UK Economic Outlook: Money, Money, Money
One of the most well-known ideas in economics is that if the amount of money increases too quickly it will result in an increase in prices. This is famously summed up in the expression ‘Too much money chasing too few goods.’ Does central bank money printing via QE therefore mean we are entering an inflationary environment?
Before we start, we need to establish the definition of “money”. Money is not just the notes and coins in circulation. These days, many people do not pay for goods with physical cash – they use their bank balances to pay via a debit card. So these balances need to be counted as money. We also need to consider the balances that commercial banks hold at the central bank to settle debts between themselves (we shall call these reserves). When all this is taken into account, notes and coins only account for 3% of what we would deem “money” in the UK. Thus when central banks ‘print’ money, they don’t actually print notes; they create central bank reserves, which are credited to commercial banks’ accounts at the central bank, in exchange for gilts. This “money” is not then suddenly let loose into the economy.
The way QE works is by lowering gilt yields, encouraging investors to take more risk elsewhere, thus lowering the cost of capital and encouraging investment. In order to cause inflation, there has to be an increase in real economy borrowing and lending by commercial banks, which is in turn a function of the profitability of investment opportunities and the demand to take advantage of those opportunities. However there is one caveat to this. If the central bank is buying gilts in order to directly finance government deficit spending i.e. the central bank is buying bonds that the government otherwise might not be able to sell at sustainable interest rates. This process could well be extremely inflationary as it effectively removes any constraint on government spending and does pump money directly into the economy. QE can therefore be a precursor to monetary inflation but may not be the direct cause of it. Of course the other way inflation can increase is by having too few goods i.e. the amount of money stays the same but a supply shock reduces availability of things to spend the money on. Famously this happened after the Black Death (side note: the plague does tend to put COVID into perspective) when, absent a central banking system to manage these types of issues, the money supply (which then consisted of precious metal coins) remained fixed, but increased significantly on a per capita basis.
The global economy has recently experienced both a demand and a supply shock with consumers staying at home but also supply chains disrupted. Looking forward, if demand picks up as the virus dissipates but supply chains are moved closer to home, and if outsourcing is reduced and reliance on China for cheap manufacturing ends, this could well be inflationary. And that is not even mentioning Brexit, a risk many have put to the back of their minds, which could have serious implications for the UK supply chain.
Both governments and central banks are very keen to avoid deflation (negative inflation) as it is both economically destructive and increases the real cost of debt, something governments at the moment will be very keen to avoid. Pension funds should also be very wary of deflation given the contractual structure of their liabilities which typically do not allow payments to fall even if inflation becomes negative. With nominal interest rates rapidly approaching levels at which further cuts become ineffective, it becomes incumbent on monetary authorities to generate inflation to prevent deflation. This has certainly been the view of financial markets where real rates have continued to fall internationally, and the price of gold which is typically negatively correlated with real rates has risen significantly. From an asset allocation perspective what does this mean for pension scheme investors? It would be unwise to bank on real rates rising any time soon.