To the casual observer it may seem absurd to suggest that the recent run-up in both inflation and asset prices is primarily a result of fiscal policy rather than monetary policy. After all, the current monetary policy response undertaken in response to the COVID pandemic has resulted in a tidal wave of new money being created in private sector bank accounts. Under the program of Quantitative Easing (QE), central banks purchase bonds from the private sector and inject cash in its place. Given that no new goods and services were created as a result of these operations, and given that inflation is often defined as “too much money chasing too few goods”, how is it that this money is not inflationary in nature?
By contrast, using this same logic, debt-financed fiscal deficits should be non-inflationary in nature. After all, standard debt-financed deficit spending merely borrows money from existing entities in the private sector and re-distributes these funds to other entities in the private sector. Under this type of a fiscal response, no new money is actually being injected into the system. The currency is clearly not being debased by the monetary authorities since no new currency or bank deposits are being created as part of the operation. Certainly it must be the case that fiscal policy of this type is non-inflationary in nature, must it not?
Complicating matters further is the fact that monetary and fiscal policy in today’s environment have become highly intertwined. Fiscal deficits have resulted in a large increase in the issuance of government debt, but monetary policy has resulted in central banks purchasing these same bonds in the secondary market by issuing new money to sellers. This, in a roundabout way, has resulted in much of the government’s deficit spending being essentially money-financed through central bank money-creation rather than debt-financed in the traditional manner using borrowed money from the private sector.
The tangled web of monetary and fiscal policy and their impacts on prices have made the current public policy response incoherent to the average observer. Most critics have resorted to recycling the tired old refrain that the current bout of inflation is being caused by central banks simply printing money “out of thin air”. They have taken to the practice of dividing the price of virtually anything by the size of the central bank’s balance sheets, as if the increase in the money supply driven by central bank monetary policies are flowing directly into the price of goods, services, and asset prices. QE, we are warned, will inevitably lead to widespread currency debasement, hyperinflation, and the eventual complete collapse of the present-day monetary system.
Most of these approaches are profoundly incorrect. They are based on the assumption that the money created as a result of monetary policy is solely responsible for the current run-up in inflation, when it is much more likely that in today’s environment, monetary policy has taken a back seat to fiscal policy. This is not to say that monetary policy, via QE, has had no impact on the prices of goods, services, and asset prices – it most certainly has. But the means by which it flows through to prices in general has been wildly conflated. This piece will clarify how fiscal policy impacts both “CPI inflation” and asset prices and will explain why this impact is largely independent of monetary policy. It will then describe the inflationary impact of monetary policy and the mechanism by which newly-created QE money flows through to inflation and asset prices versus the way that is popularly described.
1. Fiscal Policy and Inflation
When governments choose to deficit spend, the result is inflationary in nature, regardless of the fact that it does not increase the broad money supply. Consider first the mechanism by which governments deficit spend using traditional debt-financing. The government issues a bond which is first purchased by the private sector, and then spends or transfers the proceeds from the bond sale to some other entity in the private sector by means of stimulus. If we suppose that the government deficit spends to the tune of $100B, once the government has spent the borrowed funds the balance sheets of the various entities would change as follows:
Private Sector Lender:
- Change in assets = +$100B (the purchased bond), -$100B (cash lent to government)
- Change in liabilities = None
- Change in net worth = None
Government:
- Change in assets = None (borrowed money was spent in the private sector)
- Change in liabilities = +$100B (the funds owed to the lender)
- Change in net worth = -$100B
Private Sector Recipient:
- Change in assets = +$100B (transfer from the government)
- Change in liabilities = None
- Change in net worth = +$100B
What should be clear from the changes to the above balance sheets is that the act of deficit spending has increased the net worth of the private sector by $100B. The private recipient of the stimulus is now $100B wealthier, even though no new money was in fact created as part of the operation. All that has happened is that cash was moved from the lender to the recipient, with the government having injected a bond into the portfolio of the lender.
If the recipient of the government transfer, now with $100B more at their disposal, decides to spend the entirety of their new money within the economy, they will bid up prices. They will bid up prices because spending has increased the dollar-demand for economic goods and services, while the supply of goods and services has obviously not immediately increased as a result of the deficit spending. If we look closely at the implications of deficit spending upon individual balance sheets, we can now begin to see the problem with a completely money-centric view of inflation – it isn’t increasing the money supply that causes inflation, but increasing spending.
