The US has ended its money-printing programme.
For now Japan has picked up the baton. But investors could be forgiven for worrying about what might come next.
After all, when the Federal Reserve has ended quantitative easing (QE) in the past, the US economy has struggled to maintain any momentum.
Will the same thing happen this time? I’m not so sure…
Banks are lending and people are borrowing again
It’s hard to remember now – so many years have passed since QE kicked off as an ‘emergency’ monetary policy – but QE’s original purpose was not solely to drive up asset prices.
QE came about because the banking system was bust. As a result, credit stopped flowing – banks stopped lending because, in effect, they had no money. In an economy built on a complex web of promises and obligations between various parties – trust, in other words – that’s disastrous. Remove credit and you remove the trust. People stop doing business with one another. You get an economic collapse.
Whether or not you agree with this system depends ultimately on your politics. I’d say there’s room for improvement – but then, there always is.
In any case, the point of QE was to provide a safety net for the banks. Safe in the knowledge that the central bank was standing behind them, they would then feel confident enough to start lending money to businesses and individuals.
Trouble is, it didn’t work like that. At least, not right away. When you’ve come as close to annihilation as the banks did, the last thing you want to do is to get right back up and start expanding again. QE bought time for the banks to clear out their worst rubbish, and to raise more funds to heal their balance sheets.
But it took a long time – as James Ferguson of the MacroStrategy Partnership has pointed out many times in the pages of MoneyWeek, history demonstrates that a banking crisis takes years to resolve.
Meanwhile, the borrowers – the people on the other side of the banks – weren’t too keen to get out there and get loans either. They’d been burned too. And when they started to get more of an appetite to borrow, they had to turn to the burgeoning peer-to-peer sector, because the banks weren’t ready to lend.
But as Capital Economics points out, the banking system – in the US at least – may finally be ready to walk without its crutches. The Federal Reserve’s Senior Loan Officer Survey talks to banks to get an idea of how inclined they are to lend money to small businesses and households.
The latest one shows that “commercial banks are making it easier… to obtain credit, suggesting that the Fed’s QE taper has had no adverse impact on credit conditions.” Overall, banks expect to make it easier for consumers and companies to borrow in the run up to Christmas.
Capital reckons that lending to businesses should be growing at a yearly rate of 12% by early 2015. That’s good news “since smaller firms are more likely to use bank loans to boost investment” in machines or more jobs. (Big companies would rather borrow in the corporate bond market to spend on bonus-boosting share buybacks).
Meanwhile, demand for credit cards is rising, and banks are making it easier to get them.
US inflation is quietly picking up again
So people are borrowing and banks are lending again. That’s not the only sign of normality returning. Although US inflation is low at the moment (around 1.7% a year), that’s “likely to change,” according to Ana Gil of M&G’s Bond Vigilantes blog.
Firstly, rents are likely to go up. Vacancy rates are at their lowest level on record, suggesting that “the costs of renting will inevitably rise over the next 12-18 months.” Rents account for “roughly 40%” of the core inflation measure, so if they go up, that “could push the annual inflation rate up significantly.”
Secondly, the jobs market is strengthening. Not only are wages picking up, but rising demand for healthcare (which is often part of the package with a job) will probably push up healthcare costs too.
And even although the stronger dollar will make imports cheaper, the way the inflation indices are measured means that this effect will be outweighed by these other factors.
In short, it looks like the US economy is recovering. Ironically, that may not be such great news for stocks – or at least, not all of them. Companies’ costs will be rising, and they’ll be spending money on higher wages rather than share buybacks.
But it does suggest that those who still fret that we’re going to live in the ‘new normal’ – an environment of low interest rates and lower returns – forever more, are simply wrong.
Central banks are always accused of fighting the last war. Right now they’re in deflation-fighting mode. As much as anything else, that suggests that when the next big crisis arrives, it’s going to be an inflationary one.
The ingredients are all there. A tinderbox of government debt underneath all of the world’s developed economies. Rising demand and a tightening labour market at a time when monetary policy is freer and easier than it’s ever been in history.
That may be a while off. But I think we’ll start seeing the market seriously fret about this in 2015, as pressure grows on the Fed to hike rates. And the more hesitant the Fed is to do so, the more likely it is that inflation will take off.
How can you deal with this? The main thing is to have a diversified portfolio – something that can cope with a wide range of economic scenarios. My colleague Phil Oakley has set up a portfolio that is designed to ride the ups and downs of the market through thick and thin. You can find out more about it here.
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