Quantitative Easing (QE) by the Federal Reserve is creating money too slowly to generate much inflation. Currently $11 trillion, M2 money supply (the money supply measure that is most linked to changes in inflation) is growing at only 7% annually, about the same as its average growth rate over the past fifteen years. True, QE has hugely boosted bank reserves, which is money that banks have on deposit at the Federal Reserve. Fed critics fear that it is only a matter of time before banks lend out their excess reserves, causing M2 to soar and stoke inflation. They are wrong - the banking system does not lend out bank reserves!
What critics of the Fed fail to understand is that those reserves actually stay within the Federal Reserve System regardless of bank lending. That's because if a bank draws on its reserves to make a loan, when the money is spent the recipient of that money deposits it at his bank, where it adds to that second bank's reserve account at the Fed. So, while the lending bank reduces its reserve balance, the receiving bank boosts its reserve account balance by an identical amount. Thus, a particular bank can lend out its reserves, but the banking system, overall, does not. Indeed, the level of bank reserves within the banking system is determined by the Fed, and not by the lending activity of banks.
Bank reserves that are created out of thin air when the Fed purchases securities do play a role in M2 money creation. But, increased bank lending typically is what accounts for the bulk of money creation and money growth. And bank lending has been growing very slowly since our economic recovery got underway. When banks finally boost their lending, that will be in response to the interplay between the rising demand for credit and banks' lending standards at the time. And the Fed will influence credit, as always, by changing the short interest rate (now near zero) and also by increasing or reversing QE. The huge mountain of bank reserves is not inflationary because once reserves have been created, their sloshing around the banking system has no effect on bank lending or further M2 money creation.
Investment implications of the above are that there is no latent mega inflation currently in the monetary pipeline that could fuel any major rocketing of the price of gold or gold stocks. Our economy has experienced five years of QE, accompanied by low inflation. And investors have pulled back from investments that would benefit from rising inflation. We have seen two years of steady declines in the prices of gold, the SPDR Gold ETF (NYSEARCA:GLD), which relates directly to gold prices, and gold stocks, such as Barrick (NYSE:ABX), Newmont (NYSE:NEM), Goldcorp (NYSE:GG) and the Market Vectors Gold Miners ETF (NYSEARCA:GDX).
With mining companies already restraining exploration and other capital expenditures that would have raised production, there is likely not very much profit to be gained, especially at current prices, from shorting GLD or the gold miners. At some point the fall in gold and gold stock prices will stabilize and start to recover, but with so many investors and analysts still fearing future inflation from QE, we are probably not yet at the bottom of pricing for gold or the stocks of gold mining companies.
Inflation has been only 1.5% over the past twelve months. It will likely turn upward as the economy quickens and bank lending expands. How high the inflation rate will go depends on those factors plus Federal Reserve actions. But, at this time, there is nothing in Quantitative Easing to suggest anything other than a gradual and modest increase in the rate of inflation over the next 2 - 3 years.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.