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farmer
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### a quick explanation of QE and inflation

Suppose we have two borrowers. Borrower A has been in business for 50 years. Borrower A has an excellent credit rating. Borrower A's business is growing at 0%. Borrower A wants to fine-tune leverage to maximize shareholder value. Borrower B has been in business for 5 years, and has been growing at 50% a year. He has been expanding capacity. Borrower B is a chancy business, but he wants to borrow to expand capacity.Borrower A wants to lock in low interest at a 50-year maturity. Borrower B is willing to pay higher interest, and borrow with a five-year maturity. Borrower A has survived an economic downturn. Borrower B is more of a risk of default if the economy goes sour. But if the economy expands, his business should continue to expand, and he does not mind having to refinance, or even borrow more at a higher rate.Under normal circumstances, nobody would lend to borrower A. Because if interest rates go up, investors will take huge losses on their low-coupon bonds. Under normal circumstances, people would want to lend to and invest in borrower B. Because he provides a higher return, and they can reinvest their money at higher rates. Under normal circumstances, Borrower B would provide the highest expected future returns.But if the Federal Reserve promises to hold interest rates low, Borrower A becomes relatively more attractive. The promise of Borrower B, to pay off his loan and refinance at a higher rate, becomes less interesting. The ability of Borrower B to shoulder interest rate risk, so that you don't have to, becomes less attractive. If the Federal Reserve promises to hold interest rates low, and manipulates long-term interest rates down, you will be better able to capture economic growth as an equity holder in Borrower A.If the Federal Reserve promises to prop up real estate and goods prices, Borrower A's stable business model becomes more attractive relative to Borrower B. Borrower B's fortunes will rise or fall faster, if he can just get a building for cheap, or buy an input for cheap. Borrower A has already purchased and built infrastructure, so borrower A will do worse if basic prices are allowed to fall. Borrower B will benefit from lower prices in basic inputs, as a cost of his new goods. Borrower A will benefit from higher prices for his existing assets and production lines.So when the Federal Reserve manipulates long-term interest rates to prop up home prices, more capital is allocated to Borrower A than to Borrower B. So does Borrower A use that money to grow and expand, then borrow more, and grow and expand and buy more? No. Whereas if Borrower B used the same capital, he would use it to invest in something that would grow, and borrow and spend more each successive year. So by holding down long-term interest rates, the Fed makes it relatively more favorable to lend to businesses that will not engage in a self-perpetuating cycle of borrowing, spending, and expansion.The people who borrow money under QE do not expand, borrow more, spend more, and create inflation. The people who would borrow more under interest rate uncertainty, and discount/firesale asset prices, would quickly recycle that money through growth, and drive the cheap prices up in a sustaining cycle. So inflation trends sideways under QE, and would trend up under interest-rate and price uncertainty.

farmer
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Posts: 13479
Joined: December 16th, 2002, 7:09 am

### a quick explanation of QE and inflation

QuoteNobody really understands gold prices and I don't pretend to understand them eitherI can explain it to you, Ben. Gold prices were helped by specific demand, and general commodities demand, in developing economies. Then you started your "quantitative easing" and people expected, as you did, that this would lead to a pickup in inflation. So they bought gold as a hedge and for speculation.But soon enough, people who pay a price for being wrong realized QE was ending. And it would not and did not cause inflation. Inflation did not even get back to its long term trend, much less surpass it.They realized they were wrong about QE causing inflation, and dumped gold in a hurry. Meanwhile, thanks to your independence, and freedom from having your performance measured against any kind of benchmark, you continued to live in this cloud of nonsense where QE causes inflation. So yes, you are free to not learn what everybody else has learned.How come is it, that every time we see inflation lying dead on the floor, QE is whistling down the sidewalk dressed in a cop disguise? Ever wonder? Or do you just like to be surprised over and over?Even Bullard and Fisher have learned from observing the world around them, that QE does not seem to be putting us at risk of inflation any time soon. But despite having written a term paper on the subject in 10th grade, the big guy can't figure it out, making him one of the worse forecasters in the room.

farmer
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Posts: 13479
Joined: December 16th, 2002, 7:09 am

### a quick explanation of QE and inflation

Last edited by farmer on July 31st, 2013, 10:00 pm, edited 1 time in total.

