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Review & Outlook
Quarterly Market Overview
Gordon B. Fowler, Jr.
President, Chief Executive Officer & Chief Investment Officer
The Federal Reserve and Money Printing—
Lessons of the 1930s and 1940s
“Inflation is always and everywhere a monetary phenomenon.”— Milton Friedman,
a noted economist, on the relationship between money supply and inflation.
“Everything reminds Milton Friedman of the money supply. Everything reminds me
of sex, but I try to keep it out of my papers." — Robert Solow, an equally noted economist.
Summary
• With greater frequency, clients are wondering if and when the Federal Reserve’s
extraordinary money printing will cause rampant inflation.
• A review of the past century provides interesting insights, particularly between 1933 and
the late 1940s when the Federal Reserve printed money at comparable levels to those
of the Bernanke Fed.
• Although inflation in the 1930s was subdued, eventually it went from 0.9 to more than
5 percent per year as consumer prices nearly doubled in the 40s.
• While this constitutes a significant level of inflation, it was still less than during the
inflationary 70s in the United States, and certainly not a hyperinflation.
• Perhaps somewhat counterintuitively, long-term interest rates never rose above 2.5
percent during the 30s.
• When inflation became a problem in the 40s, the Federal Reserve did not shrink the
balance sheet. If Chairman Bernanke does as he says to keep inflation in check, the
Federal Reserve will find itself traversing new ground.
Fast Money at the Fed
Since 2008, the Federal Reserve has stabilized the financial markets, forcing rates down by
buying Treasury and mortgage debt. As a result, assets held by the Federal Reserve have risen
fourfold. The Fed refers to this as “quantitative easing (QE),” but others see this as “printing
money.” Repeatedly, clients raise a question that offers a less-than-satisfying answer: How
has this extraordinary level of money printing not caused rampant inflation?
May 2013
Page 1
The Federal Reserve and Money Printing —
Lessons of the 1930s and 1940s
Exhibit 1: Federal Reserve Assets
$3,500
QE3
$3,000
QE2
$2,500
QE1
$ Billions
$2,000
$1,500
$1,000
$500
$0
2007
2008
2009
2010
2011
2012
2013
Source: Glenmede, FactSet
This essay means to provide insight to this question, comparing the recent decade with the
money-printing benders of the 1930s and 40s. We will use a question and answer format, first
explaining two basic concepts:
CONCEPT 1: WHY DOES PRINTING MONEY CAUSE INFLATION?
If the government increases the money supply, but the amount of goods and services stay
the same, prices should rise. Imagine, for example, a town where half the townspeople grow
food and the rest provide lodging, and $1,000 is split evenly between the two camps. Money
is traded between food growers and lodging providers in exchange for goods and services.
If suddenly another $1,000 inexplicably materialized, the townspeople would not in fact
become wealthier. People would produce the same amount of food and lodging, just at
double the prices.
CONCEPT 2: HOW DOES THE FEDERAL RESERVE PRINT MONEY?
The process is a bit more complex than turning a machine on and off. The Federal Reserve
doesn’t actually quicken or slow its printing presses. Instead, money supply can be increased
through government purchases of securities and commodities (gold). Where the rest of us
need to have money in our account to pay for goods by check, the Fed simply makes an
accounting entry in the ledger, thus essentially “manufacturing” the needed monies. The
rationale is that the people who sold securities to the Fed will deposit the money and the
banks will lend a multiple of the money deposited, creating demand. It should be noted that
owning a money tree in the backyard does not come without risk.
Q1. What happens when too much money is printed?
A. In theory and in general practice, inflation results. Poster children for excessive money printing include Germany’s Weimar Republic, Argentina on multiple occasions and Zimbabwe.
Each previously printed excessive amounts of money that resulted in hyperinflation.
May 2013
Page 2
Yet in the United States, where money printing continues, inflation has averaged only 1.8
percent per annum since the beginning of 2008, and is currently 1.9 percent on a trailing
12-month basis.
