Central Banks Are 'Printing Money' - But Deflation Is Still The Bigger Risk
Apr. 01, 2020 10:53 AM ETDDM, DIA, DOG...1 Comment3 Likes
Summary
The Federal Reserve and other Central Banks have been rapidly expanding their balance sheets.
Is inflation a major near-term concern?
The actions of the Federal Reserve are unlikely to help the real economy and can actually perpetuate more disinflation/deflation.
Cash, Treasury bonds, and gold remain the most appropriate overweight allocations relative to a risk-balanced portfolio given the current set of data.
A large position in Treasury bonds allowed for a positive portfolio return in the month of March in the face of a massive market decline.
The most recent update of the Federal Reserve's balance sheet showed an explosion higher to a level just north of $5.25 trillion. As the Federal Reserve and other Central Banks engage in aggressive monetary policy to smooth market volatility, common inflation concerns have reemerged, similar to the past decade.
Each time the Federal Reserve and other Central Banks engage in aggressive asset purchase programs, fears of inflation or a collapse of the dollar rightfully surface.
Over the past 10 years, Central Banks have expanded their balance sheets, and the US dollar has maintained its strength, the rate of inflation has continued to march lower, and sovereign bond yields fell to new all-time lows.
Inflation and a loss of confidence in the US dollar always is a possibility. However, after careful analysis, it remains likely that deflation or disinflation is the more immediate concern, despite the aggressive actions from both the Federal Government and Central Bank.
Federal Reserve Balance Sheet:
Source: Bloomberg, EPB Macro Research
When the Federal Reserve expands the balance sheet through asset purchases, primarily US Treasury securities, Mortgage-backed securities "MBS" and newly added commercial mortgage-backed securities "CMBS," the Fed increases the excess reserves of primary dealers to pay for securities.
These actions increase the monetary base and may influence the money supply, but the increase in the monetary base does not always translate to an equal increase in the money supply.
The monetary base includes currency in circulation and excess reserves, which is why when the Federal Reserve buys assets, the monetary base increases. This alone, however, is not inflationary because the monetary base needs to be "converted" into the money supply. If the Federal Reserve increases the monetary base significantly, but that money never reaches the public, inflation is not a concern.
Monetary Base:
Source: Bloomberg, EPB Macro Research
The rate at which the monetary base is converted into the money supply is called the money multiplier, or "little m," which we can easily derive by dividing the M2 money supply by the monetary base.
The Federal Reserve does not have full control over the money multiplier as many of the factors remain less than fully understood.
Nonetheless, the money multiplier or the rate at which the monetary base is converted into the money supply has been falling rapidly over the past several decades, with the most significant decline coming after the 2008 banking crisis.
If the money multiplier continues to fall, expanding the monetary base through asset purchase programs will not necessarily translate to an increase in money supply growth or inflation.
Money Multiplier:
Source: Bloomberg, EPB Macro Research
Despite aggressive "money printing" or "reserve creation" over the past several years, the money supply never grew much above the long-term historical average, solidifying the idea that increasing the monetary base in isolation is not necessarily inflationary.
The two-year annualized rate of change in money supply growth this economic cycle has been nearly exactly the same as prior decades and today's rate of increase is not much different either.
Money Supply Growth (%):
Source: Bloomberg, EPB Macro Research
Even if the rate of money supply growth started to increase well above the historical average, an inflationary spiral is not guaranteed. Money times (*) velocity is equal to aggregate output or nominal GDP.
This comes from the equation of exchange which states:
MV = PQ
In classic economic textbooks, velocity "V" always is held constant, and thus, an increase in money supply growth automatically translates to an increase in price growth. Many analysts continue to hold velocity constant or ignore this variable in their analysis altogether.
In reality, demonstrated below, we know that velocity is not constant - at all.
Many factors contribute to the velocity of money or the rate at which money is exchanged in an economy, not all of which are fully understood either. One main factor we do understand is that the velocity of money tends to decline sharply in highly-indebted economies.
As the public and private debt levels increase, income is diverted to repay debt rather than higher velocity uses of capital.
Thus, even if the rate of money growth started to increase above the historical average, an inflationary spiral will not take hold if the velocity of money continues to crash.
