Dynamic Investment Solutions
Red Paper – The risk of rising
Is your fund prepared?
• Since August 2007, the US Federal Reserve (Fed) has implemented a range of extraordinary
policies in response to the global financial crisis that have increased the size of its balance
sheet and the US monetary base.
• To date, the increase in the US money supply has been muted as banks have hoarded funds
in excess reserves with the Fed rather than making these funds available to households,
businesses and investors.
• However, as risk aversion returns to more normal levels and banks look for more profitable
investment opportunities, the money supply will start to increase.
• Unless the Fed effectively withdraws this excess liquidity from the financial system by
implementing an exit strategy from its policies of quantitative easing, there is a risk that the
US money supply will grow too strongly to contain inflationary expectations at their desired
• To assess the potential inflationary impact of quantitative easing, we have used a large-scale
macroeconometric model of the global economy in which we ‘shock’ the US money supply.
• The results show that even a small error by the Fed in its exit strategy from policies of
quantitative easing could have a significant impact on the US money supply and hence on
• Investors need to be aware of this risk and put appropriate inflation protection measures in
place to protect the value of their investments in the event of an inflationary surge.
The risk of rising inflation
In response to the destabilisation of the financial system and the sudden collapse in economic activity in
September 2008, policy-makers around the world have enacted an unprecedented level of monetary and
fiscal stimulus. Despite this, the rise in excess capacity in capital and labour markets has resulted in most
commentators expecting very low rates of inflation over the coming year. However, as global economic
activity improves, macroeconomic policy will need to be tightened from current settings if a shift from
excess capacity to excess demand (and hence inflation) is to be avoided.
Given the coordinated and global nature of the easing cycle, the need to tighten macroeconomic policy is
an issue that will be faced by central banks and governments around the world. The focus of this paper is
on the US Federal Reserve (Fed) and the potential implications of a policy error for US inflation. The range
of extraordinary policies implemented by the Fed since August 2007 has more than doubled the size of its
balance sheet and the US monetary base. In normal circumstances, the sharp increase in the monetary base
would be expected to translate into an even larger increase in the money supply. However, the increase in
the US money supply has been muted as banks have hoarded funds in excess reserves with the Fed, rather
than make these funds available to households, businesses and investors. As risk aversion returns to more
normal levels and banks look for more profitable investment opportunities, the money supply will start to
increase. Unless the Fed effectively withdraws this excess liquidity from the financial system through
appropriate exit strategies from its policies of quantitative easing, there is a risk that the US money supply
will grow too strongly. This could place upward pressure on asset and/or consumer prices and lead to
higher rates of inflation.
Quantitative easing and the money supply
As economic conditions deteriorated following the collapse of US financial giant Lehman Brothers in
September 2008, the central banks of the US, UK and Japan reduced their cash rates towards zero. With
nominal interest rates constrained at zero, deflationary expectations cause the real interest rate (and hence
the real cost of capital to business and the real cost of credit to households) to rise, negatively impacting
the real economy. Therefore, as economic conditions continued to deteriorate, these central banks turned
to unconventional monetary policy known as quantitative easing (QE) in an attempt to stimulate economic
activity and to avoid deflationary expectations.
QE involves the central bank implicitly or explicitly targeting a level of nominal gross domestic product
(GDP) by expanding the money supply. By engaging in QE, the central bank seeks to avoid deflationary
expectations through a large and persistent shock to the money supply. This is implemented by the central
bank purchasing assets from the private sector. Because the level of real GDP is largely constrained by
supply-side variables (such as the size of the labour force and the growth in technology), a persistent
increase in the money supply increases liquidity and eventually drives up the price level. As businesses and
households come to expect a higher longer-term price level, inflation expectations rise and the real cost of
capital and credit fall, stimulating business and consumer spending.
The effectiveness of QE, as is the case with monetary policy in general, is dependent on the central bank’s
credibility in the eyes of market participants. This in turn is dependent on the bank’s commitment to its
policy targets and its ability to effectively implement policy to achieve these targets. To date, the Fed’s
actions appear to have been successful in stabilising inflationary expectations. This can be seen in Figure 1,
which reports 10-year break-even inflation rates (BEI) implied by bond markets. In late 2008, inflation
expectations priced into bond markets fell sharply, but since early 2009, dramatic policy actions by the Fed
and US Treasury have been effective in restoring inflation expectations at around 2%1.
Figure 1. Break-even inflation rates
US 10-year break-even inflation rates (%)
2004 2005 2006 2007 2008 2009 2010
Source: Factset estimate based on US Federal Reserve data
As stated by the US Federal Reserve, estimates of the BEI reflect risk premia as well as the market’s inflation expectations. For example,
the very low levels of the BEI in 2008q4 and 2009q1 reflect a sharp increase in the liquidity risk premium in addition to reductions in the
market’s inflation expectations.
