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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 Page 9 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.