Sign-Off On QE
Janet Yellen stayed the course and ended QE as expected. Before we wave goodbye, let’s cover off on a few important indicators to watch going forward. While the Federal Reserve may have put the printing press to rest for now, the tail risks from this monetary experiment still have the potential to wag.
As we can see below, QE has dramatically expanded the size of the Fed’s balance sheet, boosting it above $4 trillion at last count illustrated below by the blue bars. Each iteration of QE is evident in the chart as another step upward in the monetary base.
Source. Thomson Reuters
I for one find it difficult to appreciate just how large one trillion dollars actually is. To give it some context, it would take a tightly stacked pile of US $100 dollar bills roughly 1090km high to equal a $1 trillion, a distance exceeding the trip from Sydney to Melbourne.
It would be easy to assume that such a considerable increase in Fed assets would translate into rapid inflation. However, to date this has not occurred. A key driver of this is likely to be due to the relatively sanguine rise of money in circulation, illustrated by the black line above. Money in circulation has been constrained as the commercial banks have not been lending to their potential, instead returning excess reserves back to the Fed to earn 0.25%, evident in the offsetting yellow bars on the chart above. While money in circulation has not grown at the astronomical rate of Fed assets, it still has grown at a compound rate of around 8% over the last 3 years.
For us to see a dramatic rise in inflation it is logical that a significant rise in money in circulation is a prerequisite to kick start the multiplier effects caused by more money in the system.
For money in circulation to rise, US commercial banks need to increase lending which would have the effect of drawing down on excess reserves at the Fed and pulling them in to the system. For this to occur, we would need to see an increase in demand for credit, which requires sound levels of business and consumer confidence and a shift in the focus of US corporates from returning capital towards investing to expand productive capacity.
Thus going forward, confidence and credit growth indicators are two to watch to gain a sense of how the Fed’s balance sheet may evolve over time, and the potential for this to translate into a rise in money in circulation and potentially inflation. As we can see below, credit growth is currently running at around 6% p.a.
Source. Thomson Reuters
While conventional wisdom suggests holding gold is the best inflation hedge, we disagree, in favour of holding productive assets such as quality businesses.
To be effective in an inflationary environment, the business in question needs to have the ability to produce more for its owners in inflation adjusted terms. Over time it seems the businesses that tick this box are those with ‘pricing power’, the ability to increase the price of their product without experiencing a commensurate fall in volume, such as the McDonalds and Coca Colas of this world. This ability allows dividends and earnings to grow faster than inflation, which restores the purchasing power of the business’s owners.
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John Abernethy is the Chief Investment Officer (CIO), Executive Director of Clime Investment Management (Clime Group) and Chairman of Clime Capital Limited.