Velocity Of Money:
Source: Bloomberg, EPB Macro Research
The current humanitarian crisis around the world will lead to a massive increase in both public and private debt. While necessary, the type of debt that will be assumed is not for plant and equipment or for productive uses that will generate a future income stream.
Unfortunately, as the world recovers, economies will emerge significantly more indebted, and thus, the velocity of money is not only likely to fall, but rather accelerate to the downside.
A continuous decline in the velocity of money renders monetary policy virtually ineffective as rapid increases in the monetary base need to translate to the money supply and then will be offset (likely) by a continued collapse in the velocity of money.
High Levels of Debt Reduce The Velocity of Money:
Source: Hoisington
The Federal Reserve has expanded its asset purchases to far more assets than just Treasuries, MBS, and CMBS, which has caused concern.
Under the current Federal Reserve Act, the Fed cannot purchase corporate bonds in the same fashion that they conduct purchases of government-backed securities.
To circumvent this, the Federal Reserve and the Treasury set up Special Purpose Vehicles or "SPV" to purchase assets through the SPV.
The equity investment in the SPV comes from the Treasury, using the Exchange Stabilization Fund "ESF" so that the Federal Reserve does not absorb losses.
Continuously funding SPV from the ESF is another form of increased debt as the Treasury obtains funds from tax receipts or issuing more Treasury securities.
QE vs. SPV:
Source: Bloomberg, EPB Macro Research
Typically, an inflationary spiral will be identified in several areas that we can track below. A tight labor market can generate wage pressure. Rising commodity prices also are a signal of inflation. The strength of the US dollar and the government bond market, through breakeven rates, also can signal inflationary pressure or a loss of confidence in the value of the US dollar.
The labor market is clearly not a primary inflationary concern at this point, with millions of Americans losing jobs.
Initial Jobless Claims:
Source: Bloomberg, EPB Macro Research
The CRB Index of raw industrial commodities, outlined below, shows significant disinflationary pressure as this basket of industrial materials sinks to nearly the lowest level of this economic cycle.
CRB Raw Industrials Index:
Source: Bloomberg, EPB Macro Research
If we flip over to commodities that are easier to speculate on, proxied via the Bloomberg Industrial Metals Index, we can see a similar decline in prices - another disinflationary signal.
Bloomberg Industrials Metals Subindex:
Source: Bloomberg, EPB Macro Research
The US dollar remains extremely strong, although the aggressive use of USD Swap Lines with other Central Banks has alleviated the major funding pressure, leading to a decline in the value of the USD.
Still, relative to this economic cycle, the USD remains quite strong.
US Dollar:
Source: Bloomberg, EPB Macro Research
The US government bond market, despite substantial Central Bank intervention, remains one of the best market signals with regard to forecasting growth and inflation trends.
While breakeven rates may rise, and we'd take careful note of such a development, long-run inflation expectations have cratered to the lowest level of this economic cycle before popping slightly higher.
US 5Y5Y Forward Breakeven Rate (%):
Source: Bloomberg, EPB Macro Research
Inflation is always a possibility, and aggressive intervention in markets is always uncomfortable. Studying the facts, however, shows that disinflation or deflation remains a more immediate concern.
Through our process, we will continue to monitor all the potential channels by which an inflation spiral can emerge.
The biggest concern with regard to inflation is a change in the Federal Reserve Act, allowing the Fed to "create" money and drop it directly into the money supply. This is currently prohibited.
There are not many analysts who suggest the Federal Reserve will not be expanding the monetary base rapidly in the coming years. This was well understood even before the current crisis. Conflating an increase in the monetary base with guaranteed inflation has been a critical mistake that has resulted in many investors missing virtually the greatest rally in long-term Treasury bonds in history.
Commodities hedge inflation most strongly, while gold is more of a direct bet on the inverse direction of real interest rates.
As economies become more indebted, real interest rates must grind lower which will result in gold continuing to rise over time as it has throughout history.
This analysis has allowed EPB Macro Research to hold an overweight position in Treasury bonds for the past several years, resulting in positive performance for the month of March and a higher annualized return than the S&P 500 over the past three years.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
