Quantitative Easing Doesn't Mean Inflation - Outside View

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Quantitative Easing Doesn't Mean Inflation
Aug 16, 2010

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!

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