Q2. How has the U.S. avoided inflation?
A. Leadership at the Federal Reserve, along with many macro-economists, suggests
inflation hasn’t picked up due to lingering excess capacity from the downturn that began
in 2008. Businesses not yet operating at full capacity are unable to raise prices, while high
unemployment leaves workers unable to negotiate wage increases. These trends should
reverse once the nation gets back to work and economic activity picks up.
Q3. Will there be inflation once the economy returns to normal?
A. The Federal Reserve plans to prevent the onset of gross inflation by tipping the scales, either
by allowing purchased bonds to mature or by selling securities from the balance sheet. If all
goes according to plan, the Fed will have shrunk its balance sheet to normal and decreased
the supply of money, before inflation becomes a real problem.
Q4. Has the Federal Reserve ever done this before?
A. While we have been down this path before under strikingly similar conditions, the answer
is “not really.” Where the Fed of the 1930s and 40s stopped printing money, it never acted to
decrease the size of its balance sheet when the economy returned to higher activity. A follower
of monetarist Milton Freidman would argue that inflation in the 40s was the consequence.
The chart below shows the size of the Federal Reserve’s balance sheet since the beginning
of the last century. There is, of course, no comparison between the sizes of the balance sheet
today and 100 years ago. Unsurprisingly, both the U.S. economy and money supply are now
many times larger.
Exhibit 2: Federal Reserve Assets
10000
100
2013
2008
2003
1998
1988
1993
1978
1983
1968
1973
1958
1963
1948
1953
1938
1943
1928
1933
1
1918
10
1923
$ Billions
1000
Source: Glenmede, Federal Reserve Bank of St. Louis
May 2013
Page 3
The Federal Reserve and Money Printing —
Lessons of the 1930s and 1940s
The data becomes more interesting when the Fed’s balance sheet is scaled to the economy
or to gross domestic product (GDP). Through this lens, two distinct points crystallize where the
balance sheet peaks: the period from 1930 to 1950, and now.
Exhibit 3: Federal Reserve Balance Sheet
25%
% GDP
20%
15%
10%
5%
0%
1929 1935 1941 1947 1953 1959 1965 1971 1977 1983 1989 1995 2001 2007 2013
Source: Glenmede, Morgan Stanley
Q5. What led the Fed to “print” so much money in the 30s?
A. The Depression and World War II. On the heels of these events, two distinct actions greatly
expanded the Federal Reserve’s balance sheet. First, in 1934, the U.S. Treasury reset the price
at which it bought gold from $20.67 to $35 an ounce. Second, in the aftermath of this price
resetting, droves of foreigners (Europeans in particular) sold their gold to the United States.
Q6. Isn't buying gold a good thing? How does it count as either “printing money” or leading
to inflation?
A. For countries on the gold standard, inflation is a risk if the price at which a government buys
gold is too high. Let’s say our country buys gold at $35 an ounce and the Federal Reserve then changes policy and offers $1,000,000 an ounce. People of all nations would be incentivized
to sell their gold to the U.S. government, increasing the U.S. money supply (as was the case in
the 30s), and effectively, inflation.
May 2013
Page 4
Q7. Buying gold seems different from what Chairman Bernanke is doing with
quantitative easing.
A. Not really. Leading up to World War II, the Fed bought U.S. Treasury debt to finance the war
effort. By the end of the war, the Federal Reserve’s balance sheet was more than 8x its size
from the start of the Depression.
Exhibit 4: Federal Reserve Assets, Pre- and Post-Depression
$60
$50
$ Billions
$40
$30
$20
$10
$0
1928 1931 1934 1937 1940 1943 1946 1949 1952 1955 1958 1961
Source: Glenmede, Federal Reserve Bank of St. Louis
Q8. Didn’t that cause inflation?
A. Initially, no. From 1933 until 1940, prices were stable, only rising about 1 percent a year.
During the Depression, businesses were in no position to raise prices, and employees were
unable to seek higher wages.
