There is a lot of discussion at the moment about future inflation because of the huge amount of monetary stimulus being unleased by many of the world’s central banks as they expand the amount and scope of their quantitative easing (“QE”) programmes to combat the CV19-inspired economic collapse. Expansive monetary policies are of course being used not only by the Federal Reserve, but also by the Bank of England (“BoE”), the European Central Bank (“ECB”) and the Bank of Japan (“BoJ”), which collectively represent around 50% of the world’s GDP (of circa $92 trillion). I want to focus on the inflationary aspects of the rapid increase in money supply on the U.S. dollar, because it is the currency used most frequently in trade and is the basis of pricing of many commodities and precious metals around the world, including oil and gold. I will start by looking at quantitative easing, and its effects on the economy and inflation, before assessing what might lay ahead as far as price increases.
What is Quantitative Easing?
Quantitative easing is the purchase by central banks of longer-dated assets, normally government bonds, to effectively manage intermediate and longer term interest rates. When central banks intervene in the market to purchase government bonds (e.g. Treasuries in the U.S.), this pushes the prices of government bonds up and reduces their yield. Prior to the Great Recession, the principal monetary tool of nearly all central banks was the setting of the overnight bank borrowing rate, whilst the yield curve – meaning intermediate and longer term yields on government securities – was determined purely by market forces. However, the Federal Reserve started to use quantitative easing in late 2008 to lower interest rates across the board so as to insulate the economy during the Great Recession. By engaging in yield curve control, the Fed – and other central banks – wanted to eventually stimulate borrowing by consumers and businesses to pull the economy out of the deep recession.
The Federal Reserve engaged in three separate QE programmes between 2008 and 2014, increasing its balance sheet from around $900 billion before the first QE exercise began in November 2008 to around $4.5 trillion by the time QE ended in 2014, subsequently reducing it to around $3.8 trillion by August 2019. The Federal Reserve started a new QE programme in March to address the economic slowdown due to CV19, and since then, the balance sheet of the Federal Reserve has increased to over $7 trillion. Although not the focus of this post, the Federal Reserve also increased the scope of its QE programme beyond US Treasuries to include other assets like asset-backed securities, corporate bonds (including fallen angels) and high yield ETFs.
Why Might QE be Inflationary?
QE could prove to be inflationary – and should on paper – because there are more dollars (or euros or pounds or Yen) chasing the same amount of goods and services, which are fixed in the short term. Over the long-term, the growth in money should in principal track the growth of goods and services. When the growth of money exceeds the growth of goods and services in an economy, then too many dollars will be chasing the same amount of goods and services, essentially devaluing the dollar, or – looking at it another way – increasing the prices of goods and services. This is the principal, at least on paper, of overly accommodative monetary policy leading to inflation.
Why was there no inflation during the record 11-year economic expansion in the U.S. following the Great Recession, a recovery fuelled at least in part by very accommodative monetary policy (including QE) that was in place throughout much of this period?
This is a very logical question, and it introduces a third component into the equation - capacity utilisation. Periods of inflation in the past in the U.S. have either been related to supply shocks (e.g. an unexpected and severe increase in the price of oil like that which occurred in 1973 due to the OPEC embargo), or to overly accommodative monetary policy that ushers in a prolonged period of capacity utilisation above 85% (e.g. early/mid 1970s), a level not reached in the U.S. since 1995. Below is a graph from the Federal Reserve – which you can find here - that illustrates capacity utilisation in the U.S. since 1967.
As the graph illustrates, capacity utilisation reached 81.1% in December 2007, at the beginning of the financial crisis, and bottomed 18 months later at 66.7% (June 2009). Since then, in spite of unusually accommodative monetary stimulus consisting of record low short-term interest rates for a prolonged period and three rounds of QE, industrial production improved but never reached 80%, peaking at 79.6% in November 2018 and falling gradually since then to 76.3% by February of this year. Since industrial production never really approached a level that had in the past been associated with inflation, price growth remained in check throughout the entire period of this record economic expansion.
Having said this, much has changed structurally in the economy since the 1970s, likely causing the level of capacity utilisation associated with an economy overheating - and thus becoming inflationary – to decrease. The sorts of structural changes I am referring to include improvements in labour productivity, more efficient and automated production processes, technological changes / improvements in the workplace, and the gradual tilt of the U.S. economy from a manufacturing-based to a services-based economy. Based on these structural shifts over many years and my own research, I would estimate that that the economy is at risk of overheating, generating inflationary pressures, once the capacity utilisation rate reaches 80% or so.
