Quantitative Easing, Inflation and Commodities

15th May 2011

Developed economies continue to be tough places to be for the average man on the street. Despite quantitative easing in the UK, unemployment continues to rise, wages are stagnating, whilst the creeping growth of inflation continues to erode real spending power. Magnify all these points for the economic situation across the Atlantic in the US where the macro-economic factors continue to prove difficult to juggle.

The component parts do not sit nicely together in terms of traditional economic theory. Yes, quantitative easing can be expected to cause inflation but the route that the financial authorities were expecting this take was via higher employment and consumer spending power. Watching the numbers in action though it is clear that this isn't taking place. And more worryingly, the traditional cure for inflation, i.e. higher interest rates, will not necessarily address an inflation issue that is caused by price rises in mandatory spending on necessities rather than on discretionary items. The fact that the cost of borrowing increases will not mean less that food will be eaten but it will cause less iPhones, for example, and the latter are not the cause of current price inflation.

Let's go back to the operation of quantitative easing its mechanics. How does it work? Well, simply, a government will print more money and buy back bonds. Bonds are generally held as lower risk assets within portfolios and those with the largest portfolios, and therefore the greatest potential receipts from QE, are the financial institutions. The cash that is generated is then expected to flow into the financial markets and create wealth, or at least a perception of wealth.

The US announced QEII in November 2010 which effectively committed to releasing $600bn into the US economy in staged bond purchases through until June 2011. As expected, inflation has crept up - no surpises there, but the key components driving this have been energy costs and other commodity driven items. Only recently have the core items in the US started to inflate - hence the deflation risk discussions that have taken place. In the UK inflation is still largely food and energy driven.

What seems to have taken place is that QE has not reached the man on the street. The financial institutions receiving the cash have boosted their captial ratios, transferred into equities and invested in safe havens - the main one being gold. What does not seem to have transpired is an upsurge in commercial lending.

The advent of a flood of US dollars on the market has damaged the dollar's reserve currency status and gold is taking its place. Witness the continuing rise in gold which may be attributed to the US national debt rise over the years plus a turbo boost from QE. The rise in the equity indices can also be attributed in part to the flush of liquidity on the markets.

With a $14 trillion debt issue to deal with though the US need inflation. In real terms, paying off such a debt, or even just financing it, becomes much cheaper when there is an element of inflation eroding this each year. There is no chance therefore that the US will want inflation to do anything than to maintain a steady short term rise and then to stabilise. This will also indicate that base lending rates will not be increased significantly further reinforcing the relative value of gold versus currency. We can expect therefore that the interest in gold will also be maintained - consensus seems to be that this will not necessarily apply to silver and other metals.

The end of quantitative easing might well herald a correction in equity markets and certain commodity markets but is likely not to effect gold's longer term trend. Any lessening of inflation following the end of quantitative easing, or in fact any significant apppreciation of the dollar relative to other key currencies, could however force the hand of the Federal Reserve and they may be forced into QEIII. This may give gold another boost and also sustain the equity market rises which have few fundamentals to support there Q1 2011 rise.

The major plays are therefore in the financial markets and involve issues of short term speculative investment and identification of a reserve currency. Investment in the traditional sense through loans and direct business cash injections is not taking place in proportion to QE. This underlines the fragility perceived in the developed economies and explains the constriction in the system which stop wealth filtering through the whole demographic. Speculators are, of course, profiting!