X

Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2017 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.


Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
Quantitative Easing Doesn't Mean Inflation - Outside View
 
 
Quantitative Easing Doesn't Mean Inflation

Quantitative Easing (QE) is a term we often hear in the news. What does it actually mean? Effectively, it means that the central bank will print money. In most cases, the central bank will buy government bonds with newly printed cash. QE is usually accompanied with a low interest rate policy. The four major central banks of the world (Federal Reserve, European Central Bank, Bank of England, Bank of Japan) are all following this policy to a certain degree today.

Let's first understand the purpose of monetary policy and how a central bank can use it. An expansive monetary policy (low rates & QE) is used to stimulate the economy. The purpose of low interest rates is to encourage borrowing and investment. Low interest rates also discourage savings, and hence promote consumption. QE's purpose is to inject cash into the economy. This should also stimulate investment and spending.

Only one thought should come into our minds now - Inflation. An expansive monetary policy must lead to higher inflation. After all, printing money means more cash in circulation for the same number of goods. So that implies prices should go up, i.e. inflation.

The four major central banks all want inflation. That is why they pursue a low interest rate policy combined with QE. Why do they want inflation? Well, the developed world is full of debt, both public and private. Inflation reduces the real value of the debt, so the central banks like inflation.

In economics, there is a useful equation that describes the relationship between cash and output.

MV = PY
M - Stock of Money
V - Velocity of Money
P - Price Level
Y - Real Output

The standard theory goes like this: If you increase M (i.e. QE) real output will not change, and only price levels will rise (i.e. inflation). It assumes V is constant.

As is the case in most of economics, theory and reality are two different things. What's happening today is the variable V is falling. This means that if we increase M, it doesn't mean that price levels will rise. QE doesn't mean we will have inflation.

The velocity of money refers to how often money is turned over. So the faster we spend money, the higher the velocity is. So when individuals receive their salary, they go out and spend it. Someone else receives that spending, and then spends that same money. Money continuously gets turned over, and this is a measure of economic activity.

The reason QE is not going to create inflation for now is that money is not getting spent. Banks that are receiving fresh funds are not lending out the money. Credit is falling. Government bond yields are so low because any new money banks have is simply used to purchase government bonds. Lending isn't taking place, and this is a function of banks and businesses both becoming more cautious.

When lending and spending doesn't take place, the velocity of money falls. This can lead to deflation rather than inflation. In fact, the reason the central banks are so happy to pursue low interest rates and QE is that inflation is not a real threat. Because of the falling velocity, deflation is the real threat to the developed world today.

Deflation is much more dangerous for an economy than inflation. With deflation, the real value of debt goes up. For countries that are already heavily indebted, this is like icing on the cake. Falling prices also means that wages will fall, and demand will. Consumers put off spending in anticipation of lower prices, leading to further slowdowns in the economy and falls in prices.

From a trading point of view, what does this imply? First, gold will be affected. Gold is used as a hedge against inflation, and deflation can put downward pressure on gold prices. In fact, this applies to all commodities. Most commodities have a positive relationship with inflation, and will be affected by falling prices. US Treasury bond yields are extremely low, and according to many analysts it is a bubble waiting to burst. With deflation, treasury prices will only go higher (and yields lower). Japan is a good example of a country that has battled deflation and has some of the lowest government bond yields in the world.

Quantitative easing should cause higher prices in theory, but reality tells us a different story. Falling velocity and economic activity are more important determinants of prices compared to interest rates and money supply.

This column, A Fresh Perspective, is authored by Asad Dossani. Asad is a financial analyst and columnist. He actively trades his own and others' funds, investing primarily in currency, commodity, and stock index derivative products. Prior to this, he worked at Deutsche Bank as an analyst in the FX derivatives team. He is a graduate of the London School of Economics. Asad is a keen observer of macroeconomic trends and their effects on global financial markets. He is deeply passionate about educating investors, and encouraging individuals to take part in and profit from financial markets. To put it colloquially, he wishes to take Wall Street products and turn them into Main Street profits!

Disclaimer:
The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Useof the web site.

 

Equitymaster requests your view! Post a comment on "Quantitative Easing Doesn't Mean Inflation". Click here!

  
 

More Views on News

Sorry! There are no related views on news for this company/sector.

Most Popular

India's Big and Messy Real Estate Ponzi Scheme, Just Got Messier(Vivek Kaul's Diary)

Sep 11, 2017

The question is, whether real estate buyers are financial creditors or not.

The Recipe to Over 60% Returns in Less Than a Year(The 5 Minute Wrapup)

Sep 9, 2017

Short term crisis in some companies could unveil some great investing opportunities.

Feeling Left Out? Two Opportunities to Make Money in This Market(Daily Profit Hunter)

Sep 13, 2017

Nifty is above 10,000 once again. Have you missed the bus?

Introducing Smart Contrarian: The Blueprint for Big Profits from Small Investments

Sep 18, 2017

Welcome to a bold, new initiative designed for the truly contrarian investor.

How To Link Aadhaar With Your Mutual Fund Investments(Outside View)

Sep 11, 2017

The Government has extended the linking of the unique Aadhaar number to nearly all financial transactions.

More
 

Become A Smarter Investor In
Just 5 Minutes

Multibagger Stocks Guide 2017
Get our special report, Multibagger Stocks Guide (2017 Edition) Now!
We will never sell or rent your email id.
Please read our Terms

MARKET STATS