Swedroe: Easy Monetary Policy = Inflation?

August 11, 2014

Don’t believe everything market forecasters tell you.

One of the more persistent themes we’ve been hearing from forecasters, for quite some time now, is that the Federal Reserve’s easy monetary policy—starting with its move to drive the Federal Funds rate from 5.25 percent to zero—would inevitably lead to a dramatic spike in inflation.

As each new round of quantitative easing (QE) was announced, the chorus only grew louder. We’ve now had QE1, QE2 and QE3. As a result of those bond buying programs, the Fed’s balance sheet has more than quadrupled, from less than $1 trillion to more than $4 trillion.

Since it’s now been more than six years since the Fed first took action to address the financial crisis, I thought it would be worthwhile to take a look at how the many predictions of rampant inflation have played out.

Let’s begin by reviewing the consensus forecast for inflation from the Federal Reserve Bank of Philadelphia’s first-quarter 2008 Survey of Professional Forecasters. The consensus forecast for the five-year period from 2008-2012 called for an inflation rate of 2.4 percent. The 10-year forecast called for an inflation rate of 2.5 percent.

It turns out that, despite all the bleak forecasts, the actual rate of increase in the consumer price index (CPI) from 2008 through 2013 was just 1.7 percent—1.4 percentage points below the previous historical average of 3.1 percent. And as of the end of June 2014, the increase in the CPI over the prior 12-month period was a still low 2.1 percent. While the consensus forecast of professional economists was a bit too high, it certainly was more accurate than the forecasts of the doom-and-gloomers.

The dire predictions of rising inflation caused many investors to limit their bond holdings to the shortest maturities. That led such investors to miss out on the strong returns provided by longer-maturity bonds. For example, from 2008 through June 2014, one-year Treasurys returned just 1.2 percent per year, while 5-year Treasurys returned 4.5 percent per year and 20-year Treasurys returned 6.8 percent per year.

 

Why Hasn’t Inflation Been A Problem?

One reason we haven’t seen rampant inflation is that, over the six-year period from July 21, 2008, through July 21, 2014, the growth rate of M2—a broad measure of the money supply—hasn’t been increasing at a pace that would indicate the likelihood of widespread inflation. The rate of increase has been 6.75 percent per year, with M2 growing from $7,728 billion to $11,439 billion over the period.

While loose monetary policy—along with our massive budget deficits—does create the risk of (or potential for) rising inflation, it certainly isn’t a guarantee that rising inflation will occur.

There certainly is risk that inflation could increase dramatically. The reason it hasn’t yet is that, while the monetary base has been increasing rapidly as the Fed expands its balance sheet through its bond buying program, the velocity of money has been falling sharply, from 2.0 at the end of 2007 to 1.5 at the end of the second quarter of 2014.

If velocity were to increase, the Fed would have to undo its bond buying program to shrink the monetary base and prevent inflation from becoming a problem. And that could put pressure on interest rates. Of course, the Fed is well aware of this necessity.

If you need further evidence that easy monetary policy doesn’t necessarily lead to inflation problems, you only have to look to Japan. Despite easy monetary policy and massive budget deficits, Japan’s biggest problem has been deflation, not inflation.

Keep this in mind the next time you’re tempted to listen to some guru’s forecast about rising interest rates. The historical evidence is clear that the winning strategy in both stocks and bonds is to ignore all forecasts and stick to a well-developed plan.


Larry Swedroe is the director of research for the BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.


 

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