Deficit spending by the government has increased the net worth of the recipient, giving them an increased capacity to spend (although not necessarily the desire to do so). Those who focus on the quantity of money might reply that it isn’t the increase in wealth per se that has the potential to increase the recipient’s spending, but the fact that they have been given access to more “money supply” specifically. But we only need to look at a simple counterfactual to see this is incorrect. Imagine that instead of deficit spending being undertaken by the government, the recipient borrowed the $100B directly from the lender. In this case the lender’s balance sheet would remain unchanged, just as in the case with government deficit spending. But in this new scenario, the recipient would, in addition to the $100B of new money, have a corresponding $100B liability (money now owed to the lender).
The $100B no longer represents an increase in wealth for the recipient. It is no longer a transfer – ie. a gift – from the government. It is money that the recipient knows full well will need to be repaid with interest, at some point in the near future. By the same token, if the government stimulus were to be given to the recipient with a stipulation that the funds would need to be repaid in, say, a year, do we really believe that the recipient would be so eager to spend the newly acquired money? No – the stimulus, which is now paired with a corresponding liability, will be far less likely to be spent because the recipient’s net worth has remained unchanged. They certainly may have more actual money to spend, in the sense they have more dollars than before, but they don’t have more wealth to drive a corresponding increase in spending. The fuel for inflationary spending, therefore, isn’t money, per se, but wealth.
If we take the thought experiment further, looking at things from, say, the lender’s perspective, we can conclude that holding cash or bonds makes no real difference towards their propensity to spend since their wealth has remained unchanged. The lender clearly had no desire to spend the money they lent to the government, otherwise they would not have bought the bonds. Likewise, if the lender’s $100B bond was now suddenly replaced with cash, it would be absurd to think that the lender would now rush to spend this sum of money within the economy simply because they have $100B of cash instead of $100B of bonds. Had the lender, holding the bond, wished to make a purchase, they would merely have sold their bond for cash and proceeded to spend the cash on goods and services. Substituting a highly liquid asset (cash), for another highly liquid asset (government bonds), makes little real-world difference to the lender’s spending decisions. In a modern economy, given the ease of liquidity conversion between the majority of financial assets, the composition of financial assets makes far less of a difference on one’s spending decisions than many tend to believe. From a practical perspective, if you have a bond, you might as well have cash. Wealth, and the decision to spend that wealth, is what ultimately drives inflation – not the money supply.
Of course, as many readers will undoubtedly point out, these days the government isn’t just engaged in standard debt-financed deficit spending where the money supply remains unchanged. It is now being supplemented by central bank purchases of bonds from private investors. In other words, while it may appear that the government simply sells bonds to investors to obtain existing money, central banks subsequently create new money through QE to buy those same bonds from the private sector. In effect, as is often argued, this is more-or-less equivalent to the central bank simply creating money for the government to spend in exchange for the bond. We have already seen that deficit spending, financed through standard borrowing from the private sector using existing money, is inflationary in nature. Does the act of QE change the math behind the equation at all?
No, it doesn’t.
Importantly, whether financed by issuing bonds to the private sector or directly to central banks in exchange for newly-created money, the end result is the same – an increase in private sector wealth in direct proportion to the size of the deficit spending. Consider what would happen if, in our previous example, the $100B deficit was money-financed instead of debt-financed. Once the government had spent the newly created $100B into the economy, the balance sheets of the central bank, the government, and the recipient of the government transfer would appear as follows.
