Central Banks and the Secret Tax of Inflation

Inflation is a simple concept that most people understand.  When inflation occurs, prices rise and the purchasing power of a dollar is reduced.  Simply put, prices go up and you need to spend more money to get the same amount of goods or services. While most people understand this basic concept, inflation is actually a deceptively complex phenomenon and what causes it is not very well understood.

Supply and Demands Effects on the Dollar

In the long run, the value of a dollar is determined by supply and demand, just like every other free market. The more supply of dollars to spend, the lower the value of those dollars will be.  The more demand for dollars there is, the higher the value of the dollar should be.  Sounds simple right?  Well the factors that make up the supply and demand of currencies are much more complicated than most people realize.

Central Banks

Let's start with central banks.  Most advanced economies have established their own central banks to help control inflation in their economies.  In Canada we have the Bank of Canada, the US has the Federal Reserve, and Europe has the European Central Bank.  The structure and function of these institutions differ slightly from country to country, but they all have the main goal of controlling inflation in their countries' economies.  Generally speaking, they do this by controlling the money supply in the economy which as we discussed is one of the main levers on inflation.  They control the money supply by using a variety of tools at their disposal.

The most recognized tool they use is the direct control over short term interest rates.  The central banks set the rates at which commercial and retail banks borrow from the central bank.  This sets the price of borrowing throughout the economy because retail and commercial banks set rates for things like mortgages and other loans based on the rates set by the central bank.  The higher the rate of interest charged by banks in the economy, the less likely people will be to borrow, and therefore less money will be created by loans.

Now at this point I need to mention a very important concept that is not well understood.  Most money that exists in our economy does not actually exist in physical dollars. Most money is in fact 'credit' which is created when loans are made by banks.  This means that most dollars are not actually printed by the central bank, but they are instead created when banks make loans to their clients.  This means that credit creation is far more important to the supply of money than actual printing of money by the central bank. In addition, credit is also far more volatile than other money creation.

How Does This Creation of Money Through Credit Work?  

Well let's do a quick example to demonstrate. Let's say I want to take advantage of low interest rates set by the Bank of Canada as the central bank.  I want to borrow money at those low rates.  So I walk into my local bank branch and look to get a loan for $10,000.  The bank agrees to the loan and they give me the $10,000 with which I can do anything I want.  I can spend it or invest it in anything I choose.  What's important to know though is that the $10,000 is real money in the money supply and it will affect the prices of goods and services in the economy.  

But is there MORE money in the economy then there was before?  Well let's look at the example from the bank's perspective. By issuing a loan to me they have created an asset on their books because they have a debt which is owed to them.  But they have also given me cash representing the same amount of the loan, so there shouldn't be any additional money in the system, right?  Wrong.  Let's think about what I'm going to do with the money I've borrowed.  I'm probably going to either hold it in a bank account, or spend it.  If I spend it, the person or business that I give the money to is likely to hold it in their bank account or spend it themselves.  

Either way the money is likely to find its way back into the same banks that are originally lending it because it will get held in bank accounts. When you deposit cash into a bank the bank receives your cash and creates a liability to you.  This is called a deposit.  What you don't see though is that your cash doesn't stay in the bank.  Even though the bank still owes you that money, they take the actual physical cash and re-lend it to someone else. Banks are only required to hold a fraction of the deposits they owe to deposit holders in cash. This means that at any one time, banks only have a fraction of the money they owe to deposit holders available to pay back to them.  So you still have your money, because it's in your bank account, but the bank has re-lent that money to someone else as well.  

This goes on, over and over, and that's how money really multiplies throughout the economy.  In fact as I said, most of the money that gets spent in the economy, is actually credit and not real dollars.  Ray Dalio has stated in his video "How the Economic Machine Works" that the US economy has about $50 trillion dollars of credit, and only $3 Trillion dollars of dollars. The central banks indirectly control this credit creation and repayment through the control of interest rates.  As loans become cheaper, more people want to borrow and create credit. As interest rates go up and loans become more expensive, more people repay their loans and less people want to borrow.  

