Central banks have blown yet another bubble - here's how to protect yourself

By Dominic Frisby May 05, 2010

Dominic Frisby

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It's been more than a year now since the Bank of England began printing money, via Quantitative Easing (QE).

Governor Mervyn King told the BBC at the time: "Money in the economy is not growing quickly enough to support economic growth… What we've announced today are measures to increase the supply of money injected directly into the wider economy."

The European Central Bank is now drawing ever closer to doing something similar, as the euro crisis spins out of control. So I want to take a closer look at QE and ask, "What has it actually achieved?"

QE (sometimes known as the electronic printing press) is the process through which the Bank of England creates money out of nothing by increasing the amount of credit in its own account.

It then uses this money to buy financial assets, mainly government bonds. The institutions the Bank has bought these assets from end up sitting on lots of cash. So they are encouraged to lend, which drives the cost of borrowing down as more money becomes available, and the economy is stimulated.

Or at least, that's the theory.

Mervyn King said that QE would either encourage people to "spend directly" or that it would "increase the value of assets," which "will lead other people to feel better off and, hence, to spend". But he also proclaimed an "absolute insistence that we will try to keep inflation as close as possible to our 2% target".

What has QE achieved?

QE certainly seems to have helped boost asset prices (bearing in mind that it's not just the Bank of England who's been printing money, but the Federal Reserve too). Stock markets around the world have soared since March 2009. The FTSE 100 is up 65%, while the FTSE 250 is up by more than 90%.

Energy prices have soared, with Brent Crude Oil more than doubling, while metal prices – both base and precious – have soared too. Copper, for example, rose almost 150% from $150 to $370 a tonne. Other commodities such as cotton, cocoa and sugar have also all had bonanza years.

British house prices have surged too, albeit on lower sales volumes. Recent Nationwide data shows an annual rise of 10.5% from April 2009.

In short, we have had rampant asset price inflation. In fact more than that – these sorts of across-the-board price rises are the stuff of speculative bubbles.

So what about the 'real' economy?

As ever, this asset price inflation is not being properly reflected in official measures. The chart below from the Office of National Statistics (ONS) shows Consumer Price Index (CPI) inflation and Retail Price Index (RPI) inflation at 'just' 3.4 and 4.4%. (The chart shows RPIX too, which is RPI excluding home loan interest costs, in case you were wondering).

So this speculative bubble (and there are signs it is already starting to unravel; stocks tanked yesterday for the second time in a week) is being ignored, just as the excesses were in 2006-7. This will continue until it's too late – if it isn't already.

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But even at 3.4%, CPI is still 70% higher than the Bank's 2% target. Much of this has been driven by rising import prices, as the pound has weakened, another side effect of QE.

Meanwhile, what about the 'real economy'? Let's start with unemployment. These numbers are ugly, ugly, ugly. As of April 2010, unemployment stood at 8%, the highest rate since February 1996. Here are the charts - on the left-hand side is the unemployment rate, on the right, the employment rate.

Pay growth fell throughout 2009, but picked up towards the end of the year. Bonuses were up as banking profits recovered, while public sector pay growth at 3.7% was double that of the private sector. This chart from the ONS shows overall pay growth.

But while all this printed money might have been great for bankers and investors, small and medium-sized businesses haven't seen a penny of it. A recent Bank of England survey of credit conditions showed that, in the first three months of the year, demand for credit from sub-£1m turnover businesses rocketed, yet availability from banks actually fell.

Another survey, by insolvency specialists Begbies Traynor, showed that more than 160,000 UK companies are experiencing significant or critical financial distress. This is 14% higher than in fourth quarter of 2009.

In short, there is a major divergence between asset prices and the real economy. Why? Mike Shedlock of Global Economic Analysis writes: "The thing about stimulus plans is, governments can throw money at problems, but they do not really get to decide exactly where the money goes in the global economy".

Another bubble's been blown

The newly created money from QE and similar moves in the US, has gone straight into assets, creating another speculative bubble. The early recipients of the monetary stimulus – the banks, brokers and other associated players – have benefited the most, as is always the case during inflations and reflations.

Meanwhile, the real economy flounders. And for the man or small company on the street, the UK just gets more and more expensive. And loans are as hard to come by as at any time since the crisis began.

And the higher asset prices go, the more damaging the inevitable collapse will be. The real economy might not be feeling the benefits of the latest bubble, but you can be sure it will feel the pain of the bust.

What's most depressing of all, is that another asset price boom appears to be exactly what the proponents of QE intended. As we noted above, King stated that one of his aims was to "increase the value of assets". How many more busts do we need for these people to learn?

How you can protect yourself

So what can you do to protect yourself? This is not an environment for the long-term, buy-and-hold investor – you have to think with a trader's hat on. So if you take positions in stocks, you have to be disciplined. Have targets and stop losses, and be prepared to get out when you hit them. Also, as always, own some gold. Its price may fall during the busts, but it is the best way to play monetary instability. And keep some cash in reserve, so that you can swoop in and buy when the bust comes and everything is dirt cheap again.

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Published in Economics | More articles by Dominic Frisby

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  • 1. Tony Hart

    (05 May 2010, 11:34AM)  Complain about this comment

    If I remember correctly, the BOE pumped £200billion into QE.

    Is that what has been pumped into the FTSE and housing, ie. do the numbers add up?

    Also, the banks are proposing to lend vast sums to Prudential to buy its way into Asia. Is that the best way to invest our money?

