What is quantitative easing, and should we be concerned?

Global ratings agency Fitch, estimates that the value of Quantitative Easing (QE) implemented this year could reach $9 trillion! To put that in context, that is equal to more than half the cumulative total global QE that occurred between 2009 and 2018! The Federal Reserve in the US has alone pumped $4 trillion into the market over the past 11 weeks. This is absolutely unprecedented.

Should investors be worried about the long-term impact of all this money printing (QE)? What are the risks that we need to be aware of?

The role of central banks

Central banks around the world are in charge of monetary policy. The aim of monetary policy is to ensure a healthy economy and an inflation rate that is within the stated goal.

When the economic activity increases and the economy approaches fully capacity, inflation can begin to increase. In this situation, the central bank would normally increase interest rates (to reduce corporate profits and consumer spending) to cool economic demand. If the economy slows down, the central bank can cut rates to stimulate demand again.

Interest rates is a central bank’s primary tool.

But what can a central bank do when rates are at or close to zero? Of course, they can contemplate negative interest rates (e.g. in Germany, banks are paying borrowers to take out loans), but that is largely ineffective.

What is quantitative easing?

When interest rates stop being an effective monetary policy tool, central banks start to consider more unconventional mechanisms such as QE. QE is the process of a central bank buying assets such as bonds. They do that by issuing new currency i.e. increasing money supply (often referred to as money printing). The aim is to stimulate the economy as a whole through injecting more money into the economy.

The US Federal Reserve started buying Mortgage Backed Securities (MBS) in 2009 to help the US recover from the impact of the GFC. The idea is that lenders could sell MBS to the Fed Reserve to raise funds. In doing so, banks would then have more funds to lend to property investors and homeowners. In turn this should stimulate demand for housing and aid in the property market’s recovery. To a large degree, it worked.  

QE is not limited to MBS, however. Central banks can buy other assets including corporate bonds and even equities, which Bank of Japan has done. Central banks can target certain sectors of the economy if they so choose.

What has happened this year?

Most central banks around the globe have participated in QE, including Australia’s RBA, the US Fed Reserve, Bank of England, European Central Bank and Bank of Japan. For the most part, the QE programs have been much wider than what they were during the GFC. Central banks have been buying corporate bonds (the aim is to increase lending to the SME sector) and Exchange Traded Funds (some of which invest in non-investment-grade corporate bonds, which is seen as aggressive).

As noted in my opening paragraph, Fitch estimates that the total value of global QE in 2020 to be circa $9 trillion (AUD)!

The RBA has been providing money to Australian banks at a fixed rate of 0.25% for 3 years to promote lending to home owners and businesses. That is why fixed rates have been so attractive lately.

What impact will quantitative easing have on our investments?

A study conducted by Wharton Business School indicated one of the possible impacts of QE is that it can crowd out other types of lending. For example, during the GFC the Fed Reserve focused on buying MBS which are used to fund residential property. As such, the banks focused on this market to the detriment of business/corporate lending.

Such a focus on one type of lending could be problematic because the housing market doesn’t generate economic activity to the same extent that lending to businesses does. Also, it could create asset price bubbles.

Main criticisms of quantitative easing

There are two main criticisms of QE.

The first criticism is that central banks are interfering with a free market and artificially influencing asset prices. In a free market, the market participants set the prices of assets (investments).

What happened when Covid hit for example, was that no one wanted to buy bonds, even seemingly ‘safe’, investment-grade bonds. This created a liquidity crisis for investors as they weren’t able to sell. Also, bond issuers were unable to renegotiate facilities. Such a crisis could have greatly exacerbated the impact of the Covid event. As such, central banks intervened and provided this much needed liquidity.

However, free market supporters would argue that such intervention results in artificial prices and alters an investors risk premium i.e. it may be seen that some investments won’t be allowed to fail. The government can’t jump in and rescue investors every time something goes wrong.  

The second main criticism is that QE could cause inflation. Inflation can occur because as the volume of printed money in circulation increases, money becomes more abundant and the value of $1 falls. For example, as a result, a loaf of bread now costs you $3 instead of $2.

QE has been used in the US since 2009 but has not yet led to higher inflation. There are a few reasons cited for this including the idea that the additional money is hoarded (saved, not spent) by individuals and corporations. Secondly, wage inflation has been below trend which has offset the effect of an increase in money supply. If QE did start to create inflation, central banks could curtail it by increasing interest rates.  

The future of monetary policy

It will be very interesting to see what happens to interest rates over the next few decades. The big question is whether economies and markets will be able to support higher interest rates sometime in the future. For example, Japan has been stuck on near zero interest rates for about 25 years.

If interest rates remain persistently low for a number of years, then QE is almost certainly likely to remain in place. The Fed Reserve tried to reduce its balance sheet (i.e. unwind QE) over 2018 and most of 2019 but only very gradually, as depicted by the chart below (click to enlarge). However, every time the Fed Reserve talks about reducing is asset purchases, share markets get the jitters.

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US Federal Reserve balance sheet chart (click to enlarge)

Long term impact of quantitative easing is unknown

It is difficult to assess whether QE has had a long-term impact on investment markets including the stock market, as so many factors have changed over time. Isolating the impact of just one factor (such as QE) is near impossible.

Endlessly printing money and buying assets when investors desert a market doesn’t seem like a very wise practice. If we agree that these activities can result in artificially inflated prices for assets, then I guess the key is to avoid such potentially overinflated assets. For example, is car manufacture Tesla really worth nearly $230 billion? This is twice the value of CBA. It has never recorded a profit. Its debt has increased by 500% over the past 5 years. And its net assets are worth less than $10 billion.  

Gold is a natural inflationary hedge

Investing in gold can provide a natural hedge against inflation (if you think that is a risk). There are a number of gold ETF’s available on the ASX. Of course, most investors already have a small amount of indirect exposure to gold if they invest in index funds (e.g. via companies such as Newcrest Mining).

But given gold prices are approaching all-time highs, and QE hasn’t caused inflationary pressure over the past decade, I don’t think this is a very attractive investment.

The best response to quantitative easing is to avoid overvalued markets

It’s impossible to know what the long-term impact of QE will be. Inflation certainly doesn’t appear to be a major risk at this point. It is possible that QE has artificially influenced prices of some assets (US stocks?), but it’s impossible to tell for sure.

The best way to manage the potential risks of QE is to avoid investing in markets, sectors and companies that are trading at unjustifiably high valuation multiples. For example, Warren Buffett didn’t invest in any tech companies in the early 2000’s because he didn’t understand the valuations. In the end, the dot-com bubble proved it was a very wise decision.

Remember, your starting valuation is perhaps the best indicator of future expected returns (as long as your investment methodology is sound and robust).