Myth busting: printing money must lead to inflation


London is ranked ninth in the UBS Global Real Estate Bubble Index for residential real estate. As in many other countries, property prices in the UK hit an all-time high in 2020. A global pandemic with sudden mass unemployment should have forced UK citizens to sell their homes, but furlough policies, stamp duty holidays, and record-low interest rates more than balance that out.

A two-bedroom apartment of 1,000 square feet of living space in a posh neighborhood like Hampstead in northwest London costs around £1.5 million. The rent is around £3,000 per month, which equates to a gross rental yield of 2.4%. After you factor in maintenance and taxes, it’s like 1.7%. Many of the homes in that area are over a century old and need lots of love.

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While this low return may seem unattractive to buy-to-let owners, it has been much worse for most of the past decade when the cost of financing was higher than the rental yield. Buyers were only betting on higher prices and willing to accept negative cash flow during the investment period.

Now, thanks to COVID-19 and the Bank of England (BOE), financing costs are lower than rental income, and real estate investors are cash flow positive. For those considering buying a property for their own use, paying interest and amortization is now often cheaper than renting. What a strange world.

But buying an apartment in neighborhoods like Hampstead tends to require at least 25% equity as banks have become more conservative since the Global Financial Crisis (GFC). If the potential buyer is successful enough to save up nearly hundreds of thousands of pounds for the down payment, they will eventually still need to repay the £1.1m loan. From a pre-tax perspective, that’s roughly twice the amount of money that needs to be earned.

Some potential buyers actively bet on inflation to help reduce the debt burden over time. The theory is that all monetary and fiscal policies of the past decade will lead to higher inflation. Real income and asset valuations should increase along with inflation, but the loan amount stays the same and erodes in real terms.

Is this what real estate speculators want, or does the data support this theory?

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Expanding the central bank’s balance sheet

Central banks are often credited with saving the world with aggressive monetary stimulus during the GFC in 2008. But the crisis is more than a decade behind and the same basic policies remain. Central bank balance sheets continue to expand. In countries like Germany, this continuous printing of money is viewed with pure horror given its association with the hyperinflation in the Weimar Republic in the 1920s.

With the COVID-19 crisis, central banks have pushed their money printing to a higher level. The balance sheet of the US Federal Reserve has exceeded $7 trillion, which is the equivalent of €7 trillion for the European Central Bank. Central banks seem to have chained themselves to the public markets and feel compelled to step in every time stocks drop significantly.

The abnormal consequences of this behavior are becoming more apparent. For example, the Bank of Japan (BOJ) owns over 75% of the exchange-traded funds (ETFs) out there.

Expanding the central bank’s balance sheet

Graph Showing The Expansion Of A Central Bank'S Balance Sheet
Sources: FRED, Bank of England (BOE), FactorResearch

money supply

There are different metrics for measuring the money supply. M1 represents all physical money in circulation, whether in cash or in checking accounts, and has been trending downward in the United States, Europe, the United Kingdom, and Japan since the 1980s.

None of the monetary incentives introduced since 2009 has affected money circulation. This is true even with broader money supply measures such as M2 or M3 which include savings deposits and money market mutual funds.

In 2020, the US government issued COVID-19 stimulus checks which greatly impacted M1 by significantly increasing cash in circulation. The UK and EU governments responded differently and did not issue direct cash payments to their citizens, so the M1 in these countries remained the same.

M1 money supply increases

Graph Showing The Increase In M1 Money Supply
Sources: FRED, Bank of England (BOE), FactorResearch
The change represents 10-year rolling returns.

Central bank expansion, money supply and inflation in Japan

Japan offers compelling insights into the relationship between central bank balance sheets, money supply, and inflation. The Japanese government and central bank have been at the forefront of experimenting with monetary policy since the Japanese economy slumped in the 1990s after epic bubbles in stocks and real estate.

Today, the Japanese economy is battling demographic headwinds, but the goals of the government and central bank have remained the same: to create moderate inflation and positive economic growth.

After calculating the 10-year rolling returns for the central bank balance sheet, M1 money supply, and inflation, we have three observations:

  1. The Bank of Japan’s balance sheet has increased by multiples since 2008.
  2. Central bank activity has had little effect on the money supply or inflation.
  3. Inflation and money supply have been highly correlated sometimes, but not always.

Intuitively, inflation should follow the money supply. The more money that circulates in the economy, the greater the demand for products and services, which leads to higher prices. However, economics is made up of many intervening variables and linear models often fail to represent reality.

Central Bank Expansion, Money Supply, and Inflation: Japan

Graph Showing Central Bank Expansion, Money Supply, And Inflation: Japan
Sources: FRED, FactorResearch.
The pivots show 10-year graded returns.

Central bank expansion, money supply, and inflation in the United States

The same three economic variables in the US show the same increase in the central bank’s balance sheet as in other markets and only muted effects on money supply and inflation. Moreover, inflation can occur without meaningful changes in the money supply, for example, during the oil crisis of the 1970s.

Some investors are betting that inflation will follow a sharp rise in the money supply in 2020. While this is possible, the money supply has been increasing for more than a decade, but inflation has consistently fallen over the same time period.

Central Bank Expansion, Money Supply, and Inflation: United States

Central Bank Expansion Money Supply And Inflation United States Smaart Company Accounting, Tax, &Amp; Insurance Services Smaart Company Accounting, Tax, &Amp; Insurance Services
Sources: FRED, FactorResearch.
The pivots show 10-year graded returns.

Central bank expansion, money supply and inflation in the United Kingdom

The Bank of England contains a time series that goes back to before the Middle Ages. It’s for Eldorado For economists and financial data buffs.

UK data highlights a strong positive relationship between the Bank of England’s balance sheet, money supply, and inflation between 1947 and 1995. But then, the relationships broke down. Money supply and inflation still moved in tandem, but central bank activity seemed largely irrelevant.

We are not economists and do not know why these relations have changed. It may be due to the type of activity of the central bank. Central bank activities may have been directly related to the money supply while modern policies focus more on influencing financial markets.

Central Bank Expansion, Money Supply, and Inflation: United Kingdom

Graph Showing Central Bank Expansion, Money Supply And Inflation: United Kingdom
Sources: Bank of England (BOE), FactorResearch
The pivots show 10-year graded returns.

More ideas

A similar analysis of the eurozone reflects the same trend: money printing by the central bank is largely unrelated to money supply and inflation.

Given their usual mandate to create moderate inflation, powerful central banks seem utterly helpless. Or they are simply fighting forces they cannot overcome: negative demographics and negative productivity growth that contribute to lower economic growth.

Should investors worry about mass money printing by central banks? certainly. It has distorted financial markets and inflated prices across asset classes. But perhaps this simply leads to lower future returns rather than higher inflation.

However, if more direct financial or monetary incentives are introduced on an ongoing basis, investors may have more reason to worry. History shows that this is a recipe for disaster for tenants and landlords alike.

For more ideas from Nicolas Rabener and the FactorResearch team, sign up for our email newsletter.

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All posts are the opinion of the author. As such, it should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of the CFA Institute or the author’s employer.

Photo credit: © Getty Images / M_D_A

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