It's no secret - central banks and policy makers around the world are intentionally manufacturing inflationary pressures in the hopes of countering the global economy's prevailing deflationary headwinds. In theory, the use of monetary policy to induce inflation eventually sparks a self reinforcing cycle of economic growth, but there is growing room for doubt that injecting paper money into the system only shows growth on - dare I say it - paper. Perhaps nowhere is this more evident than Japan, which has been losing the fight against deflation for nearly three decades now.
In my last article we took an in-depth look at exactly how the Fed's easing policies work in theory and why they have come up short in practice. This article addresses the consequences and potential concerns created by this continued monetary easing, and what it may mean for "paper currencies" and alternative forms of 'storage of value' such as gold (NYSEARCA:GLD).
Manufactured Inflation: The Beast in the Cage?
Even with global central banks acting as inflation factories, the global economy continues to exhibit deflationary tendencies and lackluster growth. On the surface this may seem to imply there is nothing to be concerned about, after all, the Fed's preferred measure of inflation, the PCE Index (Personal Consumption Expenditures) has shown little cause for alarm.
Keep in mind though, the Fed has continued easing not in spite of PCE figures failing to meet its predictions, but precisely because of this. In other words, as much as lower than expected PCE is an indication of a lack of inflation, it is just as much an indication of the Fed's impotence in achieving their predictions for growth.
Yet even while PCE remains flat, there is real evidence of inflation in a different form: inflated risky asset prices. A flattening yield curve, expanding equity valuation multiples, and an endless cycle of corporate buybacks are all indications that the Fed has 'succeeded' in part its goal and has driven investors into progressively riskier assets. Yet as discussed at length in my previous article, participation in the 'wealth effect' created by rising risky asset prices requires one to have enough wealth to own risky assets to begin with. Those most in need of the 'wealth effect' have entirely missed out.
Econometric analysis suggests that income inequality has a sizeable and statistically negative impact on growth.
The Fed's easing policies have thus contributed to a potentially disastrous dual effect:
- Higher wealth inequality (hampering economic growth)
QE in essence has been a wealth redistribution from the masses to the wealthy by funding risky asset purchases with public debt
- Compromised Fed credibility
With growth repeatedly underwhelming Fed predictions, the poor effectiveness of Fed policy has served to undermine their ability to guide markets and soothe investors. Even worse- this effectiveness is likely to only get worse the longer easing continues
In other words, the Fed itself may be doing more harm than good at this point, and the rate of harm to good is getting worse. If this eventually culminates in either a) a crisis of faith in the Fed's ability to help economic growth or b) a breaking point in the disjointedness between risky asset prices and economic fundamentals, the process we have seen play out over the last few years will begin to unwind itself. As risky asset prices fall, we may even end up roughly back in the same place we started from- except with more debt to show for it, and a decade devoid of capital investment into businesses or wage growth for consumers who will own less wealth and spending power relative to the elite than ever before. A decade of lost potential growth. A lost decade if you will. Now why does that sound familiar?
And that's why there is reason to worry even without PCE directly reflecting inflation concerns. Though in theory manufactured inflation of risky asset prices helps the economy without causing runaway inflation in consumer prices, the Fed may have just needlessly created a beast that it can not contain forever... sooner or later somebody has to admit defeat: monetary policy makers or deflationary headwinds. Capitulation by the former would risk a crisis of faith in central banks, while the latter could mean a swift reversal to prevailing inflation.
See the animal in his cage that you built...
Are you sure what side of the glass you are on?
- Trent Reznor. 'Right Where It Belongs.'
Either way, the possible implications for central banks and the currencies they back are profound. And while normally- all else equal- a crisis in the Euro for instance would mean stronger USD, when the entire globe seems at risk of becoming 'the next Japan,' there isn't necessarily any particular paper currency that looks all that attractive. Of course by definition there will be relative outperformers- that's how currency works, for the EURUSD rate a strength in USD comes at the direct expense of the EUR- but the broad degree of concern about paper currency helps explain why investors are flooding into gold, a "non-paper" currency, at the fastest rate since QE first started in 2009, following 2016 announcements of Japan enacting negative rates, the ECB cutting rates even further negative and the Fed yet again admitting its rate projections were too optimistic.
And while all commodities priced in USD stand to benefit some degree from a weakening Dollar, gold is relatively unique in its role as an alternative 'storage of value' to paper currencies.
Combine record levels of monetary easing and a decreasing efficacy of policy with eroding fundamentals even as that easing takes place, and long-term gold looks to be an attractive option for overweight asset allocation and diversification with risky assets whose values have been driven by monetary policy.
In the next article we'll look further into why gold acts as a 'storage of value' and we'll compare its viability as investment to that of a potentially revolutionary newcomer to the alternative-to-paper-currency and 'storage of value' scene: Bitcoin.
Disclosure: I am/we are long GLD.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.