farmer
Topic Author
Posts: 13479
Joined: December 16th, 2002, 7:09 am

### a quick explanation of QE and inflation

QuoteFeb 18, 2013 - TOKYO, Feb 19 (Reuters) - Yields on five-year Japanese government bonds hit a record low of 0.130 percent on Tuesday, after Bank of Japan ...QuoteApr 1, 2013 - Tankan Large All Industry Capex in at -2.0%, far below expectations at +5.0% and a prior read of +6.8%.QuoteApr 5, 2013 - TOKYO, April 5 (Reuters) - Yields on benchmark 10-yearJapanese government bonds rebounded sharply from record lows on Friday as ...QuoteApr 7, 2013 - Japanese Finance Ministry Warns Surge In JGB Volatility May Lead... QuoteMay 10, 2013 - Japanese Government Bonds Halted Limit Down; Yields SpikeQuoteMay 19, 2013 - Toyota Pulls Bond Deal Due To Soaring YieldsQuoteJune 4, 2013 - Naohiko Baba - Goldman Sachs - One of the main focuses for overseas equity investors since late May has been the JGB market... Our conclusion is that the positive market reaction initially created by the policy has been almost completely undone. At the same time, a lack of credible forward guidance for policy duration means that five-year JGB yields have risen in comparison with before the easing started, and volatility has also increased. It will not be an easy task to completely rebuild confidence in the BOJ among overseas investorsQuoteJune 30, 2012 - Japan Q2 Tankan Large All Industry Capex up 5.5% vs. -2% previous
Last edited by farmer on July 31st, 2013, 10:00 pm, edited 1 time in total.

gardener3
Posts: 1496
Joined: April 5th, 2004, 3:25 pm

### a quick explanation of QE and inflation

gardener3
Posts: 1496
Joined: April 5th, 2004, 3:25 pm

### a quick explanation of QE and inflation

QuoteOriginally posted by: farmerQuoteNobody really understands gold prices and I don't pretend to understand them eitherI can explain it to you, Ben. Gold prices were helped by specific demand, and general commodities demand, in developing economies. Then you started your "quantitative easing" and people expected, as you did, that this would lead to a pickup in inflation. So they bought gold as a hedge and for speculation.But soon enough, people who pay a price for being wrong realized QE was ending. And it would not and did not cause inflation. Inflation did not even get back to its long term trend, much less surpass it.They realized they were wrong about QE causing inflation, and dumped gold in a hurry. Meanwhile, thanks to your independence, and freedom from having your performance measured against any kind of benchmark, you continued to live in this cloud of nonsense where QE causes inflation. So yes, you are free to not learn what everybody else has learned.If gold prices increased because of expected inflation, why hasn't this shown up in TIPS or treasuries? A better argument would be that gold increased because of an increase in the tail risk of a collapse. But you don't see this increase in skew in options on treasuries. Btw, you can't say that QE had no impact on inflation without knowing the counter-factual. You have to look at changes in expectations or do an event study (http://www.kellogg.northwestern.edu/fac ... gs2012.pdf)

farmer
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Posts: 13479
Joined: December 16th, 2002, 7:09 am

### a quick explanation of QE and inflation

QuoteOriginally posted by: gardener3If gold prices increased because of expected inflation, why hasn't this shown up in TIPS or treasuries.There is no arbitrage between gold and TIPS. TIPS have overstated realized inflation. So TIPS have shown expected inflation that did not materialize. There is arbitrage between QE and treasuries and TIPS.And yes, every idiot and his uncle shorted treasuries for years, until they learned that there were no borrowers coming in behind, because QE does not cause inflation.

farmer
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Posts: 13479
Joined: December 16th, 2002, 7:09 am

### a quick explanation of QE and inflation

QuoteOriginally posted by: gardener3Unless you borrow to sit on cash, borrowing will lead to money creation and inflation. Although there have been few instances of firms with loads of cash borrowing long (like google), it makes no sense unless you have good investment opportunities. I would think that lower yields, flatter yield curve, and lower spreads should help small growth firms. I don't know the answer, but should be pretty easy to test. Just look at the returns of small growth firms during these periods.Don't be silly. If people have competing investment opportunities, they will allocate money to different investments until all returns are equal. But the market rate of return will be lower under low, manipulated interest rates.Consider that active managers and indexers perform exactly the same, because taken collectively, each group holds an identical portfolio. You could point out that indexers who don't spend on research actually do better than the active managers. But the market rate of return would drop to -100% if you dropped research costs to 0, and just bought the 501st stock when its market cap rose above the 500th.I am not talking about a concept where people are surprised, I am talking about a simplified model where all investors have perfect knowledge and behave rationally. Except the Fed.The Fed is willing to take a loss by shouldering interest-rate risk, because they don't have to make money. This causes low-growth companies to be priced irrationally relative to high-growth companies. More specifically, it causes low-growth economic activities to be priced irrationally relative to high-growth activities. It makes companies that cannot afford interest rate risk relatively more attractive compared to those that can, and causes money to be allocated toward those companies and activities until the returns are equal again, given that the Fed is willing to take a loss to subsidize the low-growth ones.Yes, the S&P 500 has outperformed the Russell 2000 lately. But that is an unnecessarily complicated and indirect way to look at this. Because it assumes an adjustment period, where QE was introduced. I don't see why looking at the absolute level of growth, between one period and another, is not simpler and equally valid. The investments should perform equally, but only after more capital is allocated to one and away from the other. And that equal performance should be lower than the alternative optimum without QE.

