Where’s The Inflation?
Since, as Milton Friedman, one of our greatest economists, noted, “Inflation is always and everywhere a monetary phenomenon,” the factual data don’t support the view that we should have expected rampant inflation last year.
In fact, despite the opinion of many who seem certain we will see massive inflation, neither the bond market nor professional economists are expecting anything of the kind. We can at least get an estimate of how the market is forecasting inflation by looking at the difference between the roughly 2.2 percent yield on 10-year nominal bonds and the roughly 0.5 percent yield on 10-year TIPS. The difference is just 1.7 percentage points. Clearly, investors in the aggregate don’t appear to be concerned about rampant inflation.
Regarding the forecast of economists, the Fourth Quarter 2014 Survey of Professional Forecasters from the Federal Reserve Bank of Philadelphia has a 10-year inflation forecast of just 2.2 percent.
Again, it doesn’t believe rampant inflation is likely, let alone inevitable.
No Velocity Of Money Right Now
Don’t get the wrong idea. There’s certainly risk that inflation could increase dramatically. The reason it hasn’t is because, even though the monetary base has been increasing rapidly as the Fed expanded its balance sheet through its bond-buying program, the velocity of money has been falling sharply.
The velocity of M2 has fallen from about 2.0 at the end of 2007 to around 1.5 at the end of 2014, a drop of about 25 percent.
With that said, the risk remains that if or when the velocity of money begins to rise, inflation could increase. Of course, the Fed is well aware of that risk, and thus will likely take mitigating action—such as reversing its bond-buying program and raising interest rates—that would prevent inflation from taking off.
History Suggests QE Has Worked
It’s worth noting history does provide us with examples of quantitative easing (QE) programs similar to the Fed’s. In the 1990s, Sweden’s central bank, the Riksbank, more than doubled the country's monetary base during the Nordic banking crisis, but inflation remained moderate during and after the expansionary period. Even as the monetary base jumped from 1994 to late 1996, inflation did not follow suit and, in fact, remained flat before falling in 1996.
And Sweden was not an isolated case. The Federal Reserve Bank of St. Louis looked at past expansionary periods over the last two decades in the U.K., Switzerland, Japan, Australia, New Zealand and Iceland.
The Fed’s researchers concluded that QE is a useful policy tool, and that doubling or even tripling 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 impact in terms of increased inflation from such expansions.
They also noted that the key to successfully implementing a policy of QE is, when the crisis has passed, for the Fed to promptly unwind its balance sheet. That does mean extending maturities isn’t without risk. But the pricing of that risk is embedded in today’s yield curve. In other words, extending maturities today would result in a negative outcome only if interest rates rise more than already expected.
No Substitute For A Good Plan
Since there are no clear crystal balls, a well-developed investment plan should incorporate the possibility of greater-than-expected inflation and address that risk through the asset allocation process. For example, the more you are exposed to the risk of unexpected inflation, the more you should consider holding TIPS and short- to intermediate-term nominal bonds, avoiding long-term nominal bonds.
That’s it for lesson six. In our next post, we’ll tackle lessons Nos. 7 through 9, which include some pretty convincing data on performance chasing and dividend strategies.
Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.