Central Bank:
- Change in assets = +$100B (value of the acquired bond)
- Change in liabilities = +$100B (new deposit created to pay for the bond)
- Change in net worth = None
Government:
- Change in assets = None (borrowed money was spent in the private sector)
- Change in liabilities = +$100B (the funds owed to the central bank)
- Change in net worth = -$100B
Private Sector Recipient:
- Change in assets = +$100B (transfer from the government)
- Change in liabilities = None
- Change in net worth = +$100B
We can see that in the above example, the primary difference between money-financed deficit spending and traditional debt-financed deficit spending is that the lender is in this case the central bank rather than another private sector entity. While it is true that the central bank simply created the money to pay for the bond, because the new deposit is recorded as a liability of the central bank, the central bank’s net worth remains unchanged. Indeed, the only changes in net worth are solely the result of the transfer from the government to the private sector. The government incurs a new $100B liability as a result of the bond issuance, and the private sector is injected with $100B of new wealth, exactly the same as in the debt-financed example. The government has thus increased the capacity of the private sector to spend by increasing aggregate private wealth, irrespective of the funding method chosen.
We should note that while the effect of fiscal policy in the current environment is to increase the net wealth of the private sector, it can’t guarantee that this increase in wealth will necessarily always lead to an increase in spending. In many cases the general population may increase spending as a result of the government stimulus, especially if the government transfers are targeted towards those with a high propensity to spend. However, whenever the money finds its way into the hands of those with a high propensity to hoard financial wealth – those whose jobs were unaffected by the pandemic, for example – the inflationary impact becomes increasingly muted. In particular, due to the pandemic, the preferences of a wide swath of the population may have shifted towards increased financial hoarding over spending. This may be because of a sudden shortage of goods and services available for purchase, or simply because the increased uncertainty and fear of the pandemic has caused them to delay spending to some future date.
By extension, if an increased propensity to delay spending exists among the general population, then people will more quickly hoard the government’s fiscal stimulus and be eager to allocate the funds towards financial assets like stocks, bonds, commodities, or cryptocurrencies. This will have the effect of driving up asset prices in relatively predictable ways.
2. Fiscal Policy and Asset Prices
We have so far asserted that an increase in private sector wealth is a powerful driver of increased spending and inflation, but we have not described the specific process by which this occurs. If we follow the path that the government stimulus money takes as it moves through the economy, it will allow us to better see how fiscal policy flows through to asset prices. Consider that when a person receives a stimulus cheque from the government, they have the choice to either spend the money or hoard it into savings. If they are wealthy, they are unlikely to spend the majority of the stimulus money, as, being wealthy, they have most of what they already need. If they are less wealthy, spending most of their weekly pay on rent and other essential goods and services, it is much more likely that they will spend a large portion of the stimulus on other essential goods and services or perhaps on luxury items they would never have the means to purchase otherwise. Of course, there is a middle ground where some will choose to save only a portion of the government transfer and spend the other portion into the economy.
Consider the case where the government, financed with newly created money by the central bank, engages in deficit spending by sending $100 stimulus cheques to a select group of people in the economy. Let’s call one of these recipients Person A. If Person A has a high propensity to spend, they will spend the entirety of the $100, which will have an inflationary impact on prices and subsequently becomes income for Person B. Let’s say that Person B saves (hoards) $20 and spends the remaining $80, half of which ($40) goes to Person C and the other half ($40) going to person D. Suppose that Person C is a rich hoarder of wealth and Person D is struggling just to make rent. In this case, the $40 that went to Person C will be hoarded in its entirety while the $40 that went to person D will be spent in its entirety. At this point in the cycle, $60 of the $100 stimulus money has now been hoarded while $40 remains for spending. The $40 that Person D has left to spend will then go to Person E as income, who will save a portion of the money and transfer the rest to Person F, and so forth and so forth until the $100 is largely hoarded and withdrawn from the economy.
We can see that while the $100 cash injection into the private sector will initially stimulate spending to a degree, the new money will eventually flow through to savers who will withdraw the money from the economy and allocate it to their portfolios. If recipients of the stimulus are eager to hoard money and not spend, the funds will tend to accrue more quickly within investor portfolios. By contrast, if the various recipients of the stimulus money are eager to spend with little propensity to save, the $100 will accrue to savers more slowly and the dollar value of investment portfolios will tend to rise at a slower pace.