Exhibit 5: Cumulative and Annual Growth: 1933 -1940
1933 -1940
Cumulative Growth
Annual Growth
Fed Reserve Balance Sheet
280%
18.2%
Nominal GDP
125%
10.6%
Real GDP
109%
9.6%
8%
0.9%
Consumer Price Index
Sources: Glenmede, Federal Reserve, FactSet
May 2013
Page 5
The Federal Reserve and Money Printing —
Lessons of the 1930s and 1940s
Q9. What happened when World War II started?
A. Here the story changes. As America prepared for World War II, and through the Korean
War, prices gyrated wildly as demand for goods and services shot up amidst shortages. The
government controlled inflation by instituting wage and price controls, maneuvers retracted
following World War II. Price gyrations continued through the Korean War and into the early
1950s. Over the period from 1940 to 1952, prices nearly doubled with inflation averaging 5.5
percent per annum.
Exhibit 6: Cumulative and Annual Growth: 1941-1952
1941-1952
Cumulative Growth
Annual Growth
Fed Reserve Balance Sheet
123%
6.9%
Nominal GDP
199%
9.6%
Real GDP
58%
3.9%
Consumer Price Index
89%
5.5%
Sources: Glenmede, Federal Reserve, FactSet
Q10. Did the money printing of this period lead to inflation?
A. This would seem a cut-and-dry discussion among economists but there is a fair amount
of debate. On one side, Milton Friedman and his supporters say money printing caused
inflation, while hard-core Keynesians downplay this notion. There is, however, one quite
important individual who believes the Federal Reserve’s money-printing both exacerbated
the Depression and caused the inflationary pressures of the 40s.
Exhibit 7: U.S. Annual Inflation Rates: 1926-1955
20
Annual Inflation Rates (%)
15
10
5
0
-5
-10
-15
26
28
30
32
34
36
38
40
42
44
46
48
50
52
54
Year
Sources: Glenmede Investment Research and Haver Analytics (CPI-U: All Items, 1982-84=100, Y/Y %Change)
May 2013
Page 6
Q11. Oh, pray tell, who is this person?
A. Federal Reserve Chairman Bernanke. He accepts Milton Friedman’s conclusion that
printing money can cause inflation. Friedman’s thesis, however, also asserts that a lack of
money creation from 1929 through 1932 transformed the 1929 stock market collapse from
a mild cyclical downturn to a wrenching depression.1 The argument suggests that by failing
to print money in the early stages of the downturn (1929 to 1932), a large number of banks
were allowed to fail. This led to the loss of uninsured deposits and ultimately, the collapse of
the credit markets. While economic downturns are inevitable and to a degree, even healthy,
permitting too large an economic hole can make the climb out unnecessarily painful.
Q12. Did Chairman Bernanke initiate quantitative easing programs to prevent another
depression?
A. From Bernanke’s perspective, yes. However, mindful of inflation, he has promised to reduce
the size of the Federal Reserve’s balance sheet, “un-printing money” once economic activity
picks up, unemployment drops below 6.5 percent and inflation becomes an issue.
Q13. Did the Federal Reserve balance sheet shrink in the 1940s as inflation rose?
A. If we refer to Exhibit 2, we see that while the Fed stopped growing the balance sheet
around 1950, the balance sheet never shrunk. The government worried that to shrink the
balance sheet would raise interest rates and put the country back into depression. In Exhibit
3, we see the size of the Federal Reserve’s balance sheet, as a percentage of GDP, shrunk to
pre-Depression levels by 1960 by virtue of the fact that prices and real GDP caught up.
Q14. So, while there is precedent for the Federal Reserve to “print money,” the agency has
never intentionally shrunk the balance sheet?
A. Bingo.
Q15. Does this suggest inflation is inevitable?
A. Inflation is a real risk. Our guess is that higher inflation in the 3-4 percent range is quite likely.
It is possible the Fed will even opt to tolerate some inflation.
