Many pundits (and a good number of individual investors) have been predicting high inflation as a result of the Federal Reserve’s monetary policy. Over the four years ending 2012, inflation has averaged just 2.2 percent per year, and currently the market expects inflation over the next five years to be just 2.1 percent per year. Clearly, realized inflation has been low and the market expects inflation to be low in the future, which can hardly be interpreted as signs that high inflation is a foregone conclusion. This begs the questions of what forecasters missed and whether high inflation might still occur.
Milton Friedman famously said (or at least as famously as statements about economics can ever be) that “Inflation is always and everywhere a monetary phenomenon.” I got this directly from Wikipedia, so it has to be true. (It even had the year he said it.) Stated differently, economists would generally say that high rates of inflation are caused by high rates of growth in the money supply. The mistake many investors made over the past few years was assuming Fed policies would unquestionably lead to high money supply growth. It turns out, though, that the Fed doesn’t have direct control over the growth rate of the money supply and therefore can’t directly produce high inflation rates.
To understand why, we first need to define the money supply and a related term called the monetary base. The monetary base is essentially the sum total of the currency and coins in circulation and commercial bank reserves. Bank reserves can further be broken down into required reserves and excess reserves. Required reserves represent the amount of a bank’s deposits that it must hold and not lend out. For example, if you deposit $1,000 at your local bank when the reserve requirement is 10 percent, the bank must hold back $100 of your deposit, but it’s free to lend out $900 of your deposit. The portion of your deposit the bank can lend out represents excess reserves.
The money supply, on the other hand, is determined by the level of the monetary base and the desire to hold cash, and whether banks choose to lend excess reserves. If individuals choose to hold significant amounts of cash and banks decide not to lend excess reserves, the money supply will be lower. To the extent the money supply grows slower than the monetary base, inflation will be lower than one might expect.
Over the past few years, the Fed created an enormous amount of additional bank reserves through its “quantitative easing” program and, therefore, massively expanded the monetary base. Banks could have chosen to lend these additional reserves, but by and large they haven’t, and money supply growth has consequently been relatively low and much lower than the growth of the monetary base. Therefore, it’s no big surprise that inflation has been low.
Nevertheless, it’s possible inflation could be higher than expected. Current Fed policy certainly creates the risk (but not the certainty) of higher than expected inflation. Looking to the financial markets, however, one finds they remain confident that the Fed won’t let inflation get out of control.
Further, it absolutely makes sense for investors who are heavily exposed to the risk of high inflation to protect against that risk. The three investment strategies that can help reduce the risk of high inflation are:
- Having an allocation to Treasury inflation-protected securities
- Having diversified exposure to commodities
- Maintaining relatively short-term bond holdings
Random Links and Commentary of the Week
Ultimate irony of the week: A few ESPN talking heads have been bemoaning the Jets unfair treatment of Tim Tebow, basically arguing that cutting him after the draft may jeopardize his ability to get a job, when one of the main reasons he may not get a job is the media circus ESPN has created around all things Tebow.
Solid Mel Kiper impression from Frank Caliendo
The links above will redirect you from the BAM ALLIANCE site to other sites and content not related to the BAM ALLIANCE. The BAM ALLIANCE does not endorse or make any claims about the accuracy or content of the information contained therein. The security and privacy policies on these sites may differ from the BAM ALLIANCE.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2013, The BAM ALLIANCE