Regardless, as a result of the fiscal stimulus, investor portfolios will collectively now have a higher cash allocation relative to all other assets. If the increase in their cash allocation is desired – if they actually want to hold more cash relative to risky assets – then there will be no impact on asset prices. Investors will simply hold a larger allocation of cash and asset prices will remain unchanged. But there is no reason to expect that fiscal stimulus – the injection of cash into investor portfolios – has materially altered the allocation preferences of the average investor. If you increase an investor’s allocations to cash in the absence of an actual desire to hold this cash, investors will simply reallocate their portfolios to their original proportions. If a typical 60/40 investor has, for example, $60k of their portfolio allocated to risk assets, and $40k allocated to riskless assets, then injecting $10k of cash into their portfolios will alter their allocation to be $60k in risk assets, and $50k in riskless assets. But if investors don’t actually want to hold the new allocation of 55% risk assets and 45% riskless assets, they will move to increase their allocation to risk assets by bidding up their prices until the original 60% allocation is once again achieved.
The phenomenon by which an increase in the supply of riskless assets serves to drive up the prices of risk assets is one of the key insights behind Jesse Livermore’s Single Greatest Predictor of Future Stock Market Returns1. If, over time, the overall dollar value of bonds and cash in the system continuously increases to support economic growth, then the overall value of equity must correspondingly grow if investors are to maintain a constant average equity allocation. If corporations aren’t expanding the quantity of stock shares in existence at a rapid pace, then the only other way to increase the aggregate value of equity is for investors to bid up the prices of existing shares. Thus, as the dollar value of cash and bonds in the economy increases, and if investor preferences to hold stocks hasn’t materially changed, then over time this must force up equity prices as well.
Let us now examine how, exactly, both money-financed deficit spending and debt-financed deficit spending cause risky asset prices to subsequently rise. Recall that in our example at the beginning of this section, the $100 government stimulus cheque was financed by newly-created money by the central bank rather than by bond issuance to the private sector. In other words, the deficit spending was money-financed rather than debt-financed. If the financing occurred by having the central bank simply create new money to purchase the government bonds, this would result in the following changes to the relevant balance sheets:
Central Bank:
- Change in assets = +$100 (value of the acquired bond)
- Change in liabilities = +$100 (new deposit created to pay for the bond)
- Change in net worth = None
Government:
- Change in assets = None (borrowed money was spent in the private sector)
- Change in liabilities = +$100 (the funds owed to the central bank)
- Change in net worth = -$100
Private Sector Recipient:
- Change in assets = +$100 (money transfer from the government)
- Change in liabilities = None
- Change in net worth = +$100
In other words, in a money-financed operation funded by the central bank, cash assets are added to the private sector, which, as we have already described, will be repeatedly spent by various entities in the economy until the money is eventually hoarded within investor portfolios. At this point investors would automatically be over-allocated to riskless assets relative to risky assets. They will thus seek to re-allocate their portfolios to obtain the original weighting between risky and riskless assets by correspondingly bidding up the prices of risky assets. Government deficit spending has, in effect, leaked into specific asset classes, creating a bid in risky assets like stocks and commodities, pushing prices higher and higher automatically with each fiscal injection. Large-scale government fiscal injections, we are left to conclude, are therefore highly stimulative to risk assets, all else being equal.
At this point the reader will undoubtedly point out that this is all well and good for money-financed deficit spending, but under standard debt-financed deficit spending, no new cash is being injected into private sector portfolios. All that is happening is cash is moving from one private sector portfolio to another, with the government acting as the intermediary. A lender simply loans existing money to the government who then, via either deficit spending or direct transfers, passes this money on to some other entity in the private sector. The overall allocation to “safe assets” therefore remains unchanged, meaning there will be no corresponding bid towards risk assets. This characterization, however, misses one key point – the creation of the bond asset by the government. The following example shows the balance sheets changes resulting from standard debt-financed deficit spending.