  • 2. Keith P

    (05 May 2010, 11:53AM)  Complain about this comment

    When gold decoupled from the stock markets last week, I thought "Ah Ha! At last folks have made the connection - vast amounts of printed money and defaults threaten us all". Moneyweek wrote about the decoupling. But now gold is coupled up with the markets again, and sliding too. And yet the Euro has never looked more perilous, the Greeks don't like the austerity being thrust upon them, Spain and Portugal are both dodgy, so the incentive for getting into gold is definitely there. Also, why is the bankrupt over-printed US$ a safe haven? Hasn't the US QE'd just as much as us? Isn't it just another Greece waiting to happen? I must admit to not understanding markets or knowing what to do with my investments - maybe just have an amazingly wide spread and then stop watching.

  • 3. Peter Kellow

    (05 May 2010, 12:16PM)  Complain about this comment

    "The newly created money from QE and similar moves in the US, has gone straight into assets, creating another speculative bubble." That is telling like it is. Thank God for Moneyweek!

    Could someone explain to me why the printed money was not given to people who would definitely spend it into the economy instead of giving to proven rotten financial institutions ?

    If the pensioners, hard up businesses or people who were duped into paying Ponzi prices for houses had received the money it would have gone directly into the real economy and stimulated it

    Don't say this would cause inflation because the velocity of money would simply have increased. (Why do people still believe unproven defunct Monetarist dogma?)

    On the contrary, by saving businesses competition would be preserved so combatting inflation.

  • 4. NVP

    (05 May 2010, 12:16PM)  Complain about this comment

    Hey all

    my advice would be to UNdiversify and think local in terms of investments and trades

    the markets are very very volatile so trade/invest in what you know about and forget the rest of it....

    in markets like this things go wrong fast so keep it tight and if anything does go wrong at least you had a rough idea on the instruments you were in as opposed to one you didnt have a clue about !

    get real to survive in this climate - its not for amateurs

    NVP

  • 5. Peter Kellow

    (05 May 2010, 12:23PM)  Complain about this comment

    CORRECTION

    The four paragraph should read "the velocity of money would simply have DEcreased".

  • 6. Danfinn

    (05 May 2010, 12:40PM)  Complain about this comment

    Whats going to happen when the second volcano erupts in Iceland anytime soon? Methinks the global economy might just get a little more local. Warm clothing might be a good investment.

  • 7. webcontrarian

    (05 May 2010, 02:00PM)  Complain about this comment

    There is not a shred of evidence to couple QE and rising asset prices. The primary aim of QE was to avoid a reduction in the money supply caused by the banking crisis. To date, QE has done no more than offset the reduction and to keep the key measure of money supply approximately constant. The argument offered is a prime example of the fallacy "post hoc ergo propter hoc". Ideally, all those bankers' bonuses would be sucked back into stabilising the banks' balance sheets, enabling them to lend to SMEs. But how would that be achieved?

  • 8. dogfm

    (05 May 2010, 02:19PM)  Complain about this comment

    If the money had been given directly back to the SMEs then the bankers would have had to earn their bonuses through regular banking activities rather than placing "bets" on increasing asset prices ... maybe it would have been simply a matter of reducing corporation tax for SMEs.
    It would also have helped if the money had been given directly to people to spend locally instead of facilitating the takeover of Cadbury and now the Pru's rights issue.
    Never mind in two days we'll have some new wonderful fresh ideas to drive the economy won't we!

  • 9. Alex

    (05 May 2010, 02:43PM)  Complain about this comment

    The bounce in banks profits and balance sheets had rather more to do with assets that had been written down sharply when FAS157 was bough in, being written back up when FAS 157 and it's European equivalent were hurridly and quietly modified out of existance. All QE was doing was keeping the patient alive whilst it recovered from the heart attack caused by the same Politicians who are taking credit for the recovery.

    It's classic Gordon Brown logic...."I caused this massive mess, so vote for me because I'm the only one who can fix it"

  • 10. gyroman

    (05 May 2010, 03:49PM)  Complain about this comment

    If you can get me Copper at $370 a tonne I'll swap all my gold for it.

  • 11. Peter Eastwood

    (05 May 2010, 05:42PM)  Complain about this comment

    The Stock Market has begun to show its vulnerability. It is clearly not the time to invest in anything but to get out while the going is good. If there is a rise then it will be short lived. I think that this time next year the Stock Market will be halved.

  • 12. triode

    (05 May 2010, 09:43PM)  Complain about this comment

    Call me a conspiracy theorist. Once the government used tax payers money to buy the banks they now have an interest in all assets, from stocks to property. At some point the banks will need offloading. Print money to inflate asset prices and indirectly you increase the share prices of the banks so you can tell the tax payer this was a great play with their money. All going well, sell back at a profit to the private sector.

    As Brown kissed good bye to Prudence, policy stopped supporting those who had been prudent amongst us. For the sake of markets, I hope the natural order will be restored and governments will run out of interventions. TO paraphrase Warren B - the tide is not yet out, and there are still a lot of people swimming with no trunks.

  • 13. Kerome

    (05 May 2010, 10:52PM)  Complain about this comment

    It seems like the old argument of Keynes vs Friedman is in the process of being decided in favor of the latter. Not that this should be a surprise. To me the analysis of QE inflating another bubble looks correct - the question I have is this: will it ever be possible to deflate this bubble?

    In a way, the BoE buying Treasuries is a null sum, one arm of the government lending virtual money to another. Where it becomes real is in government buying bad assets from banks - the only way to get that money back and reconcile the loan is to sell the assets back to the private sector. Otherwise significant amounts of the money will stay in circulation...

  • 14. Michael Lewis

    (06 May 2010, 04:56PM)  Complain about this comment

    The way its painted this looks like the government won't be able to resist a bit more QE to make all the pain go away. That will push up the 'value' of houses and other real assets. No party has the cojones it seems to tackle the debt problem - default by devaluation. Even if Sterling has lost a lot of value, it looks like it could fall still further?

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