However when the amount of debt in the economy grows to such a high level that it can't support any more borrowing, this tool of the central banks does not work as well.  This is the situation we've found ourselves in since 2008. In 2008, interest rates were lowered to 0 by many central banks and even went negative in Japan and in Europe.  Because the capacity of the economy to borrow was near its limit, this did not help very much in stimulating the economy and there was a real risk that we would have deflation.  Deflation is the opposite of inflation and is very bad for the economy.  In order to avoid deflation the central banks had to look at other potential tools to try and put more cash into the economy.  

What is Quantitative Easing?

The tool that they chose was Quantitative Easing. Quantitative easing is when the central bank prints money out of thin air and uses that money to buy financial assets.  It is a way of pushing more physical dollars into the economy. It also pushes up the price of all assets such as bonds, stocks and other assets such as real estate, which makes people who own these things wealthier.  This also makes them more creditworthy as they have more collateral. Quantitative easing has had mixed results.  If we look at the actual numbers, it does seem to have succeeded in preventing deflation, however inflation in all of the developed economies has remained below central banks targets, which are typically around 2% a year.

It's also unclear whether these extraordinary measures that centrals banks have taken over the past 10 years will have unintended consequences down the road. It's not hard to see why inflation has remained below targets over the past 10 years however.  As we know, credit creation and repayment is far more important for causing inflation then printing money.  Even as central banks have tried to push real dollars into the economy, personal credit has gone down or remained stagnant.  In addition, according to a report by the McKinsey institute, the main driver of growth in household debt since 2008 has been mortgages.  

There has definitely been inflation in real estate since QE has been instituted, but house prices don't get factored into overall inflation numbers used by the central banks.  These higher house prices have been directly caused by the actions of the central banks with quantitative easing and record low interest rates. This has prevented the creation of credit for other spending and has thus dragged down the overall money supply in the economy.  So ironically, the central banks may have caused low inflation with the very tools they were using to try and create higher inflation.

It's impossible to predict what will happen going forward.  It's possible that we will have a long period of deleveraging which should keep inflation low for a long time.  It's also possible that central banks will eventually push so much money into the economy using quantitative easing that they eventually do get higher inflation.  This could be very dangerous however because it may result in much higher inflation then the central banks intended. One of the things that gets periodically discussed is returning to a 'gold standard'.  This means that the value of a dollar is pegged to the value of gold, and all dollars created have to be backed up by the holding of gold.  

A Gold Standard

A modified gold standard existed in the US and most western economies up until 1971 under the Bretton Woods agreement.  By having a gold standard it prevents the central bank from creating money out of thin air.  The main argument for returning to the gold standard is that overall inflation was lower during periods of time when the gold standard was used.  However inflation was actually more unpredictable and volatile under the gold standard than under our current system.  In addition returning to the gold standard would remove the ability of central banks to implement countercyclical policies to help during recessions or depressions.

There are also some practical problems with a gold standard.  The world's biggest gold producers (including China, Russia and South Africa) would have a disproportionate influence over the world's economy as they would have greater control over the creation of money. In addition there is tremendous cost in storing gold as a backing for currency, as it needs to be housed and guarded. Overall I don't think returning to a gold standard is a good idea. It's a bit archaic to allow our money creation to be controlled by the randomness of gold production around the world.

However it remains to be seen whether central banks will be able to retain the control over inflation that they've demonstrated over the past 35 years.  If quantitative easing and other extraordinary measures create much higher inflation then they intended, there will be increased calls for a return to a gold standard as the value of savers dollars is destroyed by inflation.  In the past governments have used high inflation as a secret tax on the populace to inflate their way out of large government debts.  I think this is a very valid concern for investors especially, as inflation can really ruin your investment returns if you're not careful, and with government debts rising in almost all of the major economies, it's becoming more of a concern all the time.  

In my next post I'm going to look at ways you can protect yourself against higher inflation.

- Craig White, BA, LL.B., CIM

Craig White is an Investment Advisor at Endeavour Wealth Management with Industrial Alliance Securities Inc. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families. Industrial Alliance Securities Inc. is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada. iA Securities is a trademark and business name under which Industrial Alliance Securities Inc. operates.

This information has been prepared by Craig White who is an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.