Private Sector Lender:
- Change in assets = +$100 (newly acquired bond), -$100 (cash paid to government)
- Change in liabilities = None
- Change in net worth = None
Government:
- Change in assets = None (borrowed money was spent in the private sector)
- Change in liabilities = +$100 (the funds owed to the lender)
- Change in net worth = -$100
Private Sector Recipient:
- Change in assets = +$100 (transfer from the government)
- Change in liabilities = None
- Change in net worth = +$100
We see that as a result of the loan to the government, the lender received a bond in exchange for their cash, with the cash then re-distributed by the government to the private sector. The government has thus effectively created a new financial asset for the private sector and increased overall private sector net worth in the process. The creation of the government bond has similarly increased the dollar value of safe assets held within investor portfolios by $100, meaning that investors will once again seek to bid up risky assets to rebalance their portfolios to their original allocations. Fiscal stimulus, therefore, serves to increase the price of equities and other risk assets as the supply of money and/or credit expands in the system. It makes little difference if the government spends via central bank money-creation or through the borrowing of existing cash from the private sector. In either case, the supply of safe assets that investors hold will grow larger than their initial target allocations, causing them to bid up the prices of risky assets in response.
The above discussion has so far relied on the assumption that investor preferences for safe and risky assets are held constant, and that as a result of the fiscal stimulus, they hold a greater proportion of their money in safe assets than they actually wish. Obviously, however, investor asset allocation preferences do not remain static over time. It may in fact be that the negative economic circumstances that necessitated the fiscal stimulus in the first place has also resulted in investors purposefully increasing their allocation to safe assets as a natural response to the economic uncertainty. In other words, an increase in the allocation of investor portfolios to safe assets may actually be desired, such that the rush into risky assets fails to immediately transpire.
However, even if this is the case, even if investors have no immediate desire to rebalance their portfolios to their original weighting of risky assets, it’s reasonable to assume that these changes to allocation preferences are ultimately temporary and will eventually mean-revert. As things get back to normal – as the uncertainty surrounding the recession recedes – investor allocations to risky assets will return to their prior levels and these assets will eventually rise in proportion to the increase in safe assets in the system. Indeed, the prices of risky assets must eventually increase in line with the size of the fiscal stimulus if portfolio allocation preferences tend to be mean-reverting over time. To the extent that any government fiscal stimulus is permanent, so too will be the rise in the price of risky assets.
3. Monetary Policy and Inflation
By far the most common narrative today regarding inflation and government policy is the assertion that central bank “money printing” is causing massive inflation among general goods and services. More specifically, the argument is that central bank “QE” has created a tidal wave of newly-created money bidding up the prices of goods and services, and that it is only a matter of time before the large-scale ramp-up in the money supply causes a currency crisis and a complete collapse of the currency involved. While it’s true that the argument has a certain populist appeal, it also vastly misses the mark.
Consider, for example, what happens when the US Federal Reserve engages in QE, purchasing $10M of government bonds from the private sector with newly created money. The seller of the bond will receive a money order from the Fed which it deposits in its account at Bank A. Because a deposit is a liability of Bank A (owed by Bank A to the depositor on demand) Bank A’s liabilities will therefore now increase by $10M. But Bank A does not simply take a new liability without a corresponding asset. In order to offset this new liability, the Fed will increase the reserve account that Bank A holds at the Fed, thus increasing Bank A’s assets by $10M. Because money held in reserve accounts are liabilities of the Fed, it also increases the Fed’s liabilities by $10M. At the end of the operation, the balance sheet of the seller, Bank A, and the Fed are changed as follows:
Seller of the Bond:
- Change in assets = +$10M (deposit at Bank A), -$10M (bond sold to the Fed)
- Change in liabilities = None
- Change in net worth = None
Bank A:
- Change in assets = +$10M (deposit in its reserve account at the Fed)
- Change in liabilities = +$10M (the bond seller’s deposit)
- Change in net worth = None
Federal Reserve:
- Change in assets = +$10M (bond purchased from the seller)
- Change in liabilities = +$10M (Bank A’s reserve account at the Fed)
- Change in net worth = None
In the above example, the net worth of the seller, Bank A, and the Fed remain unchanged as a result of QE. No entity has become any wealthier at the end of the operation, and therefore no entity is more likely to spend than before the QE operation was conducted. What QE has done is to replace a safe and highly liquid asset (a government bond) with another highly safe and liquid asset (cash). What it hasn’t done is significantly alter financial net worth within the system. As we have already described, it is net worth, not money, which represents the capacity, although not necessarily the desire, to spend on goods and services.
