Opinions

QE Infinity Is Here To Stay – Does It Lead To Inflation or Deflation?

In this exclusive The Golden Investor article Fabian Wintersberger gives his own personal opinion on quantitative easing and the damage it caused to the financial system. Nothing is certain, but as more and more experts give their opinion it seems that a financial crisis is imminent. For now, we give the word to Fabian Wintersberger:

When the Federal Reserve officially started their first „Quantitative Easing Program“ in 2009, they assured that these would be „temporary measures“ and that they would return back to normal when the financial conditions would allow it. Although markets believed that narrative back then, we are still waiting for a “normalization” as the FED was not able to fulfill its promise. On the contrary, due to the Coronavirus Pandemic the FED brought another QE-program on its way ending up buying more bonds than ever before and as a result have been demolishing the last pieces of a free-market in bonds. Looking back in history this path should have been obvious since the implementation of the FED’s very first QE-program.

In 2008 the Federal Reserve started to buy mortgage backed securities to support the struggling mortgage market, 1.35 trillion in total. Additionally Ben Bernanke stated that the FED would also buy US-Treasuries worth 300 billion dollars. In November ’10 the FED started QE2 where it bought another 600 billion of US-treasuries at a pace of 75 million per week. However, even that was not enough: QE3 started on September 13th of 2012 with additional purchases of mortgage backed securities at a pace of 40 billion per month. On October 2014 those buying programs have accumulated 4.5 trillion dollars in total assets on the central banks balance sheet. Surprisingly to many critical voices of these programs, they did not cause a rise in inflation according to the CPI. Proponents of the programs therefore saw that as proof that – if executed correctly – these asset purchases do not necessarily result in inflation.

I have a different opinion on that. It is true that all those massive waves of liquidity did not find its way into consumer prices but honestly such a scenario was not impossible as we know since Richard Cantillon has formulated his “Cantillon-Effect” back in 1755. According to Cantillon newly created money does not affect all parts of an economy simultaneously but rather spreads in steps. This observation definitely is true when it comes to QE1-3. The additionally created money flowed directly into the stock market, bond markets and the mortgage market where it caused prices to rise. While in a true capitalistic system the 2008 financial crisis would have caused price-deflation in those markets and would have caused bankruptcies for over-leveraged companies who misallocated capital, the programs put them on a life-line. That is why a reduction of the FED’s balance sheet never really happened since then because it would have caused interest rates to rise and would have hazarded those companies again.

On the contrary, the QE-programs and the low-interest rate environment encouraged more risk-taking behavior of investors and companies. Overleveraged companies started to buy-back their own stocks instead of restructuring their businesses and investors started to buy riskier bonds to receive a some yield at least. Another reason why there has been no inflation is that lots of dollar-denominated debt has been accumulated by foreign central banks and investors. However, in fall of 2019 tensions in the US-Repo market and the danger of rising swap-rates forced the FED to intervene further. Even though it was not called QE it fulfilled all characteristics, months before the coronavirus crisis was on the radar. Latest at that point investors should have been warned but the financial mania led to another bull-market run where the Dow-Jones Industrial Average reached new all time highs around 25,500 points.

In February this year the coronavirus started to become a major threat for the world-economy which finally pricked the asset price bubble. The reckless investors were in trouble again as the stock market crashed and investment grade and junk bond yields rose dramatically. As governments all around the world put the economy on halt, lots of businesses have been put under pressure as they were forced to shut down which intensified the problems. Unemployment claims rose dramatically with more than 26 million unemployed workers within 5 weeks. The FED’s and other central banks response to the crisis was obvious: more of the same, slashing in interest rates and more bond buying programs although at a much higher volume.

Not only did the Federal Reserve restart the buying mortgage backed securities and US-Treasuries, but also continued to intervene heavily in the US-Repo market, they went all-in. Chairman Powell announced that it will continue buying all kind of bonds, for example municipal bonds and even junk bonds. Furthermore, the Federal Reserve will make direct loans to struggling business and additional cash-payments to unemployed workers. As a result workers in the majority of the states will now earn more than their normal salaries according to Wall Street Journal.

The consequences of those policies will be disastrous for several reasons: First of all a lot of workers will quit their job to get unemployment benefits, especially in low-paid jobs. Secondly, businesses, which may have got out of business anyway, will receive those benefits which will only delay their bankruptcies. Thirdly, with economies all around the world coming to standstill, there will be a shortage in supply. While the FED’s and other Central Banks’ policies can stimulate demand they are ineffective when it comes to the supply side of the economy. By keeping demand steady, the result of a shortage in the supply of goods and services may be a rapid increase in prices, this time with a high probability of not only inflating stocks and bonds but also consumer prices. And fourth, the coronavirus crisis will cause a change in economic activity, especially in the service-sector economy. Even if one is optimistic, he must admit that the demand for restaurants, traveling and other leisure activities is likely to decrease sharply after the world will overcome the coronavirus pandemic.

Does this mean that we are on the edge of dollar hyperinflation? Not necessarily, as investor Raoul Pal recently pointed out in a Twitter-thread: The crisis also led to a huge dollar-shortage all around the world as the dollar is the worlds-reserve currency and safe haven. The expansion of the FED’s balance sheet is also correlated with the latest rise in the dollar-index and on the other hand led to a free-fall in emerging market currencies. Another interesting fact is that the velocity of the newly created money is decreasing rapidly and as a result crowds out emerging market currencies. Given those arguments a debt-deflation scenario is also likely, even though I have a different opinion on that.

As the FED has floated the markets with money created out of thin air directly into the real economy this time I think that the chance of a rise in inflation is of a higher probability. Not only in the United States and in the dollar but also in the euro and other currencies. However, the leveraging of US-companies, households and the government is extra-ordinary if we compare it to European standards. If one assumes a rise in inflation due to the recent supply chain disruption there may be a point where the German Bundesbank and other Central Banks of Northern Europe will refuse to continue with negative interest rates and quantitative easing. Nevertheless, the damage will be done already regardless whether we will experience deflation or inflation next.

Disclaimer: These comments on latest QE-policies are of Fabian Wintersberger personally. The comment is his personal opinion and thus does not necessarily reflect his employers opinion on the topic.

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