Why printing money must lead to inflation
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Associate Editor
David Stevenson Mar 12, 2009
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Deflation is today's big bad economic bogeyman.
Deflation is very bad news for anyone who owes large amounts of money. It means that the real value of your debt just keeps getting larger, at a time when your wages are likely to be static or falling.
But it looks like there's a change in the wind. It's a bit early yet, but the signs are that inflation could start making a comeback next year.
Of course, that's not such good news for anyone who's a saver, or is trying to live off a fixed income. So if you're not up to your eyeballs in debt, it could soon be time to start thinking about how to protect your cash...
Printing money will eventually push prices higher
The threat of deflation is how governments around the world have justified splashing vast chunks of cash, which they don't have, on bailing out industries from banking to car manufacturers. And it's also the reason why the US Federal Reserve, and now the Bank of England - through Quantitative Easing (QE) – are printing money like there's no tomorrow.
We've written about QE a fair bit already in Money Morning (Why quantitative easing won't work) and in MoneyWeek (get your first three issues free here) so I won't go over all the same ground again.
Suffice to say that QE might not do anything at first. Banks might simply hoard the extra money being pushed into the economy. After all, they've made so many dodgy loans that they might just keep the cash in their vaults to offset the next round of write-offs.
But although it may take a while to 'work', all this money-printing can eventually lead to just one thing – the return of inflation.
Businesses and private individuals neither want, nor are able, to rack up more debt. But governments are more than happy to do so. Barack Obama has already saddled the US statute book with a $787bn mix of tax cuts and government spending, and wants Congress to pass a budget with a record $1.75trn deficit. Somehow that gap must be met, even if that means that the printing presses have to be cranked up even faster.
That means yet more cash looking for a home. And if companies aren't producing more stuff, to keep up with all that extra money, then consumer prices are likely to rise.
Rising inflation is bad for bonds
In fact, Pimco, the world's biggest bond fund manager, reckons the combined money-printing efforts of the US government and the Federal Reserve will start jacking up the costs of goods and services as soon as next year. And as commodity producers have been delaying their production projects following the slide in commodity prices, supply will be limited. So any demand pick-up will drive up raw material prices, too.
That's very handy for the US government. If it can start repaying the $1.75trn it owes out of devalued money, so much the better for it. But investors are already realizing that this is the plan – and the strain is showing on the bond market.
To spell it out - rising inflation is bad for bonds. If inflation is going up, the value of a fixed income stream is worth less. So investors demand a higher fixed income in return. That means yields are driven up and bond prices forced down.
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US Treasury 10-year yields have already risen from their low of 2% to nearly 3%. The spread between these and Treasury Inflation Protected Securities (TIPS) – which move in line with expected inflation - has widened sharply. In short, the market's starting to 'price in' consumer prices rising again next year.
That may be what the government wants just now. But if inflation expectations pick up too much, long-term interest rates will be forced higher. That could cut off any economic recovery before it's even begun. And given the past track record of governments and central banks when it comes to managing monetary policy successfully, don't count on them being able to walk the tightrope between "too much" and "too little" inflation successfully.
How to protect your wealth when inflation returns
Over here in the UK, there aren't too many signs as yet of inflation returning. But with more pounds being printed, sterling is plunging again. That in turn will ramp up the price of all our vital imported goods. I've seen a classic example this week. My breakfast banana, bought from a stall outside Southwark station every day, has just undergone a 20% price hike.
For the moment, with the Bank of England buying up all those bonds, there's no sign of investors being spooked. Indeed the opposite. Over the last week, since the QE terms were announced, gilt yields have dropped from 3.6% to 3% as buyers have piled in - to make a 'turn' by selling their bonds back to the central bank.
But this bullish tone's unlikely to last too long. We wouldn't recommend buying more conventional government bonds. And while it may be a bit early to buy inflation protection, you should have it on your agenda.
Index-linked gilts, which do what they say on the tin, i.e. their value moves in line with consumer price rises, can at least stop inflation ravaging your savings this time round. We'll be keeping an eye on these and talking more about them shortly.
But in the meantime, there's another good hedge against inflation which has been falling in price recently – gold. Gold is also a good protection against financial instability, and we can certainly expect more of that over the coming months. If you don't hold any already, we'd suggest you get some exposure – the price may continue to fall in the short-term, but long term we doubt you'll regret it. You can find out more about how to buy gold here: Investing in gold.
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