge the problem of inflation. The Financial Times provided an animation of the Fed’s dot plot over time. That chart shows where members of the Fed expect their interest rates to be in the future.
Each policymaker gets to put a dot on the plot for each year, which tells you where the numbers are on future interest rates. Remember, this is from the people actually setting the rates.
Back in September 2020, barely a rate rise was in sight as all the dots sat between 0% and 0.5% for the foreseeable future. In December, the dot plot for the year 2023 began to resemble a pyramid, with a few policymakers sticking their neck out for interest rate increases in 2023.
In March 2021, the 2023 pyramid got top-heavy as most still expected rates to stay at zero, but a few anticipated implementing ever-higher rates. 2022’s dot plot, meanwhile, turned into a pyramid, suggesting the possibility of interest rate hikes next year.
In June 2021, the 2023 dot plot is an even bar of predictions between 0% and 1.5%. So Federal Reserve policy members are more or less evenly split on where rates will be by then. The 2022 pyramid has grown a little steeper…
The point is that even the Federal Reserve’s policymakers are taking note of inflation spiking. And they’re increasingly acknowledging that interest rate hikes might be needed to slow it down. Ever and ever sooner…
As a result of the Fed’s announcements, the gold price plunged because higher rates make it less attractive in relative terms. But that may be a red herring of what’s to come.
The question in coming months and years will be an age-old one. Will central banks be ‘behind the curve’? This refers to the speed with which interest rates and inflation rise relative to each other.
If inflation is rising faster than interest rates, for example, then increasing interest rates is not necessarily tightening monetary policy. That’s an important sentence to grasp.
For monetary policy to be tightening, interest rates must be rising faster than inflation. Furthermore, monetary policy tightening can mean that it is merely becoming less loose.
What people really care about isn’t the interest rate itself, but the real interest rate. That is, the interest rate adjusted for inflation. Consider these two examples.
The interest rate is 3%, and inflation is 2%. This means the true costs of debt is 1% because what you buy with the borrowed money can be rising in price by 2%.
But if the inflation rate rises to 5% and central banks increase interest rates to 4%, then the true cost of borrowing falls to negative 1% because prices are rising faster than the cost of paying the debt. It becomes a no-brainer to borrow and buy.
One key cause for the 2007 housing bubble was that the Fed stayed behind the curve, which increased rates slower than inflation. What looked like tightening monetary policy to the naked eye — increasing interest rates — actually wasn’t in real terms. Hence the housing bubble continued to inflate.
What we have right now is deeply negative real interest rates, as in the second example above. Inflation is running well higher than interest rates. Hence the debt bloom and surging house prices. It makes more sense to borrow and buy than save because prices are rising faster than the cost of debt.
As inflation rises, will central banks raise rates faster than inflation increases? Will they raise interest rates above inflation? I don’t think that’s possible given the amount of debt in our economies now.
Here’s what I do know. Now that inflation is acknowledged and central banks are twitching at the interest rate lever, we’ll need to focus on real interest rates more than ever before.
Keep one eye on central banks and the other on inflation. If you go cross-eyed, expect a financial crisis. If you get a lazy eye, buy gold.
Until next time,
Editor, The Daily Reckoning Australia Weekend
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