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BookmarkTHE RESORT to further Quantitative Easing (QE) in the US (that is, creating money) on an unlimited scale has been announced by the US Federal Reserve’s open market committee. Since January 2007, the money base in the US — the cash supplied by the Fed to mostly banks and the public — has grown from a mere $872bn to $2,672bn by July this year.
Of this increase in the money base, more than $1,500bn of the extra cash is being held as deposits by member banks with the Federal Reserve system in excess of their cash reserve requirements. The Fed’s intention is to add to this cash at the rate of more than $80bn a month through further Fed purchases of US treasury bonds and mortgage-backed securities. Yet this huge increase in the money base, sometimes described as the high-powered money of the economic system, is not — yes, not — expected to increase inflation in the US. We can draw this conclusion by observation of the US government bond market.
The market in long-dated fixed-interest US government bonds offers investors an extra 2.4% a year to bear the risk that inflation may increase markedly and unexpectedly over the next 10 years.
If inflation were expected to rise beyond the 2.4% a year currently priced into the bond market, long-term interest rates will rise and the market value of long-dated fixed-interest securities will decline markedly. What is regarded today as a safe haven for portfolio managers could prove anything but safe.
This 2.4% compensation for bearing inflation risk is derived from the gap between the yield on a vanilla 10-year US treasury bond (about 1.8% at present) and the yield on a 10-year inflation-linked US Treasury Inflation Protected Security (Tips), currently offering a negative (real) yield of -0.6% a year.
The market clearly does not regard US money creation as likely to lead to much more inflation this time round. That the banks are hoarding the extra cash supplied to them, rather than making extra loans with the cash at their disposal, has clearly reduced any immediate inflationary dangers.
At some point, however, the extra cash currently hoarded by the banks will have to be withdrawn through the timely reversal of QE. That is, at the point or rather before that moment in time when the banks start drawing on their abundant excess cash (held as deposits with the Fed) to make credit available to help finance spending intentions.
Lending rather than hoarding the vast stores of extra cash currently at the disposal of the banks would, if unchecked, pose severe inflationary dangers. The Fed will then have to sell securities from its swollen balance sheet in exchange for the cash of the banks. The proverbial punch bowl will have to be removed before the party gets going. And the punch bowl is a particularly spiked one.
While Fed chairman Ben Bernanke is confident he will be up to this monumental task, and while the bond market seems to offer support for his capability to do so, there must be some chance that his success will not be complete. If so, spending and inflation in the US could pick up very strongly — as it has historically after every burst in money creation. This chance of inflation slippage and too much (rather than too little) money in circulation has surely increased with QE3.
Protection against such a possibility is available from the inflation linkers issued by the government, including the US Treasury. Protection is also offered by real assets, including equities, that are a claim on the real assets employed by firms that supply the goods and services that make up the inflation basket.
The real asset that history suggests is highly inflation-proof is gold. The cost of holding gold may be regarded as the interest rate foregone on the inflation-linked bonds. These have declined to record low levels. Holding gold rather than other assets that produce interest or dividend income has never been less expensive. The price of gold has responded accordingly.
The future price of gold is very likely to be determined by the opportunity cost — the interest foregone when holding gold. This is best represented explicitly by the real yield foregone on a 10-year inflation-protected US government bond, which at present offers a negative real yield. This negative real yield may be regarded as an expensive insurance policy against unexpectedly high inflation. Holding gold — especially if these inflation-linked yields decline further — may be regarded as a still more attractive insurance policy against unexpectedly high rates of inflation.