farmer
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Posts: 13479
Joined: December 16th, 2002, 7:09 am

### a quick explanation of QE and inflation

Last edited by farmer on July 31st, 2013, 10:00 pm, edited 1 time in total.

farmer
Topic Author
Posts: 13479
Joined: December 16th, 2002, 7:09 am

### a quick explanation of QE and inflation

QuoteOriginally posted by: gardener3You have to look at changes in expectations or do an event study (http://www.kellogg.northwestern.edu/fac ... gs2012.pdf)I could do a similar study, to see if stealing food causes people to be fat. I might find two things, 1) the people I give the food to get fat, and 2) the overall price of food drops. Because the people I give it to are paying zero, and the people I steal it from start just buying rice, since they know whatever they buy will get stolen anyway.The amount available to steal will go down each period, as people migrate into the recipient population. The total food consumed might go up on the first day, as I trace it from theft to mouth. But total food spending and consumption will trend down over the long run.The correct measurement would be the total population multiplied by average human weight after I begin stealing. Or, in economics, total growth after I begin QE. Measuring a particular channel, or event, or recipient, does not capture all effects of the action.
Last edited by farmer on July 31st, 2013, 10:00 pm, edited 1 time in total.

gardener3
Posts: 1496
Joined: April 5th, 2004, 3:25 pm

### a quick explanation of QE and inflation

QuoteOriginally posted by: farmerQuoteOriginally posted by: gardener3Unless you borrow to sit on cash, borrowing will lead to money creation and inflation. Although there have been few instances of firms with loads of cash borrowing long (like google), it makes no sense unless you have good investment opportunities. I would think that lower yields, flatter yield curve, and lower spreads should help small growth firms. I don't know the answer, but should be pretty easy to test. Just look at the returns of small growth firms during these periods.Don't be silly. If people have competing investment opportunities, they will allocate money to different investments until all returns are equal. But the market rate of return will be lower under low, manipulated interest rates.Consider that active managers and indexers perform exactly the same, because taken collectively, each group holds an identical portfolio. You could point out that indexers who don't spend on research actually do better than the active managers. But the market rate of return would drop to -100% if you dropped research costs to 0, and just bought the 501st stock when its market cap rose above the 500th.I am not talking about a concept where people are surprised, I am talking about a simplified model where all investors have perfect knowledge and behave rationally. Except the Fed.The Fed is willing to take a loss by shouldering interest-rate risk, because they don't have to make money. This causes low-growth companies to be priced irrationally relative to high-growth companies. More specifically, it causes low-growth economic activities to be priced irrationally relative to high-growth activities. It makes companies that cannot afford interest rate risk relatively more attractive compared to those that can, and causes money to be allocated toward those companies and activities until the returns are equal again, given that the Fed is willing to take a loss to subsidize the low-growth ones.Yes, the S&P 500 has outperformed the Russell 2000 lately. But that is an unnecessarily complicated and indirect way to look at this. Because it assumes an adjustment period, where QE was introduced. I don't see why looking at the absolute level of growth, between one period and another, is not simpler and equally valid. The investments should perform equally, but only after more capital is allocated to one and away from the other. And that equal performance should be lower than the alternative optimum without QE.I am not following what you are saying here. Yes, the returns should be equal (after adjusting for risk), but you are claiming the FED is causing a mispricing. If there is mispricing then valuations must change. Otherwise, what else does it mean for a firm to be 'relatively more attractive'? And value rises by having greater relative returns. I don't have a prior, I can see it going either way. Anyways, it'd take 5mins to test this.

