[This post is an excerpt from a recent TSI commentary]

Once an equity bear market is well underway it runs its course, regardless of the Fed’s actions. For example, the Fed started cutting interest rates in January of 2001, but the bear market that began in March of 2000 continued until October-2002. For another example, the Fed started cutting interest rates in September-2007, but a bear market commenced in October-2007 and continued until March-2009 despite numerous Fed actions designed to halt the price decline. On this basis it can be argued that the Fed’s introduction of a new asset monetisation program roughly one week ago won’t prevent the stock market from rolling over into a major bearish trend. However, there is a good reason to think that it could be different this time (dangerous words, we know) and that the Fed’s new money-pumping scheme will prove to be game-changer.

The reason to think that it could be different this time is that in one respect it definitely is different. We are referring to the fact that although the Fed started cutting interest rates in the early parts of the last two cyclical bear markets (2000-2002 and 2007-2009), it didn’t begin to directly add new money to the financial markets until the S&P500 Index had been trending downward with conviction for about 12 months.

To further explain, when the Fed’s targeted interest rates follow market interest rates downward, which is what tends to happen during at least the first half of an economic downturn, the official rate cuts do not add any liquidity to the financial system. It’s only after the Fed begins to pump new money into the financial markets that its actions have the potential to support asset prices.

During the last two bear markets, by the time the Fed started to pump money it was too late to avoid a massive price decline. This time around, however, the Fed has introduced a fairly aggressive money-pumping program while the S&P500 is very close to its all-time high and seemingly still in a bullish trend.

The Fed has emphasised that the new asset monetisation program should not be called “QE” because it does not constitute a shift in monetary policy. Technically this is correct, but in a way it’s worse than a shift towards easier monetary policy. The Fed’s new program is actually a thinly-disguised attempt to help the Primary Dealers absorb an increasing supply of US Treasury debt. To put it another way, the Fed is now monetising assets for the purpose of financing the US federal government, albeit in a surreptitious manner.

This relates to a point we made in a recent blog post. The point is that when the central bank is perceived to be financing the government, as opposed to implementing monetary policy to achieve economic (non-political) objectives such as “price stability”, there is a heightened risk that a large decline in monetary confidence will be set in motion. One effect of this would be an increase in what most people think of as “inflation”.

Summing up, it’s possible that the Fed’s new asset monetisation program will extend the current cycle (prolong the equity bull market) and lead to more “price inflation” than earlier programs.

[This post is a modified excerpt from a recent TSI commentary.]

We regularly look at what’s happening with monetary inflation around the world, but today we’ll focus exclusively on the US monetary inflation rate. This is because of the recent evidence that the unusually-low level of this long-term monetary indicator is starting to have a significant short-term effect.

The following chart shows that the year-over-year rate of change in US True Money Supply (TMS), a.k.a. the US monetary inflation rate, made a new 12-year low in August-2019. Furthermore, the latest TMS growth figure for the US is very close to the 20-year low registered in September-2006.

Within three months of the TMS growth trough in September-2006 the first obvious crack appeared in the US mortgage debt/securitisation bubble. The crack was a trading update issued by HSBC on 5th December 2006 that noted the increasing “challenges” being faced by the Mortgage Services operations of HSBC Finance Corporation. This initial sign of weakness was followed by the appearance of a much larger crack on 7th February 2007. That’s when HSBC issued another trading update that included a profit warning due to substantially increased loan impairment charges. Within days of this February-2007 HSBC update, the shares of sub-prime lending specialists such as New Century Financial and NovaStar Financial went into freefall. This marked the beginning of the Global Financial Crisis, although the US stock market didn’t top out until October of 2007 and industrial commodities such as oil and copper didn’t top out until mid-2008.

The above-mentioned events could be relevant to the current situation, in that the recent chaos in the US short-term funding market could be the initial ‘crack’ in today’s global debt edifice. While the low rate of US monetary inflation was not the proximate catalyst for the recent chaos, there is little doubt that it played a part. Temporary issues such as a corporate tax deadline and a large addition by the US Treasury to its account at the Fed would not have had such a dramatic effect if the money supply had been growing at a ‘normal’ pace.

Generally, when the money supply is growing very slowly within a debt-based monetary system, a relatively small increase in the demand for cash can create the impression that there is a major cash shortage.

Now, if there’s one thing we can be sure of it’s that the next crisis will look nothing like the last crisis. The financial markets work that way because after a crisis occurs ‘everyone’, including all policy-makers, will be on guard against a repeat performance, making a repeat performance extremely improbable. Therefore, we can be confident that even if the recent temporary seizure of the US short-term funding market was a figurative shot across the bow, within the next couple of years there will NOT be a major liquidity event that looks like the 2007-2008 crisis. However, some sort of crisis, encompassing an economic recession, is probable within this 2-year period.

The nature of the next crisis will be determined by how the Fed reacts to signs of economic weakness and short-term funding issues such as the one that arose a few weeks ago. In particular, quick action by the Fed to boost the money supply would greatly reduce the probability of a deflation scare and greatly increase the risk that the next crisis will involve relatively high levels of what most people call “inflation”.

