Written by Andrew Cassar Overend
10 min read
Last Updated on May 13, 2021
You can find a flowchart which can help facilitate your thought process in this section
As discussed in our master class on inflation, global policymakers have resorted to extreme measures in an attempt to propel economic activity.
Conventional interest rate policy has proved to be incapable of providing the required stimulus to stimulate the debt-ridden global economy. Therefore, policymakers resorted to unconventional tools which involve money creation, the effects of which have yet to be seen.
The first innovation was implemented to recapitalize
However, QE did not work as expected. Commercial banks were reluctant to pass on the money into the real economy by granting loans, because:
they needed to recapitalize their balance sheets after the notable losses which were incurred when the housing price bubble exploded;
their risk tolerance was impaired and they were hence unwilling to lend, especially with such low return potential due to the low interest rates (recall that bank's business model relied on interest revenue from loans - when interest rates are lowered, profit margins are suppressed).
Therefore, the Central Bank stimulus got caught up in the financial system. Instead, of leaving these reserves on their balance sheets, commercial banks opted for the less risky option of buying Government bonds. This increased the demand for bonds, drove their price higher and reduced their yield.
In light of the lower yield on bonds, institutions like hedge funds, pension funds and other investors allocated their capital towards higher yielding assets like equities and real estate. This higher demand for risky assets fueled the asset inflation over the past decade.
However, since the Central Bank stimulus did not escape the financial system, the money did not reach those who really needed it - those workers who lost jobs, those people who were left incapable of financing their mortgage, those small businesses who were unable to sustain their operations.
To make matters worse, the fiscal response by Governments at the time was relatively modest and short-lived. Thus, goods and services inflation measured by the Consumer Price Index (CPI) remained muted, and several economists' fears of inflation were dispelled.
However, the Covid-19 crisis shows that policymakers learnt their lesson. Governments joined forces with Central Banks to ensure that the stimulus reached the real economy.
Governments wanted to ensure that the money escaped the financial system and therefore they decided to raise the finance themselves and disburse it where it deemed fit. They did so with the assistance of the Central Bank, which indirectly purchased Government securities via special purpose vehicles. By inflating Governments' bank account (in addition to providing commercial banks capital via Quantitative Easing), Governments were able to spend the money as it deemed fit, disbursing it at great speed and ensuring that it was channeled to who needed it the most.
This led to a key debate since the start of 2021 - will goods and services inflation emerge this time round?
In our inflation master class we mentioned the three types of inflation: Goods and services inflation, asset price inflation and monetary inflation. The great Milton Friedman
While deflationists argue that the inflationary response from the monetary stimulus is temporary and structural forces like demographics, debt and technological advancements will continue to enact secular downward pressure on prices, inflation proponents suggest that the size of the fiscal stimulus and the fact that it reached those who really needed it, imply that inflation may indeed emerge.
To form an opinion on which club to join, we constructed a decision tree to help you formulate your own assessment, accompanied by links to some key charts to monitor so that we will be able to diligently strategize our investment decisions.
In response to lagged recovery in employment following the pandemic, and with interest rates already at very low levels, we assess the implications of the significant monetary inflation.
Monetary inflation can take two forms:
Quantitative Easing and/or
Government borrowing from the Central Bank to raise money, a.k.a deficit
Now, let's consider option (1) Quantitative Easing. Central bank buys bonds and increases reserves on commercial bank balance sheets, so the Monetary Base (M0)
But an increase in the monetary base does not mean that the money supply will increase.
Therefore, the first question we should ask is: does broad money supply increase in response to the increase in the monetary base?
This can be monitored using the money multiplier, which is the ratio of the Broad Money Supply (M2 or M3, depending on the economy) divided by the Monetary Base (M0).
If the money multiplier continues to decline, then this means that banks have not transmitted the money into the real economy. For every currency unit in Central bank stimulus, there is a smaller transmission of broad money into the economy. To assess whether money is being created in the US, bank lending can be monitored using the loans and leases data.
If bank lending remains subdued, the next thing to ask is what banks will do with the reserves on its balance sheet. If banks choose to buy safe assets, the additional demand for bonds will cause yields to go lower. In search for yield, institutional investors, pension funds and other investors will resort to higher yielding assets, which may lead to prices of riskier assets like equities to soar.
Under quantitative easing, asset prices are likely to reach new highs and monetary inflation will probably transfigure into asset price inflation. The wealth divide will continue to increase:
The above chart shows that following the Financial Crisis, despite the money printing by the US Central Bank, the wealth of the bottom 50% was most negatively impacted, while the the wealth of the other cohorts held up. Since the money printed did not trickle down into the real economy, QE exacerbated wealth inequality.