To achieve the desired impact on the market’s inflation expectations, the Fed’s QE policy has led to an
increase in the monetary base of around US$1.1 trillion2 or 230% (in line with the expansion of the Fed’s
balance sheet). In normal circumstances, this sharp increase in the monetary base would be expected to
lead to an increase in the money supply of US$8.2 trillion or around 100% (based on a historical average
money multiplier3 value of 8.5). However, the increase in the US money supply has been muted as
commercial banks have hoarded funds in excess reserves with the Fed, rather than making these funds
available to households, businesses and investors. This has led to a sharp fall in the money multiplier and an
increase in the money supply of only 8%.
However, as risk aversion returns to more normal levels and banks look for more profitable investment
opportunities, banks will increase lending and the money supply will start to increase. Unless the Fed
effectively withdraws excess liquidity from the financial system through appropriate exit strategies from its
policies of QE, there is a risk that the US money supply will grow too strongly to contain inflationary
expectations at their desired level.
The consequences of increases in the US money supply
To assess the inflationary impact of such an event, we have used a large-scale macroeconometric model of
the global economy (NiGEM4), in which we ‘shock’ the US money supply. Specifically, we have tested four
scenarios ranging from a 10% increase (from base5) in the US money supply to an 80% increase in the
money supply. While we expect the chance of the Fed allowing an 80% increase in the money supply to
eventuate to be minimal, we have included it in our range of scenarios as it indicates the likely outcome if
the majority of banks’ excess reserves were allowed to flow through into the money supply.
Specifically, we have looked at the following four scenarios:
• A 10% increase in the money supply – this would involve a leakage of around $100 billion from
the total amount of $1 trillion currently held as excess reserves.
• A 20% increase in the money supply – this would result in an increase in the money supply
similar to that which occurred during 2003-2005 during the Fed chairmanship of Alan Greenspan.
• A 40% increase in the money supply – this would result in an increase in the money supply
similar to that which occurred in the 1970s.
• An 80% increase in the money supply – this would be the increase if US$800 billion of the
banks’ excess reserves were allowed to flow through into the money supply.
Figure 2 depicts the paths of the US money supply (as measured by M26) for each of the four scenarios.
Source: QIC estimated from US Federal Reserve releases H.4.1, H.3 and H.6.
The money multiplier is a measure of the increase in the money supply brought about by an increase in the money base.
We use a modified version of the NiGEM model of the global economy developed by the National Institute of Economic and Social
Research. Details of QIC’s modifications to the NiGEM equation system are available on request.
In our base-case simulation, we assume that the US Federal Reserve adjusts its policy in a way that supports economic growth in the
short term (i.e. 2009 to 2011), but contains inflation in the medium to longer term (i.e. over the next 10 years).
M2 refers to the notes and coins in circulation plus non-interest-bearing bank deposits plus building society deposits plus National Savings
Figure 2. Impact of leakage in bank excess reserves on US M2
US - M2 (% annual average)
Perm anent m onetary shocks
1962 1972 1982 1992 2002 2012
Impact on equities, bonds and the exchange rate
In our model, the surge in liquidity caused by the increase in the money supply drives an increase in
aggregate demand due to three main factors:
• Rising asset prices and lower real interest rates
• Rising inflation expectations
• Currency devaluation.
Rising asset prices and lower real interest rates
Rising asset prices are captured by (i) higher equity prices, (ii) a fall in real interest rates (i.e. higher bond
prices), and (iii) higher house prices. These factors increase real household wealth, which stimulates
consumer spending. They also lower the real cost of capital to businesses, which stimulates business
investment spending. As a result, aggregate demand strengthens.
Rising inflation expectations
As businesses and households factor in a higher long-term price level, inflation expectations also rise. A
higher future price level encourages consumers and businesses to bring forward their expenditure to take
advantage of the lower current price level. This results in a rise in the current level of aggregate demand.
Finally, the increase in the US domestic price level reduces the competitiveness of the US traded-goods
sector and leads to a deterioration in the US trade balance. This increases the US economy’s foreign
borrowing requirement, requiring an increase in overseas funding. To attract additional funds and restore
competitiveness in the traded-goods sector, US assets and US goods and services must become cheaper on
international markets. This occurs through a devaluation of the US exchange rate. The fall in the US
exchange rate, however, raises the cost of imported goods and services, leading to higher rates of US
inflation. A higher level of foreign demand also increases competition for labour and capital within the US
economy, resulting in higher domestic costs. This in turn causes further inflationary pressure.
Table 1 reports the impact of each of the four scenarios on bond yields, equity prices and the US effective
exchange rate in the first year of the simulation (reported as deviations from their respective levels in the
base case). These results reflect the significant impact quantitative easing measures have on asset markets
and the economy:
• Increasing liquidity in the economy by increasing the money supply causes asset prices to increase
initially, with equity prices rising and bond yields falling (bond prices rising).
• The rise in equity prices and the fall in bond yields drive consumer demand and business investment
higher and increase domestic demand.
• The increase in the money supply also drives inflation expectations higher. Higher inflation
expectations bring forward spending, which leads to further upward pressure on domestic demand.
• As domestic demand rises, the US trade balance deteriorates and the exchange rate devalues.
• Higher growth in domestic demand and a lower exchange rate places pressure on prices, leading to
rising levels of inflation.