gardener3
Posts: 1496
Joined: April 5th, 2004, 3:25 pm

### a quick explanation of QE and inflation

QuoteOriginally posted by: farmerQuoteOriginally posted by: gardener3You have to look at changes in expectations or do an event study (http://www.kellogg.northwestern.edu/fac ... gs2012.pdf)I could do a similar study, to see if stealing food causes people to be fat. I might find two things, 1) the people I give the food to get fat, and 2) the overall price of food drops. Because the people I give it to are paying zero, and the people I steal it from start just buying rice, since they know whatever they buy will get stolen anyway.The amount available to steal will go down each period, as people migrate into the recipient population. The total food consumed might go up on the first day, as I trace it from theft to mouth. But total food spending and consumption will trend down over the long run.The correct measurement would be the total population multiplied by average human weight after I begin stealing. Or, in economics, total growth after I begin QE. Measuring a particular channel, or event, or recipient, does not capture all effects of the action.The point was: to see the affect of stealing food when there is at the same time a famine going on, you need to know what the weight would have been without theft. And yes you have to look at different channels as the aggregate effect may be ambiguous. I keep reading for instance, that when the FED prints money and buys bonds their prices go up, because there is greater demand. If there is only one channel, then presumably when the Zimbabwe central bank print money and buys Zimbabwe bonds their prices go through the roof.

farmer
Topic Author
Posts: 13479
Joined: December 16th, 2002, 7:09 am

### a quick explanation of QE and inflation

QuoteOriginally posted by: gardener3Yes, the returns should be equal (after adjusting for risk), but you are claiming the FED is causing a mispricing. If there is mispricing then valuations must change.Valuations need not change. If the amount of foot traffic on a street rises, a restaurant won't always make more money, if people open additional restaurants in anticipation of the increase in foot traffic. If the foot traffic is being diverted from the red light district, the value of restaurants might go down. As whoremongers get into the restaurant business, so that everybody makes less money than when people were buying whores. Even though the relative value of restaurants relative to whorehouses has gone up.Suppose your parents told you don't bother getting a job, we will still be paying your rent five years from now. Would you be more likely to get a job, or less likely, because you feel secure in your future? The relative value of jobs would go down.Now suppose five years from now you asked your parents why they are giving you less money. They might say, well, every time we gave you $100, we stole$10 back when you weren't looking. It is running low. It would be different if the Fed printed goods, rather than money. But if all they are doing is printing money for you to buy the stuff you are making anyway, it is a mirage.The Fed's promise to loan you money in five years sends a price signal that goods will exist in five years. The price signal competes with opportunities to actually expand a factory, and produce something in five years. the Fed's price signal makes non-growing companies appear more valuable relative to growing ones.

gardener3
Posts: 1496
Joined: April 5th, 2004, 3:25 pm

### a quick explanation of QE and inflation

These are the daily Fama-French factor returns for periods sorted based on 3mo treasury:Average of smb Average of hml1 0.02678% 0.00357%2 0.01545% 0.04258%3 -0.01657% -0.01137%4 -0.00461% 0.03051%5 -0.01245% 0.02287%Sorted on 10 year - 3 month:Average of smb Average of hml1 -0.04945% 0.02682%2 0.00840% -0.01435%3 0.02004% 0.01961%4 0.02037% 0.00540%5 0.00829% 0.05131%

gardener3
Posts: 1496
Joined: April 5th, 2004, 3:25 pm

### a quick explanation of QE and inflation

QuoteOriginally posted by: farmerQuoteOriginally posted by: gardener3Yes, the returns should be equal (after adjusting for risk), but you are claiming the FED is causing a mispricing. If there is mispricing then valuations must change.Valuations need not change. If the amount of foot traffic on a street rises, a restaurant won't always make more money, if people open additional restaurants in anticipation of the increase in foot traffic. If the foot traffic is being diverted from the red light district, the value of restaurants might go down. As whoremongers get into the restaurant business, so that everybody makes less money than when people were buying whores. Even though the relative value of restaurants relative to whorehouses has gone up.Suppose your parents told you don't bother getting a job, we will still be paying your rent five years from now. Would you be more likely to get a job, or less likely, because you feel secure in your future? The relative value of jobs would go down.Now suppose five years from now you asked your parents why they are giving you less money. They might say, well, every time we gave you $100, we stole$10 back when you weren't looking. It is running low. It would be different if the Fed printed goods, rather than money. But if all they are doing is printing money for you to buy the stuff you are making anyway, it is a mirage.The Fed's promise to loan you money in five years sends a price signal that goods will exist in five years. The price signal competes with opportunities to actually expand a factory, and produce something in five years. the Fed's price signal makes non-growing companies appear more valuable relative to growing ones.OK, even if you assume perfect competition with zero economic profits, instantaneous adjustments, etc., the relative performance will still be different.