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The Fed signaled recently that it will continue its 85 billion per month Quantitative Easing or QE program.

What does this mean for the investor and what is the best way to position a portfolio in response? Will this program bring inflation as the popular press warns? Will it bring growth as the Fed hopes or will it fail to defeat deflation as the bears claim?

The answer to this question requires a closer look at money supply and its effects on the overall economy.

The Fed is purchasing bonds with currency.

The Fed is currently engaged in a monetary operation where it is buying old bonds with new currency. When the Fed engages in QE it removes bonds from the market and adds new currency into the banking system. The new money forms bank reserves and may or may not make its way into the economy. Excess bank reserves are part of the monetary base but are not part of the money supply.

Exhibit 1 shows the sharp increase in U.S. Treasury Bonds held by the Federal Reserve and the corresponding increase in bank reserves (red). These two lines represent two sides of a balance sheet - private bank assets and Fed liabilities.

There are also two other ways to view this. On one hand, it represents the amount of currency swapped for bonds. On the other, it is the quantity of bonds no longer available on the open market.

Exhibit 1. U.S. Securities held by the Federal Reserve

(click to enlarge)

The Money Supply and Inflation

There is speculation in the press that these new reserves will leak into the money supply and cause inflation in the future. Possibly severe inflation. However, inflation and its causes are often misunderstood. Like most things, it is more complicated.

The conventional wisdom states that an increase in the money supply will directly cause inflation, as more money chases goods and services in the economy.

The conclusion behind the current inflation scenarios can be traced to Milton Freedman's Quantity Theory of Money. In a simplified form the Quantity Theory states that:

Money x Velocity = Price x Quantity

This equation states the amount of Money in the economy multiplied times the Velocity in circulation in a given period will equal the Price of the goods sold times the Quantity of goods sold. It is a dynamic of four variables.

People believe "money printing" will cause inflation, because if you hold Velocity and Quantity constant within the equation then the formula looks like this:

Money x 1 = Price x 1

or simply:

Money = Price

Therefore, if when the amount of Money goes up then it would follow that the Price goes up with it. An increase in the Price of goods is inflation, and therefore an increase in Money translates into an increase in Price or inflation. This is the conclusion most often drawn.

In this scenario, there exists a direct connection, like a lever on a car jack. More Money, more inflation. It's pretty simple. And that is the problem; it is pretty simple. The economy however is not.

In fact, as can be seen in Exhibit 1, some of this money has leaked into the money supply and caused inflation. The rate of inflation has increased slightly to 2.32 percent from 2.12.

Exhibit 1: US CPI

(click to enlarge)

Output Inflation

The simple idea that increasing money creates equally increasing inflation is an oversimplification. In reality, Velocity and Price are not constant. They move around a lot in the day-to-day economy, if the quantity of Money goes up there are a lot of things that might go up.

For instance, if instead of Velocity and Quantity, we alternatively hold Velocity and Price constant then:

Money x 1 = Quantity x 1

or:

Money = Quantity.

When this occurs the Quantity of goods produced inflates instead of the Price of the goods. We then get an inflation of output - or economic growth. This is the result that the Fed is hoping to produce.

Exhibit 2 shows GDP rising after the Fed started its bond purchases in November of 2008. After falling rapidly in the financial crisis, some of the new money is expanding output in the economy.

Exhibit 2. Real GDP per Capita in the United States.

(click to enlarge)

Decreased Velocity or Inflation of Savings

Another result from increased money supply could be an inflation of savings. This would occur if Quantity and Price are constant. When Q and P are constant the equation looks like this:

Money x Velocity = 1 x 1

or:

Money = 1/Velocity = - negative Velocity.

An increase in money supply could be offset by a corresponding decrease in velocity. If people simply stuff all the new money under their mattress there will be no inflation.

Money Velocity is how fast the Money in the economy changes form one hand to another. If people are not spending they are most likely saving. If everyone is saving all of their Money the Velocity is zero. Therefore, a decrease Money equals increased savings. If people save all the new Money, there won't be any inflation.

