The Consequences of QE

 

There is a good article by Mervyn King, then Deputy Governor and subsequently Governor of the Bank of England, published in 2001 that is very pertinent to today's quantitative easing (QE) program and its consequences in time. Specifically, in Chart 1 he shows rather convincingly that expansions in the money supply, with an appropriate lag, will lead to an proportionate increase in consumer price inflation with a 99% correlation. With today's QE program, we already see 1-to-1 correlation between increases in the monetary base and assets prices, particularly stock prices as seen in Chart 2 where the ratio of the S&P500 index / US monetary base has flat-lined since 2009. In other words, the strong growth we have seen as of late in the US stock market is being equally offset by the growth in the monetary base. This increase in the S&P500 index can be dubbed in general, asset inflation, and financial assets such as stocks tend to be among the first things 'bid-up' in price due to an expansion in the money supply. And as clear as day turns to night, with an appropriate lag, eventually that asset price inflation will spread into consumer prices and formally enter the 'inflation' metrics as commonly computed; the CPI.

 Chart 1 : Money growth shows a 99% correlation to consumer inflation with an appropriate time lag.

The stated objective by central banks for engaging in these QE money expansion programs is to stimulate the economy. However, again thanks to Mervyn King, Chart 3 in his paper blows a hole in this stated objective. As can be seen below, there is no correlation (-0.09) between money growth and real GDP output growth. In other words, the historical data refutes the idea that money expansion will stimulate the economy in real terms. So behind the talk, what is the real reason why QE is being used so aggressively? It seems to be for the purpose of creating asset price inflation in order to avoid governments, banks, and central banks fear of asset price deflation. In hard core asset price deflation, particularly for assets that are collateralized and debt financed, they could end up on the banks balance sheet and their deflating value could lead to individual and system-wide bank failures. For government, their inflation tax does not work during deflation. For example, if nominal asset prices increase 100% after 5yrs, that gain can be taxed even though say in real terms (inflation adjusted) the price is still the same. In a deflationary world, if asset prices fall 50% in nominal terms, the holder of that asset can get a tax benefit by taking a tax loss even if in real terms the price had not changed. Without inflation, a large portion of a government's effective tax revenue would go into reverse. The last reason for QE has to do with decreasing the relative value of the 'unit of account', i.e. the US dollar. By doing so the effective level of debt can be decrease without formally defaulting on it. In the common vernacular, this has been called inflating ones debt away.

Chart 2 : Ratio of the S&P500 / US monetary base

Chart 3: Money growth shows no correlation with real output growth.