Q16. What happens to interest rates in this scenario?
A. While it would be logical to assume interest rates would rise, history presents a surprisingly
different result. Rates were low between 1933 and 1952 and the long bond remained below
2.5 percent even though inflation averaged over 5 percent from 1941 to 1952. In theory, this
shouldn’t have happened.
1
A Monetary History of the United States, 1867 to 1960 by Milton Friedman and Anna Schwartz.
May 2013
Page 7
The Federal Reserve and Money Printing —
Lessons of the 1930s and 1940s
U.S. Long-Term Government Interest
Yields (%)
Exhibit 8: U.S. Long-Term Interest Rates: 1926-1960
5
4
3
2
1
0
26
28
30
32
34
36
38
40
42
44
46
48
50
52
54
56
58
60
Year
Sources: Glenmede Investment Research and Ibbotson Associates (U.S. Long-Term Government Yield %)
Q17. How did the Fed manage low rates amidst high inflation?
A. During this period, prices were extremely volatile — substantially increasing one year and
then, on occasion, staying flat or decreasing. Investors may have seen inflation not as a
permanent phenomenon but as a transitory shock that, over the long run, would average to
a low number. That was certainly the case in the 1930s.
Exhibit 9: U.S. Annual Inflation Rates: 1926-1955
20
Annual Inflation Rates (%)
15
10
5
0
-5
-10
-15
26
28
30
32
34
36
38
40
42
44
46
48
50
52
54
Year
Source: Glenmede, Haver Analytics
May 2013
Page 8
Q18. Did investors also prefer bonds over stocks during this period? Didn’t the Depressionera version of Jon Stewart — Will Rogers — say he was more interested in the return OF capital
than the return ON capital?2
A. With the stock market crashes of the Depression a fresh memory, investors willingly accepted
a rate of return below inflation just to be assured of the safety of their principal.
Q19. Is investor sentiment similar today?
A. In some ways, it is. While inflation is low at around 2 percent and money markets yields are
close to zero, U.S. cash balances are quite high. Holding long-maturity fixed income would
not make sense given plunging yields. Yet with history as a guide, we may be shocked by how
long it takes for yields to rise despite rising inflation.
Q20. Let me summarize what I have heard so far:
1. The Federal Reserve “printed” comparable money levels during the 1930s and 40s.
2. Although initially subdued, inflation eventually became very high (about 5 percent per
annum). Notwithstanding this, we avoided Argentinian-style hyperinflation and interest
rates remained low.
3. When economic activity returned to normal in the 1940s, the Federal Reserve did not act
to shrink the balance sheet. If Chairman Bernanke does as he says, the Federal Reserve will
pursue an untested path.
A. I think you have it.
Q21. Aren’t there other material differences between the 1940s and today that we
haven’t discussed?
A. Sure, back in the 30s and 40s, military conflict was widespread and the global balance of
power in flux; the U.S. fiscal deficit was huge; Wall Street was held responsible for the collapse
of the economy, which led Congress to pass a massive and confusing piece of financial
regulation; U.S. states and localities were on the verge of bankruptcy and America’s president
was considered a socialist by his opponents.
2
Actually, I cannot find a place where this quote is actually attributed to Will Rogers. There are in fact numerous people who would argue
that this quote has been misattributed.
May 2013
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The Federal Reserve and Money Printing —
Lessons of the 1930s and 1940s
Q22. Oh, come now. Remove your tongue from your cheek. There are real
differences, right?
A. Yes, foreigners today own more of our debt, which potentially lessens our control of interest
rate policy and makes rising rates a greater possibility. We are running massive deficits fueled
by entitlement spending growth that will not naturally recede as war spending had and
which may eventually impact the creditworthiness of the U.S. Population growth, a significant
contributor to economic growth, is slowing and the economic effect of global warming
introduces potential uncertainty.
