The US Federal Reserve balance sheet is expanding at an unprecedented pace.
If investors thought 2008-2018 was extraordinary enough due to a decade of near-zero Fed fund / interest rates, the last 3 months can only be described as absolutely absurd.
This chart shows the Fed’s balance sheet in trillions of USD:
In <6 months, the Fed expanded the balance sheet by ~$3 trillion (from $4 trillion to $7 trillion).
The $3 trillion before that took 10 years to accumulate (from $1 trillion in 2008 to $4 trillion by end of 2018).
While the US economy has expanded since 2008, the Fed balance sheet is still materially larger even if we look at it as a % of GDP:
It’s no wonder that media and investors around the world are concerned for the future of the USD as a reserve currency and the stability of our financial system. (On USD as a reserve currency, please also see this recent post on why USD reserve currency status is stronger than people think).
These concerns are extremely widespread.
For example, here’s USA Today:
In its frantic scramble to save the American economy, the central bank of the United States seems to have the ultimate superpower.
It works like magic. With a few strokes on a computer, the Federal Reserve can create dollars out of nothing, virtually “printing” money and injecting it into the commercial banking system, much like an electronic deposit.By the end of the year, the Fed is projected to have purchased $3.5 trillion in government securities with these newly created dollars, one of many tools it is using to help prop up the ailing economy during the COVID-19 pandemic, according to Oxford Economics.
“The way you and I have checking accounts in our banks, that’s how all these other banks have accounts at the Fed,” said Pavlina Tcherneva, an economist at Bard College in New York. “All the Fed does is literally credit them. They just type it in.”Source: USA Today
Here’s another example from the New York Times:
The Fed’s Message: The Money-Printing Presses Are Fired Up and Ready to GoSource: NYT
And, here’s Bloomberg (the publication, not the person):
Pandemic Bills Are So Big That Only Money-Printing Can Pay ThemSource: Bloomberg
And, of course, here’s China’s own media amplifying the consensus view that the Fed is absolutely reckless:
The Federal Reserve always opts to stave off economic downturns and contractions by printing large sums of money, even though it may cause a global inflation problem and leave the world to shoulder its crisis-handling costs.Source: Global Times
The view that the Fed is printing money is not only consensus, there’s actually almost no debate at all about what is presumably a fact. The consensus’ conclusion is that the US is heading for financial ruin with hyperinflation coming and the loss of reserve currency status.
Despite how important and consequential the Fed and its actions are to the functioning of world financial markets, the consensus understanding of the Fed’s actions are, surprisingly, (very likely) incorrect.
And because the consensus understanding of the Fed is incorrect, not only are calls for hyperinflation unlikely to be realized, investors are likely misallocating capital across asset classes.
To understand why, we need to understand the Fed’s actions at a micro level…but before we examine the real world situation, it helps to to start with a simplified example…
If the US was a Desert Island…
Imagine the US is just a small desert island with only two people on it. We’ll call them Apple and Orange.
Apple owns an apple juice stand that charges $1 for a cup of juice.
Orange is fairly wealthy and is a loyal customer of Apple. Orange buys a cup of apple juice every day.
While Orange is wealthy, Orange doesn’t usually like to keep cash under the mattress for safety reasons (and because Orange is pretty savvy with money and understands that investing it produces better results over time)…most of Orange’s money is invested in bonds, stocks, and real estate in the form of 2 sandy beaches / beach houses on the small island.
Orange doesn’t usually have to touch his bonds, stocks, or real estate in order to support his luxurious lifestyle of having a daily cup of hand-squeezed apple juice because Apple is actually a tenant at one of his properties and pays Orange $1 a day in the form of rent.
This economy functions pretty well – Orange pays Apple $1 in the morning for a cup of juice, and Apple pays Orange $1 in the evening to stay at the beach house.
One day, a mysterious virus was unexpectedly discovered on the island. For sanitary reasons, the island government (composed of just Apple and Orange) decided that it would be unsafe for Orange to rent out his beach house to any guests. Apple, unfortunately, was forced to spend the night under a palm tree.
While this in and of itself was not particularly disruptive, the island economy almost immediately seized up. Since Apple did not stay at Orange’s beach house, Orange did not receive $1 of rent. Without that $1 of rent, Orange could not buy Apple’s juice the next morning. With no customers, Apple was suddenly faced with potential business closure.
