Is Inflation Risk Overstated?

Last Updated Jan 25, 2011 7:51 PM EST

To combat the recent financial crisis, the Federal Reserve engaged in a policy known as quantitative easing (QE). The Fed's actions, buying Treasuries for their account, has resulted in the monetary base more than doubling, from about $800 billion to over $2 trillion.

The tremendous growth of the monetary base has greatly increased the noise in the financial press about the risk of inflation -- which is a monetary phenomenon (too much money chasing too few goods). The question is: Is there a direct link between the increase in the monetary base and future inflation? The answer is no.

Monetary Base Vs. Money Supply While the monetary base was more than doubling, the rate of growth of M2 (a broad measure of the money supply) over the past three years has only been about 3.5 percent. It's important to understand that the monetary base and the money supply are different. The deep recession caused the velocity of money to fall, so the Fed tried to offset that impact by stimulating the economy by lowering interest rates.

However, that policy "gun" ran out of bullets when rates reached zero, so the Fed engaged in QE in hopes of offsetting the negative effects of a drop in the velocity of money. The success of the strategy depends on how much of the increased reserves turn into new loans, raising the supply of money through what's known as the multiplier effect. Given the lack of demand for borrowings, the increase in the base hasn't led (at least not yet) to a large increase in the money supply.

The Outlook for Inflation If QE automatically meant we would see rising inflation, we should certainly expect to see that reflected in economic forecasts. Yet the Philadelphia Federal Reserve's latest Survey of Professional Economists shows that economists are projecting inflation over the next 10 years to average just 2 percent - and that figure is down from 2.3 percent in the previous quarterly survey.

Another place we would expect to see the risk of future inflation showing up is in the breakeven rate between TIPS and nominal bonds. As I write this, the 10-year Treasury note is yielding about 3.4 percent, and the 10-year TIPS is yielding about 1.2 percent. Thus, we have a breakeven inflation rate of just 2.2 percent, pretty much in line with the Philly Fed's survey - especially if we consider that the yield on the nominal Treasury incorporates a risk premium for unexpected inflation. Even on 30-year bonds, the breakeven rate is only about 2.5 percent (4.6 vs. 2.0). Clearly, the market does not expect rampant inflation will result from the Fed's policy of QE.

Historical Precedent We also have the benefit of historical evidence on prior episodes or quantitative easing. In the 1990s, Sweden saw its monetary base more than double during the Nordic banking crisis. However, inflation remained moderate. The monetary base jumped from 1994 to late 1996, but inflation remained flat before falling in 1996.

And Sweden wasn't an isolated case. The Federal Reserve Bank of St. Louis looked at past expansionary periods over the past two decades in the UK, Switzerland, Japan, Australia, New Zealand and Iceland. The Fed's researchers concluded that QE is useful, but relies somewhat on public perception to keep inflation at bay. Large jumps in a country's monetary base doesn't lead to high inflation if the public views the increase as temporary and expects the central bank to maintain a low-inflation policy. In fact, they found little increased inflation from such expansions. However, a significant key to successfully using QE involves promptly unwinding the balance sheet once the crisis is over.

My crystal ball is cloudy as always, so I don't know if the Fed will be able to successfully unwind its balance sheet at the right time. However, we can confidently state that QE has occurred without triggering high inflation. We also know that the Fed is well aware of the risks of failing to remove the stimulus. The market reminds them of it almost daily. We also know that investors who have been scared by all the media attention and thus altered investment plans to avoid the risk, have paid a steep price for avoiding term risk. As always, the winning strategy is to ignore the noise of the market and adhere to your well-developed plan, one that already incorporates the risks of unexpected inflation.

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Inflation or Deflation: Which Economic Risk Is Greater? How to Hedge Both Inflation and Deflation Can Advisors Add Alpha Without Using Active Management? How Did the "Sure Things" Fare in 2010? The Death of Buy and Hold
Hear Larry Swedroe discuss current investment trends and topics every Sunday at noon on 550 AM KTRS in St. Louis or streaming via the KTRS Web site. Can't catch the show? Download the podcast via www.investmentadvisornow.com or through the Buckingham Asset Management podcast page on iTunes.
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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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