These harsh realities aside, emerging markets present a tremendous opportunity, there is
a steady stream of new technologies and there are a growing number of nations with a
shared interest in maintaining peace and stability. In the U.S., there is sizeable opportunity for
increased productivity in two parts of the economy with meaningful price inflation: healthcare
and higher education.
Q23. What does all of this mean for my portfolio?
A. This analysis of history does not change our approach to portfolio strategy. However, it
provides directional insight into the timing of inevitable moves in inflation and interest rates.
At some point, “money printing” will cause inflation if the Fed doesn’t act. But even if the Fed
doesn’t act, inflation may only reach the mid-single-digits and not the stratospheres of the
mid-70s.
For holders of fixed-income securities, any rise in inflation is not good. In the best-case scenario,
even a mid-single-digit rise could lead to negative real yields. At relatively low inflation of 2
percent, for example, many Treasury bonds would offer zero or even negative yields. Those
awaiting a rate spike may find it takes longer for this to occur than anticipated.
The story is different for equities. This asset class more easily handles inflation as companies
can pass the burden to consumers through price increases. In fact, an environment of low real
yields is quite good for the equity market, particularly for undervalued areas like international
developed and emerging markets. It also benefits other risk assets such as bank loans and
high-yield debt. These investments are not without volatility but as policymakers struggle
to reduce government deficits, we advocate building in risk controls through nonstandard
strategies such as option overlays and absolute return or foreign debt instruments.
At some point, real yields — bond yields less inflation — will rise, although the precise timing is
uncertain. As we just reviewed, rates did not rise in the 50s following the inflationary 40s. When
real yields rise, equities suffer as investors revalue assets to lower multiples. If history repeats
itself, we would be spared rising real yields for another 25 to 30 years (assuming the present
May 2013
Page 10
period is analogous to 1940s). However, due to the lack of fiscal rectitude demonstrated by
our federal government, an inflationary environment could come sooner than later. Indebted
countries dependent on foreigners to fund their debt run a real risk of incurring higher real
rates. For now, we are not at this point. Federal debt as a percent of GDP remains well below
100 percent, a stark contrast to the more profligate southern European countries. Hence, the
environment for equities, while volatile, is OK.
Let me close by noting that in such environments, interesting ideas often can be found in
the private markets. These investments are not for everyone given the minimum capital
requirements and potential lock-up periods. For those interested we emphasize three themes:
1. Identify opportunities caused by market dislocation. Acquire secondary interests in
private equity funds, capitalizing on market dislocations caused by regulatory and
/or funding pressures. Invest in funds well-positioned to acquire distressed assets at
attractive prices.
2. Sell up the food chain. Invest in funds able to buy and build companies that will be
attractive to larger buyers with plentiful liquidity. Examples are lower-middle-market
buyout, midstream energy and real estate secondaries (attractive properties versus
REITS).
3. Evaluate non-correlated investments. Identify strategies where returns do not primarily
depend on the state of the financial markets. For example, invest in retro-reinsurance
in the property and casualty market or in drug patents.
Q24. Will history really repeat itself?
A. Although we believe the answer is “no,” our history is an inevitable part of understanding
the future. Investors, however, may be paying a little too much attention to the wrong history.
The most scarring event investors have lived through was the inflationary 70s, whereas the
Depression and inflationary 40s escape popular memory. While there are vast differences
between now and the Depression era, our current environment and markets have unfolded
far more closely to these faraway times than the economy and markets of the 1970s.
May 2013
Page 11
Review & Outlook
Quarterly Market Overview
Review & Outlook is intended to be an unconstrained review of issues, topics and considerations of possible interest to Glenmede's clients
and is not intended to be applicable to any one particular client. Actual investment decisions for particular clients are made in light of
applicable considerations and may be different from the views expressed here. Likewise, actual portfolio performance may differ from
the results discussed. Clients are encouraged to discuss the applicability of any topic or view contained in any Glenmede publication,
especially Review & Outlook, with their Glenmede representative.