As an aside, there’s a big difference between the Fed cutting its targeted short-term interest rates and the Fed directly boosting the money supply. For example, in reaction to signs of stress in the financial system the Fed commenced a rate-cutting program in September of 2007, but it didn’t begin to directly pump money into the system until September of 2008. In effect, during the last crisis the Fed did nothing to address liquidity issues until almost two years after the appearance of the initial ‘crack’. As a consequence, the monetary inflation rate remained low and monetary conditions remained ‘tight’ until October of 2008 — 12 months after the start of an equity bear market and 10 months after the start of an economic recession.

Early indications are that the Fed will be very quick to inject new money this time around, partly because 2007-2008 is still fresh in the memory. These early indications include the rapidity of the Fed’s response to the effective seizure of the “repo” market last month and the fact that last Friday the Fed introduced a $60B/month asset monetisation program. This program is QE in everything except name. In other words, the Fed already has resumed Quantitative Easing even though GDP is growing at about 2%/year, the unemployment rate is at a generational low and the stock market is near an all-time high.

In summary, while it is too early to have a clear view of how the next major crisis will unfold, something along the lines of 2007-2008 can be ruled out. Also, there are tentative signs that the next crisis will coincide with or follow a period of relatively high “inflation”.

The events of the past 10 years have fostered the belief that central banks can create a virtually unlimited amount of money without significant adverse consequences for the purchasing power of money. Since the law of supply and demand applies to money similarly to how it applies to every other economic good, this belief is wrong. However, the ‘failure’ of QE programs to bring about high levels of what most people think of as inflation has generated a false sense of security.

The difference between money and every other economic good is that money is on one side of almost every economic transaction. Consequently, there is no single number that can accurately represent the price (purchasing power) of money, meaning that even the most honest and rigorous attempt to calculate the “general price level” will fail. This doesn’t imply that changes in the supply of money have no effect on money purchasing power, but it does imply that the effects of changes in the money supply can’t be explained or understood via a simple equation.

Further to the above, the Quantity Theory of Money (QTM) is not a valid theory. Ludwig von Mises thoroughly debunked this theory a hundred years ago and I summarised its basic flaws in a blog post two years ago. Unfortunately, QTM’s obvious inability to explain how the world works has strengthened the belief that an increase in the supply of money has no significant adverse effect on the price of money.

The relationship between an increase in the money supply and its economic effects is complicated by the fact that the effects will differ depending on how and where the new money is added. Of particular relevance, the economic effects of a money-supply increase driven by commercial banks making loans to their customers will be very different from the economic effects of a money-supply increase driven by central banks monetising assets. In the former case the first receivers of the new money will be within the general public, for example, house buyers/sellers and the owners of businesses, whereas in the latter case the first receivers of the new money will be bond speculators (Primary Dealers in the US). Putting it another way, “Main Street” is the first receiver of the new money in the former case and “Wall Street” is the first receiver of the new money in the latter case. This alone goes a long way towards explaining why the QE programs of Q4-2008 onward had a much greater effect on financial asset prices than on the prices that get added together to form the Consumer Price Index (CPI).

Clearly, the QE programs implemented over the past 11 years had huge inflationary effects, just not the effects that many people expected.

A proper analysis of the effects of the QE programs has not been done by central bankers and the most influential economists. As a result, there is now the false sense of security mentioned above. It is now generally believed that substantially increasing the money supply does not lead to problematic “inflation”, which, in turn, lends credibility to monetary quackery such as MMT (Modern Monetary Theory).

Due to the combination of the false belief that large increases in the supply of money have only a minor effect on the purchasing power of money and the equally false belief that the economy would benefit from a bit more “price inflation”, it’s a good bet that central banks and governments will devise ways to inject a lot more money into the economy in reaction to future economic weakness. As is always so, the effects of this money creation will be determined by how and where the new money is added. If the money is added via another QE program then the main effects of the money-pumping again will be seen in the financial markets, at least initially, but if the central bank begins to monetise government debt directly* then the “inflationary” effects in the real economy could be dramatic.

The difference between the direct and the indirect central-bank monetising of government debt is largely psychological, but it is important nonetheless. When the central bank monetises government debt indirectly, that is, via intermediaries such as Primary Dealers, it is perceived to be conducting monetary policy (manipulating interest rates, that is). However, when the central bank monetises government debt directly it is perceived to be financing the government, thus eliminating any semblance of central bank independence and potentially setting in motion a large decline in monetary confidence.

According to the book Monetary Regimes and Inflation, ALL of the great inflations of the 20th Century were preceded by central bank financing of large government deficits. Furthermore, in every case when the government deficit exceeded 40% of expenditure and the central bank was monetising the bulk of the deficit, a period of high inflation was the result. In some cases hyperinflation was the result.

In summary, growth in the money supply matters, but not in the simplistic way suggested by the Quantity Theory of Money. There’s a good chance that this fact will be rediscovered within the next few years, especially if legislative changes enable/force the Fed to monetise government debt directly.

*In the US this would entail the Fed paying for government debt securities by depositing newly-created dollars into the government’s account at the Fed. The government would then spend the new money. Currently the Fed buys government debt securities from Primary Dealers (PDs), which means that the newly-created dollars are deposited into the bank accounts of the PDs.