What has the price of gold signalled regarding inflation?
Gold has proven to be a reliable indicator of inflationary concerns in the past, although it also has a status as a “safe haven” asset during troubled times reflecting the fact that it is a reliable store of value. Let’s take a look at two graphs - one for annual CPI in the U.S. and the other for the price of gold.
As you can see, the price of gold increased throughout much of the 1970s, matching the run-up in inflation that accelerated as the decade wore on. Both gold and inflation increased because of the overly accommodative monetary and fiscal policies early in the decade and the “supply shock” from the 1973 OPEC oil embargo. (Also, the U.S. abandoned the gold standard in 1971, and the Nixon administration adopted a series of ill-advised fiscal policies like wage-and-price controls early in the decade.) Gold rose most of the decade, only falling in price and eventually stablilising after decisive Federal Reserve actions that dampened inflationary expectations. Gold then drifted sideways around $400/ounce for many years until just before the Great Recession. This might be considered the first round of gold price increases related to inflationary concerns.
The second round of gold price increases occurred in the late 2008 to 2012 period, during and just after the Great Recession. Future inflation had become a fear because of the Federal Reserve’s aggressive use of unconventional monetary stimulus to combat the Great Recession and its aftermath. The price of gold increased from $734/ounce in November 2008 (the onset of the first round of QE) to $1,861/ounce by September 2012.
Of course, another key attribute of gold is that it is a “safe haven” asset, meaning that investors often shift from riskier assets like stocks and bonds during uncertain times into gold, since gold is considered a reliable store of value. By 2008, the global economy had slipped into its deepest recession since the 1930s, causing the U.S. financial system to teeter on the edge of collapse. The recovery was also initially frail, fraught with all sorts of lingering issues, including a Euro-sovereign crisis that reached its worst point in 2012 leading to extreme anxiety globally. Gold became the cornerstone of many portfolios because of this heightened systemic risk. Of course, it is impossible to say whether the surging popularity of gold during this period reflected mainly inflation concerns or mainly extreme economic uncertainty. It was probably a combination of both. However, after reaching its record price of well over $1,800/ounce in 2012, gold fell steadily over the next few years to a decade low of $1,065/ounce in January 2016, then bounced along between $1,065/ounce and $1,200/ounce until 3Q2018. Beginning in 4Q2018, gold broke out and rose to nearly $1,500/ounce by the end of last year, probably triggered more by gold’s safe haven status than inflationary concerns. You might recall that the U.S. equity market went through a very difficult patch in 4Q2018, and this was followed by ongoing concerns throughout 2019 related to a variety of policy matters involving U.S. trade, as well as a growing view that the equity markets were over-valued. These factors sharpened investors’ focus on safe haven assets like gold.
Since the first mention of COVID-19 in January, gold has marched upwards to over $1,700/ounce, although one must take care – as I have already mentioned – to remember that gold is both an inflation hedge and a “safe haven” asset. This is where we find ourselves at the moment as far as gold, which has stabilised in the low $1,700/ounce area as investors generally have become more optimistic about the economy. Still, the huge amount of liquidity that the Fed has added to the system is likely to keep a floor on the price of gold around these levels, and to eventually push the price higher.
What is the yield on the 10-year U.S. Treasury signalling?
The graph below illustrates the yield on the 10-year constant maturity Treasury compared to annual CPI since the 1960s.
This graph shows that over time, yields on Treasuries (the blue line) trend upwards as inflation (the red line) increases, and the rate of increase in Treasury yields accelerates as inflationary expectations become entrenched in an economy. This is exactly what happened throughout the 1970s in the U.S. It was only after the Federal Reserve decided to address inflation head-on by taking the painful step of raising the Federal Funds rate to 19% that the yield on the 10-year Treasury finally began to fall. The economic cost of these policies to see off inflation was severe, leading to back-to-back recessions in the late 1970s and early 1980s. However, the Fed was ultimately successful, and inflation worked its way down from a high of 13.5% in 1980 to fall below 5% in 1991, and then fell further to eventually stabilise in a range between 2.5% to 3.5%. The 10-year Treasury yield also declined throughout the period, chasing inflation down as inflationary expectations moderated. The 10-year U.S. Treasury fell from a yield of nearly 16% in 1981 to around 2% by 2012.