Table 1. Initial impact of increases in US money supply on equities, bonds and exchange rate
Monetary shock Deviation Deviation Deviation
Permanent 10-yr govt Equity Effective
% deviation from base bond yields (bps) prices (%) exchange rate (%)
10% -22.8 12.5 -5.5
20% -35.3 24.4 -10.0
40% -48.4 47.3 -17.4
80% -52.0 91.1 -28.1
While market pricing reflects a range of potential factors, price movements since November 2008 (when
QE was introduced in the US) appear broadly consistent with market participants expecting a 20% to 40%
increase in the US money supply.
Impact on inflation
The impact of the four scenarios on inflation is shown in Figure 3. Figure 3 shows the average annual
inflation rates to 2020. These are compared to the base case forecast, which generates an average annual
inflation rate of close to the central bank target of 2% over the next ten years.
The results show that an expansion in the money supply of between 40% and 80% could lead to a period of
inflation of between 8% and 14% (similar to that experienced in the inflationary period of the 1970s). An
expansion of the money supply of between 10% and 20% has a less dramatic impact on inflation, with a
period of inflation rates of between 3% and 5%. Nonetheless, such rates are significantly higher than current
market pricing (around 2%).
Figure 3. Impact of increases in the US money supply on average annual inflation rates
US - PCE price index (% annual average)
Perm anent m onetary shocks
1962 1972 1982 1992 2002 2012
Rising inflation - Is your fund prepared?
The expansion in the Fed balance sheet and the increase in the US monetary base present clear risks to the
inflation outlook as economic and financial market conditions return to more normal conditions. The
results from our simulation show that a small error by the Fed in its exit strategy from policies of
quantitative easing could have a large impact on the US money supply and hence on inflation, especially over
the medium term (i.e. over the next five years).
Sharp and unanticipated rises in inflation have the potential to significantly erode investment returns. For
example, the global inflation shock of the 1970s severely impacted economic growth and returns on assets.
This can be particularly problematic for defined benefit schemes, as inflation can result in growth of
liabilities without a corresponding rise in assets.
Therefore, now is an opportune time for investors to prepare for an environment of economic recovery
and position their funds for a potentially higher inflation environment by putting appropriate inflation
protection measures in place.
QIC has been managing inflation-linked bonds for our clients for many years, and we have developed
extensive capabilities in providing inflation protection in a cost-effective, capital-efficient way. We have
access to the major global counterparties in the global inflation market and are the first point of call for
potential issuers in the Australian inflation market. By working with our clients and counterparties, we
have helped develop the Australian inflation-linked swap market.
The advantages QIC offers for inflation management are:
• Experience in managing large global and Australian inflation portfolios
• Dedicated inflation specialists. The QIC Global Fixed Interest (QIC GFI) team are expert
managers of inflation portfolios, while our Strategy team provides market leading solutions in
structuring inflation protection portfolios.
• Diversification of counterparty risk and strong collateral management processes through the use
of International Swaps and Derivative Association (ISDA) Master Agreements and Credit Support
• Strong risk management through the use of BlackRock Solutions systems, which enable a detailed
understanding of risk profiles from synthetic exposures
• Access to proprietary inflation-linked swap curves to facilitate valuation and fair-market pricing
• Strong local and global counterparty relationships to provide access to deal flow
• A rigorous relative-value process to identify the optimal portfolio of global inflation-linked
• Strong relationships where we are able to articulate our requirements for price and volume.
For more information or to find out more about QIC’s inflation protection solutions, please contact Scott
Cornfoot (Director of Business, QIC Global Fixed Interest) on +61 7 3360 3942 or email@example.com.
QIC Limited ACN 130 539123 (“QIC”) is a wholesale funds manager and its products and services are not directly available to
retail investors. QIC is a company government owned corporation constituted under the Queensland Investment Corporation
Act 1991 (Qld). QIC is regulated by State Government legislation pertaining to government owned corporations in addition to
the Corporations Act 2001 (“Corporations Act”). QIC does not hold an Australian financial services (“AFS”) licence and certain
provisions (including the financial product disclosure provisions) of the Corporations Act do not apply to QIC. Please note
however that some wholly owned subsidiaries of QIC have been issued with an AFS licence and are required to comply with the
Corporations Act. QIC, its subsidiaries, associated entities, their directors, employees and representatives (“the QIC Parties”)
do not warrant the accuracy or completeness of the information contained in this document (“the Information”). To the extent
permitted by law, the QIC Parties disclaim all responsibility and liability for any loss or damage of any nature whatsoever which
may be suffered by any person directly or indirectly through relying on the Information, whether that loss or damage is caused
by any fault or negligence of the QIC Parties or otherwise. The Information is not intended to constitute advice and persons
should seek professional advice before relying on the Information. QIC owns the copyright in all Information, or has a licence or
agreement to use that copyright where it is owned by someone else. You may only reproduce the Information for personal or
non-commercial use, and it must not be distributed or transmitted to any other person, or used in any other way (except to the
extent permitted by law).