For those readers who may find the above reasoning counter-intuitive, think of it this way: if you have a bond, you might as well have cash, since a bond can be readily sold and converted quickly to liquid cash for the purpose of spending. Changing the composition of safe and highly liquid assets from bonds to cash is largely unimportant for the vast majority of savers in a practical sense. A saver with $100,000 in government bonds is hardly going to go on a spending spree if they suddenly had $100,000 of cash in place of the bond. Had they wanted a $100,000 car, they would simply have sold the bond for cash and used the cash to purchase the car, irrespective of QE.
This, of course, is not to say that QE has had no effect on inflation. Readers will have undoubtedly recognized that since QE serves to lower yields and raise the price of bonds, the seller of the bond will wind up with more cash than they would have otherwise had in the absence of QE. Logically, having more wealth on hand would therefore leave the seller of the bond with increased spending power to serve as additional fuel for inflation, driving up overall prices as a direct result of capital gains from the sale of the bonds. This, of course, is true, and a point readily conceded. We would only point out that the amount of capital gains that will accrue to an investor is small in comparison to the original market value of the bond, which is almost always what critics refer to when they talk about central bank money-printing leading to high or runaway inflation. The criticism has generally not been that the small amount of capital gains from the bond sale will be used to drive spending and inflation, but that the entire sum of money created by the central bank will somehow wash over the economy while simultaneously raising prices across the board. Capital gains due to the sale of the bond to the central bank certainly are realized, but we should not exaggerate its follow-through impact on spending.
Having discussed the various ways in which QE fails to significantly drive inflation, we now turn our attention to the primary mechanism by which it does – interest rates and credit creation. The purpose of QE is to bid up the prices of bonds of various maturities, which correspondingly decreases the yields of bonds across the spectrum. Lower interest rates across the yield curve will typically feed through to increased borrowing which, as we will see shortly, has the potential to drive spending growth in a similar manner as fiscal stimulus. Recall that fiscal policy derives its inflationary power from government deficit spending, but the same inflationary impact of deficit spending can also be applied to individual borrowers in the private sector. Consider a borrower who, because of QE, can now obtain a cheap $10k loan from Bank A in order to start a widget-making business. In modern banking, Bank A does not actually lend existing money to the borrower, but simply creates a new deposit of $10k for the borrower “out of thin air”. The new deposit is obviously an asset of the borrower, but (as we have previously stated) it is also a liability of Bank A. Immediately after the loan, then, the balance sheets of the borrower and bank will appear as follows.
Borrower:
- Change in assets = +$10k (new deposit at Bank A)
- Change in liabilities = +$10k (loan now owed Bank A)
- Change in net worth = None
Bank A:
- Change in assets = +$10k (the loan, now owed by the borrower)
- Change in liabilities = +$10k (the borrowers new deposit)
- Change in net worth = None
As the borrower uses the new $10k loan to purchase a widget-making machine, they acquire a productive asset while at the same time injecting a new $10k of cash into the private sector. By borrowing to spend productively, the net worth of the private sector increases in the following manner.
Borrower:
- Change in assets = -$10k (payment for widget-making machine), +$10k (new widget-making machine)
- Change in liabilities = None
- Change in net worth = None
Seller of the Widget Machine:
- Change in assets = +$10k (payment for widget-making machine)
- Change in liabilities = None
- Change in net worth = +$10k
Thus, $10k of new wealth has therefore arisen as a direct result of the borrower’s “deficit spending”. Along the same lines as the process previously described in section 2, the seller of the widget-making machine will either spend the funds in turn, hoard it into savings, or some combination of the two. To the extent that the new $10k of wealth is further spent by the seller of the widget-making machine rather than withdrawn into savings, it has the capacity to increase inflation within the economy.
Note that the process we have described above is not something we should specifically attribute to QE. It is simply part and parcel of the natural process of credit creation in a normally functioning modern economy. As the economy grows, borrowers take out loans from banks to make productive investments. The corresponding creation of new wealth in the economy increases the ability of private entities to increase spending. If the rate of spending growth outpaces the growth of actual real goods and services produced by the borrowers, then inflation tends to result. Monetary policy in general sets the hurdle that borrowers must clear in order to make a profit on their investment. If conditions ease, by QE or some other form of interest rate manipulation, then credit may expand more quickly and thus feed through to higher levels of future spending and inflation.