Apple went to Orange and pleaded for him to buy a cup of juice because Orange is rich. He needs to support the economy.
Orange empathized with Apple, but, unfortunately, while Orange is rich, all of his money is illiquid in the form of bonds, stocks, and real estate. He is rich, but has no money!
Very quickly, the economy seemed doomed and was likely spiraling into a great depression. This was puzzling because Orange actually has “money”…but not really!
The island government quickly convened to come up with a solution. The economy needs more liquidity – Orange needs a way to convert his bonds, stocks, and real estate into cash so that he can spend, again.
The island government decided to print a new $1 bill. Initially, it was very tempting to just give the $1 to Apple or Orange. However, both Apple and Orange could vaguely remember the Econ 101 class they took years ago before getting stranded on the desert island. In that class, they learned about supply and demand and understood that if they just printed new money and gave it to people, there would likely be a lot of inflation. That $1 cup of Apple juice will likely soon cost $2 instead, once things get going again.
After printing this new $1 bill, the island government decided that the best course of action would be to transfer it to Orange in exchange for $1’s worth of bonds held by Orange. This way, Orange can access his money and spend, again, but without doing anything too crazy like just giving everyone free money.
After receiving the $1 worth of bonds, the island government also decided to just lock it up in a vault and never actually give it away unless someone pays them $1 back for it.
The next day, the economy was back on track! Orange had a $1 bill that he could spend at Apple’s juice stand, again. He had to give up $1 worth of bonds, but that seemed like a fair exchange. $1 bill for $1 bond. And he gets to go back to satisfying his daily craving for apple juice…
Did the island government “print” money? Yes.
Did the total “money” on the island expand? I think you’ll agree with me that the answer is no. The money on the island did NOT expand ($1 went into the economy in the form of a new $1 bill but $1 worth of bonds was taken out of the economy as well). The money on the island was unchanged, but the liquidity increased.
What Actually Happens when the Fed “Prints Money”
Hopefully the example above was simple enough to understand.
In effect, the US Fed did exactly that over the last few months. The Fed “printed” a lot of new money.
But the Fed didn’t just give that money away.
The Fed bought treasuries / bonds and some stocks as well.
No one got free money from the Fed. People had to give the Fed treasuries / bonds and stocks in exchange for liquidity.
Well that seems like a different story than what the media is suggesting…is it true?
Didn’t Fed Chairman Powell say that he’s printing money in a recent 60 Minutes interview?
PELLEY: Fair to say you simply flooded the system with money?
POWELL: Yes. We did. That’s another way to think about it. We did.
PELLEY: Where does it come from? Do you just print it?
POWELL: We print it digitally. So as a central bank, we have the ability to create money digitally. And we do that by buying Treasury Bills or bonds for other government guaranteed securities. And that actually increases the money supply. We also print actual currency and we distribute that through the Federal Reserve banks.Source: CNBC / 60 Minutes
So how do you explain that, Capital Flywheels?
Well, the funny thing is that the media and many investors (seemingly) haven’t bothered to look up what the Federal Reserve defines as money or money supply (or, if they have looked it up, seemingly don’t understand the definition).
To save you some time looking it up, here’s what Powell thinks he is saying when he talks about money and money supply:
What is the money supply? Is it important?
The money supply is the total amount of money—cash, coins, and balances in bank accounts—in circulation.
The money supply is commonly defined to be a group of safe assets that households and businesses can use to make payments or to hold as short-term investments. For example, U.S. currency and balances held in checking accounts and savings accounts are included in many measures of the money supply.Source: Federal Reserve
So money, according to the Federal Reserve is ONLY cash and bank balances.
According to the Federal Reserve, bonds, stocks, real estate, jewelry, bitcoins, collectible cards, gold and a host of other things that at least some people would consider as “money” is not money at all.
Has money, as defined by the Federal Reserve, increased by an ungodly sum in the last 6 months? Yes! More than $3 trillion!
Has money as normal people would define it increased by an ungodly sum in the last 6 months? Capital Flywheels believes the answer should be unequivocally, “No”! While liquidity has expanded, the Federal Reserve also removed “money” in the form of bonds and stocks from the economy and locked it away in a vault with the promise of never releasing it back to the economy again unless someone pays them back in the equivalent amount of dollar bills.
