By now, most people have heard about the second round of “Quantitative Easing” being conducted by the Federal Reserve. In short, this means that the Fed will be purchasing treasury bills with freshly printed money to inject more cash into the monetary system. To date, most of this additional liquidity has been limited to banks who have opted to hold the capital instead of loan it out. The reason for this is because the banks can borrow from the Fed at extremely low overnight interest rates and use the capital to purchase treasuries with a yield rate that exceeds their cost of borrowing.
However, this round of monetary expansion is likely to ripple out into the economy much more quickly than the last one. In practice, it means that prices are likely to adjust with more money out in the system and the same amount of goods and services being produced. This is expected to create a nominal increase in prices. The items that will experience this price increase first will be those that are bought with cash and have a high transaction velocity. Treasuries, Stocks, Food, Energy, and Commodities are the first places where nominal price increases are likely to show up.
As time goes by, the nominal price inflation is expected to work its way throughout the economy. This is the intended purpose of quantitative easing, and one of its principal dangers. Actions by the Federal Reserve are being taken to stabilize nominal prices. If further weakness is seen in the price for things like real estate, there is a possibility that the Federal Reserve will take even more action to keep nominal prices stable. The problem comes when the nominal price of things like homes are held stable, but the price of things like food, energy, and other things that are considered ‘necessity’ items of life increase in value.
The likely output of such a scenario will be ‘real’ value decreases that are hidden behind ‘nominal’ price stability or even increases. When analyzing decisions for your personal and investing behavior, it is critically important to understand the importance of these monetary effects. There are many ‘doom and gloom’ proclamations floating around that anticipate a second recessionary dip for the economy. Our assessment of the situation is that the Federal Reserve will continue with its expansionary monetary policy for the express purpose of avoiding value contractions that would initiate a secondary recession.
The likely outcome of these decisions will be an extremely slow economic recovery as activity stops and starts in reaction to price signals. Increases in nominal prices will temporarily spur activity, but increases in key costs will subsequently dampen that additional activity. This see-saw action is likely to continue throughout the process of quantitative easing and for a considerable time afterward.
Practically speaking, this means that investors must be ready for considerable uncertainty over the next couple years. It also means that nominal price gains must be measured against the real purchasing power of the dollars that they are denominated in. Astute investors should seek opportunities to fix their cost of capital at today’s low rates and invest in assets that will have their nominal value carried upward by inflation.
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The Solomon Success Team
Flickr / DonkeyHotey
