Since the financial crisis began in 2008 after the meltdown of Lehman, global central bankers have responded in a number of different ways. The one method linking all of these central banks responses together has been the use of Quantitative Easing, or QE as it is more commonly called.
The aim of QE is to stimulate the real economy, and it is considered unconventional.
Monetary Policy. Until 2008, central bankers' general response to recessions has been cutting interest rates. In theory - and largely in practice as well - lower interest rates will encourage businesses and consumers to increase their economic activity by borrowing more money at these lower rates.
In the post-World War II era, lower interest rates have generally sufficed to lift economies out of economic recessions. Lowering interest rates has not, however, been sufficient to boost economic activity across western economies since the "Great Recession" began. Since 2009, interest rates in the European Union, the U.K. and the U.S. have all been largely one percent or lower, meaning that are at or near the so-called "zero-bound" where central bankers have not been able to lower them any further. Hence central bankers have turned to QE instead in a desperate attempt to stimulate their economies and keep the financial system afloat.
The process of QE is best explained by providing a rough overview of the steps involved in its implementation. It is worth noting in advance that many economists and financial analysts will have slightly different definitions of what QE is and how it works:
1) First, a central bank will create new money. In the past, this meant literally printing money; today however it simply means creating new money electronically.
2) Next, a central bank will use this newly created money to buy more conservative bond investments - generally government or government-guaranteed bonds - directly from financial institutions such as banks, pension funds and insurance companies.
3) This purchase of government bonds by the central bank should lower the interest rates that these bonds pay to financial investors. This is based on simple supply and demand. Large purchases of bonds by a central bank will increase the price of these bonds, which lowers the yield the bonds will pay (when it comes to bonds, their price and yield is inversely proportional).
4) The hope is that these financial institutions - especially banks - will respond to lower bond yields by lending money to consumers and businesses in the real economy to achieve a higher rate of return.
5) Then, once the economy recovers, the central bank will sell the bonds back into the marketplace, thereby recovering the new money it created in the first place.
Just to give one example of what the scale of QE has been, to date the U.K.'s Central Bank, the Bank of England or BOE, has implemented QE to the tune of £325 billion (or US$517 billion). Meanwhile, the American central Bank, the Federal Reserve has used QE to purchase approximately US$2 trillion of bonds in the marketplace. All together, the balance sheets of eight of the world's most important central banks have collectively almost tripled in the past six years:
The major question that central banks' QE has created is whether all of this new money will lead to high inflation? Many analysts have argued that because businesses and consumers are not borrowing and most banks are not lending, that the risk of significant inflation is small because the proceeds from QE are just sitting on banks' balance sheets rather than reaching the real economy.
An excellent recent article by Liam Halligan in the U.K.'s Daily Telegraph, however, notes that inflationary risks of QE are very real. Mr. Halligan argues the following:
"Future inflation, not disinflation, is the problem the U.K. faces. For now, most of the QE "proceeds" are sitting on the balance sheets of banks pretending to be solvent ... What happens to inflation when that massive increase in base money is leant out? What happens when the mask slips and the markets focus on "currency debasement"?"
Whilst Halligan's article focuses on the U.K., the same question could be asked of the U.S. Fed or any central bank which has implemented QE. The US FED, for example, has seen its balance sheet expand from approximately US$800 billion in August, 2007 to nearly US$2.4 trillion today. For American readers who want to explore this further, this link to the FED's website allows users to play around with different dates and explore how the Fed's Total Balance Sheet has gradually expanded over time.
One question investors might ask themselves if they do believe that much higher inflation is a real future possibility is "what type of investments would I want to protect my investment portfolio and retirement security from the substantial inflationary risks created by QE?"
Just to take the example of agriculture, we pointed out in a previous article here on Seeking Alpha that the long-term rationale for agriculture and farmland investment is compelling, as global arable land is decreasing whilst global population continues to rise inexorably. Certainly, however, similar arguments could be made for assets as diverse as tropical forestry, oil and energy, and of course a variety of precious metals. The good thing for retail investors compared to the last high inflationary period in the 1970's is that these types of real assets such as farmland are no longer the preserve of the wealthiest investors such as the legendary Jim Rogers (who is a huge proponent of agricultural farmland investing by the way), but are now also accessible by individuals.
For those looking for the liquidity of accessing this real assets theme through an online trading account, the options are plentiful and will certainly be known to most Seeking Alpha readers:
- For farmland and agriculture, consider any high quality fertilizer stocks such as Mosaic (MOS) or Potash (POT).
- For oil, oil trusts such as BP Prudhoe Bay Royalty Trust (BPT) or Pengrowth Energy Corp of Canada (PGH) are excellent options. Oil trusts are required to pay out 90% of their income as dividends, and are the next best thing to actually owning an oil well directly!
- For forestry, consider Plum Creek Timber (PCL) is by far the best option for a U.S. timber REIT to gain direct access to large timber reserves.
- Finally, for precious metals, the options are innumerable from buying gold and silver bars directly, to owning a Gold ETF such as GLD, or the Market Vectors Gold Miners stock index (GDX).
Whilst the final chapter of the financial crisis has yet to be written - see Spain as proof that we are not out of the woods by a long-shot - it is not too early even for those who are not concerned with inflation today to consider a real asset investing strategy as a future inflation hedge.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. Our firm is involved with real asset investments such as forestry or farmland, although none of these are mentioned in the article and we own no positions in any of the stocks mentioned.