Of course, low interest rates brought about by QE are not necessarily a guarantee that credit will automatically expand. In a recession, borrowers may have little desire to take on additional debt and lenders may have little desire to take on the added risk that a borrower will default. If no willing credit-worthy borrower exists at the prevailing interest rate, the loan will not happen, regardless of monetary policy and QE. Indeed, in the midst of a recession when borrowers and lenders retrench, interest rates may actually fall as a result of monetary policy in conjunction with contracting bank credit. Rather than stoking inflation, the end result could instead be disinflationary or deflationary in nature. QE and monetary policy can encourage lending which may feed through to spending and inflation, but if borrowers and lenders fail to cooperate to expand the quantity of credit accordingly, there will be little flow-through to overall inflation via increased spending.
4. Monetary Policy and Asset Prices
Many people agree that QE does not actually result in rising prices for goods and services, but still assert that it results in rising prices for assets. This is not necessarily incorrect. QE most certainly does apply upwards pressure to a variety of asset prices across the spectrum, but the degree to which QE actually influences these prices is highly exaggerated. What is often missed is the fact that the majority of the money created through QE does not simply flow freely into equity and commodity markets as is often claimed by central bank critics. Rather, the majority of the QE money stays trapped in the fixed income markets and exerts far less of an impact on the price of risk-assets than is generally believed by the investing public.
When central banks engage in QE, they purchase bonds from investors in the secondary market by injecting cash into their portfolios while removing bonds. Given that one of the primary objectives of QE is to depress interest rates across the yield curve, and given that bond prices move inversely to interest rates, QE has the very deliberate effect of driving up bond prices throughout the financial markets. There can be no denying the fact, then, that QE serves to drive up the prices of the assets they purchase directly from investors – in this case, bonds. As a result of the purchase, QE has swapped a safe and highly liquid asset (bonds) within investor portfolios for another safe and highly liquid asset (cash). Now if investors haven’t significantly changed their portfolio allocation preferences as a consequence of QE – hardly a sure thing – they will have approximately the same allocation to safe assets and risky assets that they had prior to QE. If asset allocation preferences haven’t changed, why would investors as a group suddenly decide to use all of their new safe cash holdings to bid on risky assets like stocks? They wouldn’t. More likely, they would invest the cash in other low-risk assets that serve as close substitutes to the bonds they had just sold to the central bank.
Consider that many of the largest recipients of the QE money are large investors like pension funds and insurance companies. These institutions own large amounts of government bonds due to very specific properties that can’t be duplicated by equities and other risky assets. Bonds have known cash-flows, fixed maturity dates, and extremely low risk of default that makes them the perfect vehicles for matching their assets with future liabilities. These large investors do not just take the bulk of the cash from QE and buy stocks. They might instead reach out on the yield curve to purchase lower-priced government bonds, or perhaps look to the debt of less senior levels of government, but it’s highly unlikely they will suddenly implement a dramatic rebalancing of their portfolios into high-risk assets. It’s simply not a reasonable thing to expect.
Now up to this point we’ve been assuming that investors tend to maintain a fairly constant portfolio allocation preference between risky and safe assets throughout the QE process, but is this necessarily true? Probably not, since meaningful and significant changes to investor asset allocation targets will likely occur as a direct result of QE itself. By driving up the price of bonds and lowering yields through QE, central banks meaningfully lower the future return profile of low-risk assets. As interest rates fall and expected fixed-income returns to bond-holders decline, it makes sense that investors considering prospective future returns will reduce their fixed income holdings in favor of risky assets in order to meet their return targets. This will have the effect of bidding up the prices of risky assets until the expected returns from risky assets fall far enough to entice investors at the margin to want to hold bonds again. In effect, QE makes buying bonds so uncomfortable to risk-averse savers that it practically forces them to reach further out on the risk-spectrum in order to meet their desired return targets. In this sense, QE may force investors to re-balance out of their old allocation targets and re-establish new portfolio asset allocations with a higher weighting towards risky assets. Clearly then, if the process of QE itself decreases the desire among investors to hold safe assets, this would have the eventual effect of bidding up the price of risky assets throughout financial markets.
