Earlier this week, we began discussing 10 important lessons that the markets taught us in 2015 about the prudent investment strategy. In lessons one through three, we explored active management as a loser’s game, the “conventional wisdom” about the correlation between the economy and the stock market, and the “Sell in May” myth. Today we’ll pick up with lessons four through seven.
Lesson 4: Inflation Wasn’t, and Isn’t, Inevitable
One of the most persistently asked questions that I’ve received since 2009 has been some version of the following: What should I do about the inevitable rampant inflation problem we’re going to face because of the huge fiscal and monetary stimulus that’s been injected into the economy?
While the risk that massive budget deficits, a zero-interest-rate policy and the Federal Reserve’s bond-buying program would translate into rising inflation certainly did exist in 2015, this outcome wasn’t (and still isn’t) inevitable. Since 2008, we haven’t had a single year in which the CPI exceeded 3%. In fact, 2011 was the only year when it exceeded 2%, and 2015’s rate was less than 1%.
A related myth persists among many investors as well. I frequently hear concerns about the exploding growth rate of our nation’s money supply. This belief likely has been fueled by certain commercials—you know, the ones that recommend buying gold because central banks are printing money like we’re experiencing Weimar Germany all over again.
The fact is that M2, a broad measure of the money supply, hasn’t been growing at rates that would suggest rampant inflation should be expected. For the seven-year period from Dec. 8, 2008 through Dec. 7, 2015, the Federal Reserve Bank of St. Louis reports that the rate of growth in M2 was 6.1%.
Since, as Milton Friedman, one of our greatest economists, noted, “Inflation is always and everywhere a monetary phenomenon,” the factual data doesn’t support the view that we should have expected rampant inflation. In fact, despite the fears of many investors who seem certain that 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 the market’s forecast for inflation by looking at the difference between the approximately 2.3% yield on 10-year nominal bonds and the roughly 0.7% yield on 10-year Treasury inflation-protected securities (TIPS). The difference is just 1.6 percentage points.
Clearly, investors—in aggregate—don’t appear concerned about rampant inflation. As for economists’ expectations, the Federal Reserve Bank of Philadelphia’s Fourth Quarter 2015 Survey of Professional Forecasters has a 10-year forecast of inflation averaging just 2.15% at an annual rate. Again, they don’t believe rampant inflation is likely, let alone inevitable.
But don’t get the wrong idea. The risk that inflation could increase dramatically is still very much present. It hasn’t happened so far because, even though the monetary base has been increasing rapidly (as the Fed’s balance sheet expanded through its bond-buying program), the velocity of money (as measured by M2) has fallen pretty persistently from about 2.0 at the end of 2007 to about 1.5 at the end of 2015, a drop of approximately 25%.
That said, there remains the risk that if or when the velocity of money begins to rise, inflation could increase. Of course, the Fed is well aware of this risk, and would likely take action—reverse its bond-buying program and raise interest rates—to prevent inflation from taking off.
Lesson 5: Ignore All Forecasts—All Crystal Balls Are Cloudy
In January 2015, The Wall Street Journal surveyed economists, asking them to forecast what the federal funds (FF) rate would be at the end of the year. The average projection called for a rate of 0.89%. The Fed’s target rate remained unchanged at 0.00-0.25% until Dec. 16 and ended the year at 0.25-0.50%.
Investors paying attention to such forecasts likely would have kept their bond allocations either in cash or in very-short-term instruments, and paid the price in terms of lost opportunities. Last year, Vanguard’s Short-Term Bond Index Fund (VBISX) returned 1.2%, underperforming its Intermediate-Term Bond Fund (VBIIX), which returned 1.8%. However, its Long-Term Bond Index Fund (VBLTX) lost 2.4%.
Here’s another important reminder. Despite what many investors believe, the Fed’s decision to raise the federal funds rate does not mean that longer-term rates will rise. The reason is that the yield curve reflects the market’s expectations for future short-term interest rates. As an example, on Dec. 16, 2015, when the Fed raised rates, the 10-year Treasury yield was 2.30%. It ended the year slightly lower, at 2.27%.