By Michael Katz and Christopher Palazzolo


Investors' Next Concern
While there's no shortage of topics to analyze as a result of the 2008-2009 global recession, the unprecedented monetary stimulus has justifiably focused investor attention on potential inflation. As an institutional asset manager with strategies incorporating inflation-linked assets, we are frequently asked how best to hedge against inflation.

There is undoubtedly a case to be made for higher future inflation; there are also strong arguments for more moderate levels. Our aim in Part I of this series is not to predict, but rather to outline what we believe are the key issues surrounding the inflation debate, and to clarify some misconceptions about inflation and inflation-linked assets. We also offer some analysis which investors may find helpful in deciding how to position a portfolio for various inflationary environments. In a follow-up paper to this series, Part II will discuss the potential rewards and risks of holding various assets in a portfolio during distinct inflation and economic environments.

What Causes Inflation?

Inflation is caused by an increase in money supply relative to output (i.e. real GDP) and the velocity of money (the speed at which money changes hands). Money supply is a product of the monetary base and the money multiplier (how much banks lend relative to their reserves). In the absence of economic growth, if output and the velocity of money are kept steady while the money supply grows, prices should increase. However, if money supply grows at the same rate as economic activity, prices should remain stable.

It is important to emphasize that inflation rates are a product of the relationship between GDP growth and the overall increase in money supply, not simply the physical monetary base. In the U.S., there has in fact been a dramatic increase in the monetary base as the Fed has pursued monetary stimulus by lowering the Fed Funds and discount window short-term lending rates. It has also pursued "quantitative easing," the direct purchase of longer-term government and private debt to provide liquidity to the market. However, despite the Fed's efforts, the overall velocity of money and the money multiplier in the U.S. economy have dramatically declined as banks have been reluctant to extend credit and economic activity has slowed. Put simply, the Fed has "printed" a lot of money, but it isn't being fully deployed into the economy. Figure 1 below shows the annual percentage change in the U.S. monetary base (MB) and money supply (M2).1 August 2008 Despite the unprecedented increase in the monetary base, the growth in overall money supply remains in line with historical values.

Why No Inflation in 2009?
Despite the significant growth in the U.S. monetary base, money supply has grown modestly. Furthermore, there is excess capacity in the economy evidenced by an approximate 70% capacity utilization and an "official" 2 10% unemployment rate (see Figure 2). As a result, 2009 did not see a significant positive realization of inflation by year-end, though the inflation growth rate changed from negative to positive. Figure 3 displays the annual inflation rate and consumer price index (CPI) since 2005. Inflation rates remain below pre-crisis levels, and the trend in the CPI index is not currently showing signs of a dramatic increase in inflationary pressures.

However, significant questions about inflation remain: Is there a case for a future spike in inflation? If the velocity of money picks up as the economy recovers and banks resume lending, will inflation follow? The Fed is well aware of the need to withdraw liquidity to manage inflation and inflation expectations.3  In recent meeting 'minutes' the Fed has expressed the need for a measured end to its emergency monetary policies in order to manage inflation expectations (the often-discussed "Exit Strategy"). In fact, the Fed has broadly outlined the steps it will take to drain liquidity in 2010 and beyond including ending the emergency asset purchase program, among other measures. The Fed's current unprecedented stimulus posture may not generate abnormal inflation pressures if the Fed can, in an effective and timely manner, withdraw excess liquidity from the economy as money velocity and bank lending begin to increase.

There is another more technical reason that the increased monetary base may not generate the same abnormal inflation pressures it would have generated in the past: the Fed is currently paying interest on bank reserves. If the Fed continues this policy in conjunction with raising the rates it pays on reserves, banks may be willing to hold a higher percentage of their assets in cash. Prior to October 6,  2008, when the Fed began paying interest on cash reserves, the Fed primarily used open market operations - buying and selling of Treasury Bills to manage the monetary base. The Fed's selling of T-bills reduced the reserves held by banks, thereby lowering the monetary base. By paying interest on bank reserves, the Fed has implicitly made reserves a substitute for T-bills. Banks might therefore be inclined to hold more cash than they would have done in the past. If this holds true, the economy could absorb a larger monetary base without generating abnormal inflation pressure. Figure 4 displays the total amount of reserves held by U.S. banks and other depository institutions, demonstrating a significant increase in cash assets held.