Since the advent of the quantitative easing (QE), the Fed's unprecedented attempt at reversing the impact of the credit crisis, many long-held beliefs and assumptions have been demolished. One of the most sacred assumptions on the part of investors and economists alike is that central bank money printing always eventually leads to inflation. Yet six years have passed since the Fed first embarked on its historic attempt at reversing the effects of the credit crash and alas, no signs of inflation are on the horizon.
Quantitative easing has increased the stock of money in economies of the U.S., the U.K. and Japan by nearly $4 trillion in recent years. The success of this coordinated monetary policy response to global deflation was an undeniable success; since 2009 the U.S. economy has been in recovery mode while other major economies have had varying degrees of recovery. That's not to even mention what QE has done for equity markets: several major U.S. indices are at or near all-time highs as of this writing. So what could possibly be wrong with the latest idea being bandied about among several commentators, namely that printing money should be employed more often by central banks in the coming years?
An old Chinese proverb says, "Success breeds failure, and failure breeds success." Unfortunately, this saying definitely applies to the economic realm. Many economists wrongly assume that since QE has failed to create inflation the problems normally associated with loose money have been permanently solved. Nothing could be further from the truth. As we shall see, the Fed's timing in implementing QE was fortuitous given the current phase of the long-term cycle of inflation/deflation. Circumstances beyond the Fed's control have more to do with QE's failure to create inflation than either policy or infrastructure.
In a recent Bloomberg Businessweek editorial, Michael Metcalfe, an asset strategist at State Street Global Markets, suggests that money printing could be a useful tool for alleviating global poverty. Since inflation didn't jump in the wake of QE as the alarmists predicted it would, Metcalfe believes the Fed and other central banks should push the envelope by printing even more money in the name of global poverty relief. Metcalfe argues that investors are confident of central bankers' ability to stop printing if inflation ever does become a problem. He seemingly falls victim to the trap of extrapolating current trends into the distant future, never considering that the last five years could be the exception to the rule.
Metcalfe also maintains that the lack of inflation is partly explained by the ongoing weakness of growth, characterized as it is by spare capacity in many industries, tepid bank lending and low money velocity. "Nevertheless," he writes, "the experience of quantitative easing has demonstrated clearly that, under the right economic conditions and with a credible inflation-targeting central bank, the creation of money by sovereigns can be an effective policy tool to flight disinflation."
Metcalfe also suggested that as long as it sees little risk of inflation, the Fed could print money to match the government's overseas aid payments up to a certain limit. He also proposed "creating money to buy bonds of countries receiving aid that are directly linked to development goals."
Metcalfe opined that "print aid is technically possible" and wouldn't necessarily create inflation. "The experience of the financial crisis has shown that the risks from money creation are more manageable than previously believed," he concluded. "Now might also be the only time in which developed nations can actually afford to provide the level of aid to the world's poor they've always aspired to."
The theme sounded by Metcalfe in his Businessweek editorial is also being echoed by other commentators. In their book Modernising Money, Andrew Jackson and Ben Dyson argue in favor of governments issuing perpetual interest-free bonds. Under this scheme, central banks would then be required to purchase these bonds in certain amounts. The bonds, the authors claim, won't add to the national debt since they never mature.
Money printing schemes such as the ones proposed by Metcalfe, Jackson and Dyson are symptomatic of the unusual economic environment of the past five years. An economist wouldn't be an economist if he didn't show fidelity to the Cardinal Rule of their trade: linear extrapolation. They see the success of the Fed's unprecedented QE policy and naturally conclude that money printing can be pursued to infinity with no inflationary consequences. What they fail to consider is that the past five years are likely to prove the exception, not the rule.
More than any other factor, the final deflationary phase of the 60-year cycle can be attributed to the lack of inflation in recent years despite QE. With the long-term cycles creating counter-inflationary undercurrents there was no reason to believe that inflation would ever be a problem during the years 2009 to 2014. With the start of a new 60-year cycle later this fall, however, those currents will reverse. Inflation, not deflation or disinflation, will be the new long-term normal. The danger occurs if policy makers listen to the wild proposals of economists like Metcalfe and continue to inflate the money supply above and beyond the demands of the economy. If they do, then inflation will become a very real problem at some point in the coming years.
The million dollar question is what happens when banks, businesses and consumers finally throw off the caution that has characterized the market since 2008? At some point the velocity of money will reverse its decline as confidence increases and investors realize that the threat of deflation has disappeared. Will the hundreds of billions in sidelined money enter the economy as a slow, gradual trickle? Or will it re-enter the channels of commerce quickly as a mighty onrushing torrent? Since no one can definitively answer this question, the wisest policy would be to resist the temptation to employ money printing schemes as a palliative for solving global poverty or anything else.
Instead of exploring the outer limits of an apparently successful money printing scheme (namely QE), policy makers would do better to consider the potential pitfalls of the coming long-term inflationary cycle. Once the new 60-year cycle kicks off next year and becomes established it wouldn't be surprising if the proverbial termites come teeming out of the woodwork. The unaccountably large amount of liquidity created by central banks in recent years will likely contribute to inflation at some point, and it might happen sooner than economists think.
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