Let me digress one moment, as I would be remiss if I were not to also acknowledge that the cost of U.S. government debt should also reflect the fiscal condition of the U.S., meaning that the U.S. should logically have to pay more for its debt as it fiscal situation deteriorates. This deterioration can be seen, for example, in the ratio of federal debt-to-GDP and in debt service as a percent of the annual budget. In fact, both of these ratios are increasing very quickly as I write this article. However, the reality is that the U.S. Treasury market is considered the safest and most liquid sovereign bond market in the world, reflecting trust in the U.S. government and faith in its democracy. Moreover, the U.S. Dollar enjoys a unique status as the world’s reserve currency. These factors mean that the U.S., unlike nearly all other countries (aside possibly from Japan), can manage through a deteriorating fiscal status with virtually no effect on its cost of borrowing. Of course, the Federal Reserve, similar to other large central banks, is buying its government’s own debt, creating a distorting force in the marketplace and pushing down yields (the purpose – after all – of QE). For this reason, I have chosen to ignore Treasury yields as a reflection of the quality of the U.S. since investors do the same, and instead focus on the inflationary signals that yields have historically provided.
What else might affect inflation?
I can think of two other things that might affect inflation: the migration of supply chains back on shore, and the increase in the price of oil. One effect of the pandemic will be that countries become less global as they encourage their large companies to move their supply chains back on-shore. This will be particularly true in the U.S., as the government focuses on encouraging companies to reduce their dependency on suppliers that are located abroad, particularly those located in China or in other countries deemed to be less friendly to the U.S. This works against the economic theory of comparative advantage. Moving supply chains back on-shore will almost certainly increase the cost of many component parts, and this will inevitably cause prices to increase as manufacturers seek to preserve their profit margins.
As far as oil, the low price currently is related to a supply-demand imbalance that – as we have seen over many years and many cycles – will find its equilibrium at some point . When this occurs, prices will stabilise at a level that is probably more in the $50-$60/barrel range (WTI), similar to where prices were prior to the pandemic. However, this will take time because demand is so weak at the moment, so higher oil prices should not create severe pressures as far as costs for at least a couple of years. Similar to higher costs of on-shoring, higher oil prices could eventually influence end prices for those companies that have oil or petroleum-based products as a major cost component in their manufacturing process, or that depend on transportation.
Both the on-shoring of suppliers and higher oil prices will be factors that in several years could create cost pressures that could translate into inflation. But this will take time.
So will it be inflation or deflation?
In my opinion, we are not likely to face inflationary pressures in the U.S. during the short term (defined as for at least two years). The economy is in the beginning stages of a very deep recession that will curtail consumer spending as unemployment approaches record highs and will reduce – or at least defer - business investment because of the uncertain outlook. A sustained recovery is a ways off given these circumstances, and for all we know at this point (and in spite of the recent equity market rally), the CV19 pandemic could rage on for longer than currently expected. Because demand is so weak, I do not see oil returning to pre-pandemic levels for some time, and the on-shoring of suppliers cannot and will not happen overnight. In fact, there is so much excess capacity and so little spending / consumption at the moment that I believe the near-term risk is more skewed towards deflation than inflation, and as Japan has experienced since the 1990s, deflation is much more difficult to tame than inflation. I suspect that the U.S. will be able to avoid deflation without turning to negative interest rates (or at least I hope so), although inflation in the U.S. will be closer to 0% than the Fed target of 2% for at least two years.
Looking beyond this period, I am concerned about inflation, even though the record recovery after the Great Recession initially fuelled inflationary expectations that never really materialised. This time could be different because the quantum and scope of QE is significantly larger, and it is accompanied by record fiscal stimulus measures to soften the economic blow of CV19 (with more likely coming). Eventually capacity will approach more normal levels, and we will be left with the likelihood of the on-shoring of supply chains increasing production costs, adding further to inflationary pressures. My hope is that past policy mistakes and their aftermath will guide the Federal Reserve and the government towards coordinated and effective actions to ensure that inflation in excess of the target 2%, should it emerge, not become significantly higher and - more importantly - entrenched.