Of course, the bidding up of bonds does not just decrease future returns for new investors, it also increases the immediate wealth of existing bond holders. As was discussed in the previous section, because QE immediately increases the price of bonds, the sellers of these bonds receive more funds from the sale of their bonds than they otherwise would have if QE had never been conducted. In other words, the bond sellers (investors) receive additional capital gains as a result of QE and end up with increased wealth following the sale of their bonds to the central bank. Even if the portfolio allocation preferences of these bond-sellers haven’t changed as a result of QE, they will now be slightly over-exposed to safe assets as a result, and will seek to rebalance their portfolios such that a portion of their increased wealth will be used to bid up the price of riskier assets. Other existing bond-holders too, seeing the market value of their bonds increase and their safe-asset allocations rising above their desired allocation targets, may also seek to rebalance their portfolios by bidding up the price of risky assets. QE, then, to the extent that it does result in capital gains for bond holders, will serve to stimulate the bid for certain assets like stocks.
So yes – QE money, via capital gains in the fixed income space, will almost certainly leak through into other risky assets to some extent. But this is virtually never the argument put forth by critics accusing central banks of irresponsibly debasing the currency. Rather, the argument almost always made is that a $1T injection of QE money results in approximately $1T of new money bidding up stocks and other risk assets throughout financial markets. But this is not what happens at all. What happens is that some portion of the gains which accrue to bond holders might be rebalanced into more speculative markets as investors find themselves holding more safe assets than they actually want. But this is a far cry from $1T of new unwanted safe assets being injected into investor portfolios looking for a speculative home (which would be what would happen in the case of a $1T fiscal injection).
Lastly, we should not forget that the entire point of QE is to ease financial conditions via the interest rate channel. Recall from our widget-business example in the previous section that the expansion of credit for the purpose of investment serves to increase private sector wealth. Now the new wealth that is injected into the private sector through the creation of a loan takes the form of either new deposit money for a borrower (if the loan is from a bank) or a new bond for the lender (if the loan is from another private sector entity). Either way, the resulting assets eventually wind up in investor portfolios, leaving them with a larger allocation towards safe assets than these investors actually want. In response, investors will rebalance their portfolios by bidding up the prices of other risky assets until their preferred asset allocations are once again re-established. Again, similar to QE’s impact on inflation via the interest rate channel, if the lowering of yields does not cause an expansion of credit by bringing together new credit-worthy borrowers with willing lenders, the transmission of QE through to asset prices via the interest rate channel will be fairly muted.
5. Summary
While monetary policy has been widely blamed for the recent increase in both general prices and asset values, it is far more likely that easy fiscal policy has been the primary driver of rising inflation. Although critics are correct that Quantitative Easing involves the creation of new money “out of thin air” by central banks, this money has far less impact on private sector wealth than deficit spending and is therefore far less stimulative to spending (and therefore to inflation) than is generally assumed. In addition, QE largely replaces safe and liquid assets (government bonds) with other safe and liquid assets (cash), meaning that central banks have not actually injected a sudden excess of safe assets into investor portfolios that will suddenly be used to bid up risky assets like stocks.
By contrast, easy fiscal policy (deficit spending), serves to increase private sector wealth in proportion to the size of the deficit. This increase in wealth represents the capacity, although not necessarily the desire, for the private sector to increase spending. Government stimulus, therefore, is potentially highly inflationary provided that recipients of government stimulus have a high propensity to spend these new funds within the economy. Regardless of how the deficit is funded, either money-financed or debt-financed, fiscal stimulus will add either new bond assets or cash to the private sector. All else being equal, this increase in safe assets within investor portfolios will be more than investors actually want to hold, causing them to increase their allocation to risky assets by bidding up assets like stocks and commodities.
None of this is to say that QE has no stimulative impact on inflation and asset values – it most certainly does. It’s just that such an impact has been wildly overstated by investors and analysts who have forgotten the lessons of the various QE programs born out of the 2008 financial crisis. Most critics today have become hyper-focused on the inflationary aspects of monetary policy, leading to QE currently becoming the biggest economic side-show on the planet. Fiscal policy, by contrast, has become the new inflationary battleground, although not one in a hundred currently see it.