Savings is deflationary because businesses, governments, and people on the whole cannot both save and spend simultaneously. If the government stopped spending, business saved all of the revenue, and everyone decided to save 100 percent of their next paycheck then the economy would stop because there would be no Velocity.

The sequester if it stays in place is a form of government savings, as the government taxes in more money than it spends.

In Exhibit 3 the velocity of money (blue) in our economy is declining and the amount of gross savings (red) is increasing. Some of the new money is currently being saved.

Exhibit 3: United States Money Velocity and Gross Savings

(click to enlarge)

Increasing Imports.

Price x Quantity is also another way to state nominal GDP.

If we hold Velocity constant, then we get

Money x 1 = nominal GDP

GDP can also be stated as domestic nominal GDP + Net Exports.

Therefore:

Money = GDP + Net Exports.

If we hold domestic GDP or Price & Quantity constant, we get this

Money = negative Net Exports = Imports

or simply

Money = Imports.

This means we could simply export the additional Money out of the country. In fact, this is what we currently do with China, we export Money to China and import coffee makers or whatever back from China. Typically, the Chinese save the Money we export to them into U.S. Treasuries. This lowers the Velocity in our domestic economy.

We essentially export the Money we have printed and effectively the change in Price or the inflation in China. China then does a Quantitative Easing its own and prints Quan and buys the U.S. dollars. Just like the Fed, it exchanges Quan for dollars and dollars for U.S. Treasuries. Same thing with one more step. This increases the Chinese money supply and reduces our Velocity.

Exhibit 4 show the correlation between the growth of US Imports from China and the growth of Chinese inflation. Some of the new money is fueling inflation in China.

Exhibit 4: US Imports from China and Chinese CPI

(click to enlarge)

In summary, there is not one scenario, inflation, but scenarios from an increase in Money supply in the economy.

Higher Prices

  • More GDP or less output
  • More savings or less velocity
  • Export inflation to China

Which one happens depends on which variables change.

The Money Supply and Inflation

From the graphs above we can conclude one thing, there are no straight lines and therefore the variables are never constant. And an increase in Money may or may not cause inflation. Contrary, to popular opinion there is not direct connection.

Below is a graph of the money supply and inflation. Notice the lack of correlation between money supply and inflation?

Exhibit 5: Money Growth versus Inflation Rate

(click to enlarge)

Investment Strategy

There are three investment actions based on the underlying variables - Money, Velocity, Price, and Quantity. You can think of these as Money Supply, Deflation, Inflation, and Growth.

If you think Money Velocity and Quantity will be relatively constant, then expect that the additional Money will create inflation. In this scenario, you should consider buying Treasury Inflation Protected Securities or TIPs or an ETF like (NYSEARCA:TIP) or (NYSEARCA:IPE) to protect the portfolio from inflation.

If you see Quantity and Price as flat in the future, Velocity will drop as the economy saves more income. In this case, consider investing in U.S. Government Bonds or (NYSEARCA:TLT) or (NASDAQ:VGLT). Saving ultimately ends up in U.S. Government Bonds.

If you feel that Price and Velocity will be unchanged there will be low inflation and increased nominal GDP output or economic growth. In this situation, you should invest in the consumer stocks, high-yield bonds (NYSEARCA:JNK) and preferred stocks like (NYSE:PFE). Investments that benefit from a vibrant economy that is spending money and generating steady cash-flow.

In practice, it is rare there will be a pure reaction to a money supply increase. Most increases will involve a combination of reactions between the four variables.

If you don't know you which of these will be the case you should simple diversify between all three outcomes and make some allocations to all three. You might use a sailboat portfolio.

Source: Inflation, Growth Or Deflation: What Next?

Additional disclosure: This article is for informational and educational purposes only. The views expressed in this article are the opinions of the author and should not be interpreted as individualized investment advice. Investment objectives, risk tolerances and the financial situation of individual investors may vary. Please consult your financial and tax advisors before investing.