As we shall see in the next section, in response to the 2020 pandemic, Governments learned their lesson and resorted to fiscal stimulus instead. In fact, the wealth of the bottom 50% actually increased during a recession.
Now if option (2): Government deficit financing occurs, or if banks do lend the money following option (1) QE, then the money supply in the real economy should increase. Under this scenario, the next thing to inquire is: who received the money? and will this stimulus recur?
If the stimulus or bank lending is only provided to those who are wealthy, high income earners or large, well-established businesses, then the effects of the stimulus on goods and services prices is likely to be minimal.
These wealthy people are less likely spend the money on goods and services because:
they do not need the stimulus to spend - they could have bought what they wanted without the stimulus
if they do spend the stimulus, they are likely to do it on pricey non-essential luxuries which are unlikely to have a high weighting in the Consumer Price Index.
Therefore, instead of spending the stimulus, wealthy individuals and well capitalized firms are likely to invest in more assets to further enhance their wealth.
Big businesses can use the additional capital to buy back their shares and increase their equity price or pay out more dividends. Therefore, asset price inflation emerges and the rich get richer.
However, if the stimulus is channeled to those who actually need it, such as the poor, low to middle class income earners and small businesses, then the outcome may be different.
Whether inflation emerges or not ultimately boils down to how these individuals and small firms use the stimulus.
I have listed four plausible options:
Balance Sheet repair: if these people and small firms choose to pay off their debt, then the effect of the stimulus will not be inflationary - actually, it would be the opposite. This is because by repaying debt, people and firms will be reducing the amount of circulating money supply. A deflationary deleveraging
Precautionary Savings: if the stimulus recipients were caught off guard by the pandemic and found themselves living on the edge, then they may choose to save it. This means that the stimulative intentions will not materialize. Again, inflation will remain muted in this case.
Investment: If people and firms choose to invest the stimulus, the effects on inflation depend on whether the investment is productive or unproductive. I usually define productivity of investment as one which generates future cash inflows which exceed the initial investment outlay. But in this case, I define productivity as one which generates sufficient ripple effects into the real economy. For instance, if people use the stimulus to invest in the stock market or in cryptocurrencies, this is an unproductive investment because no new jobs are created and no real productive output is created. In this case, the stimulus will cause asset price inflation. But if the stimulus is used by an individual to start a new business and employ new people, then this means that new output is being produced and new incomes are being created. Similarly, if small firms expand their workforce or upgrade their operating infrastructure, then new incomes and new value is created. In this case, upward price pressures may happen. Therefore, whether inflation emerges or not depends on how recipients of the stimulus spend invest the money received.
Spending: If people and firms directly spend the stimulus on goods and services, then inflation will indeed emerge.
Another important consideration is the persistence of stimulus.
If the stimulus is a one time thing, the stimulus recipients will be poorer in the following period, due to base effects. Therefore, if the multiplicative effects from the stimulus are insufficient to sustain economic activity, then any inflation which emerges is likely to be transitory.
A one time stimulus is less inflationary than a stimulus which will be augmented every time economic activity shows signs of weakening.
Therefore, the more stimulus is prolonged and the more financial conditions remain easy, the more the likelihood that inflation emerges, especially if expectations of inflation are revised upwards. Indeed, people's fears of inflation may become self-fulfilling, urging them to spend today in fear of a higher price in the future. This is very dangerous however, because it can lead to an inability of policymakers to bring inflation under control, causing a loss of confidence in the currency.
One should also be mindful of base effects. This is a mathematical concept - if in a particular year there was a sharp decrease (or increase) in prices, then the following year it will be even less likely to keep up the decreasing (or increasing) pace. Actually, it is even more likely to witness a significant increase (or decrease) in prices following a strong decrease (or increase) the year prior.
The pandemic is a clear instance of how base effects may cause inflation to appear high, but in fact, prices may only recovering from the previous years' lows. In 2020, when people were forced to stay home and were unable to spend resulted in subdued inflation. The following year, a significant increase in inflation is expected on the back of low base effects. However, to gauge whether inflation is actually occurring, we need to wait towards the end of 2021 so that base effects from the prior year are removed.
That said, there are other non-policy drivers of prices. In our inflation master class, we go into detail on the salient cyclical and secular drivers of inflation, which would supplement the above analysis well. Demographics, debt and technology remain strong deflationary forces. However, policymakers are undeniably testing uncharted waters with these extreme money printing policies.
We are in the middle of a massive financial experiment, the outcome of which is left to chance. Therefore, we should prepare our portfolios for all eventualities so that our finances are fortified in all situations.
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