When Powell says he’s printing money, he’s not saying what people think he’s saying.
Prove It / And What Real “Money Printing” Would Actually Look Like.
In the Federal Reserve’s own words:
The New York Fed purchases Treasury securities as directed by the Federal Open Market Committee (FOMC). These purchases are conducted in the secondary market for Treasury securities.Source: Federal Reserve
The key word is secondary market. In laymen terms, this means buying from investors that already own the treasuries, not from the creator of the treasuries (US Treasury).
The Fed has been printing a lot of money for investors, but investors need to give the Fed an equivalent amount of treasuries in exchange for the money.
Has total “money” of the economy expanded? No.
What would actual money printing look like?
If the Fed were truly “printing money”, investors would get the money without having to exchange something of equivalent value for it.
Another way the Fed could truly “print money” is if it gave the US Treasury money directly. For example, the US Treasury could issue new treasuries and the Fed would print money and buy it directly from the US Treasury.
Why is buying treasuries directly from the US Treasury different from buying treasuries from investors?
Because there is money creation on BOTH sides of the equation. The US Treasury created money in the form of treasuries AND the Federal Reserve paid for it by printing money.
When the Federal Reserve buys treasuries from investors, the investors did NOT create the treasuries. There is no money creation. Instead, the US Treasury created the treasuries, but the investors previously paid for it with real hard-earned cash (not silly money printed in a printing press).
This is an incredibly important nuance that the media and seemingly many well-respected investors do not (or prefer not to) understand.
What This Means for Capital Allocation.
The main concern with money printing is potential inflation.
If money increases while the supply of goods is unchanged, there will be more “money” for each unit of good available.
This means that, over time, the cost of goods will need to rise in order to absorb the extra money floating around.
Given how many investors believe that the money supply is expanding uncontrollably over the last 10 years, inflation hedges like gold have been popular investment vehicles.
However, there’s been no inflation! In fact, the US government is having a very hard time even getting inflation to what would be considered normal (2-3% per year).
And, inflation hedges like gold have been very average investments despite what seems like an uncontrollable expansion of money supply.
Here’s what gold has done in 10 years:
And it all comes down to the misunderstanding of reality: Liquidity has increased, but money hasn’t actually increased all that much.
In fact the world is almost constantly running out of USD. The demand for USD around the world (due to its position as a reserve currency) is actually leading to a shortage of USD, not an excess…
This is most clearly visible in the strength of the USD. The USD has unequivocally strengthened since 2008, despite significant “money printing” as the media wants you to believe.
It has strengthened despite all that new “money”:
It has strengthened despite treasury bond yields declining to almost nothing:
But, according to the media, there is inflation! It’s asset inflation!
Now that is a true statement.
But why is it that only assets are seeing inflation whereas we have no inflation anywhere else?
This is because the media and investors, again, misunderstand what is going on.
Assets (bonds, stocks, real estate, bitcoin, etc) are seeing prices go up NOT because we are printing so much money that we are on the verge of hyperinflation…asset prices are going up because the Fed has reduced the supply of assets, NOT because they have increased the supply of money.
In exchange for liquidity, the Fed has REMOVED bonds, stocks, and mortgage assets from the economy. Trillions and trillions of dollars worth of bonds, stocks, and mortgages are no longer circulating in the economy. But investors still want those things! Hence the price is going up.
But make no mistake, the price of bonds, stocks, and mortgages is not going up because the Fed is creating hyperinflation, but because it has removed the supply of those things.
What does this mean for capital allocation? It means that investors are right to NOT fight the Fed and buy what the Fed is buying.
But Capital Flywheels believes it is a fool’s errand to assume hyperinflation is coming…Capital Flywheels also believes it is a fool’s errand to get out of equities and buy gold or other inflation hedges.
This does not mean that there can’t be hyperinflation in the future…that could happen very quickly if the Fed decides to buy treasuries directly from the US Treasury (the true definition of fiscal monetization). But until that happens, Capital Flywheels’ believes investors waiting for inflation will be continually frustrated.
The right course of action is not to buy gold, but to buy bonds, stocks, and mortgages / real estate. And the best thing to buy is anything that benefits from secular growth forces in any of those asset classes.