By Jeffrey Klingelhofer

Since the “Great Recession” began in late 2008, the Federal Reserve has responded decisively and aggressively in an attempt to contain economic malaise and spur growth. With the Federal Funds rate effectively pegged at zero, the traditional means of “easing” conditions vital to growth have been exhausted, and the Fed has been forced to resort to less conventional measures to spur activity. Chief among these have been Large Scale Asset Purchases (LSAPs), better known as quantitative easing. While many debate the efficacy of these policies, a clear outcome of the purchases has been unprecedented growth in the scale of the Fed’s balance sheet (Figure 1), leaving us to wonder about the eventual consequences for the real economy.

 

 

The leading concern is the fear of an eventual and significant rise in inflation. At the time of this writing, both GDP growth and inflation were annual return (-0.25 percent), it is understandable that investors harbor concerns.

Here we will examine the currently available data, look at potential pathways to a significant rise in inflation, point to the risks we are watching, and share our outlook.

Does a Significant Increase in Money Supply Always Result in an Increase  in Inflation?

Milton Friedman proclaimed, “Inflation is always and everywhere a monetary phenomenon.” While we agree that inflation is always the result of too much
money chasing too few goods, the question we face in today’s environment is whether a significant rise in money supply always results in a rise in inflation.

It turns out, at least over the past 25-year period, that the answer has been “no.” Money and inflation have actually exhibited an inverse relationship (see Figure 2). If one looks at a longer period into the 1960s, the relationship does turn positive, though it remains weak at best. But recent history alone does not
mean that investors should become complacent to the threat of inflation. So let’s dissect the relationship between the expansion of the Fed’s balance sheet, money supply, and its effect on inflation.

We start with a simple equation put forth by the Monetarists, a school of economists focused mainly on the government’s control of the money supply as a primary means of controlling both economic output and price levels. Using a common Monetarist equation, we attempt to explain the relationship between money supply and inflation: MV = PY.

Put simply, this equation states that the money supply (M) multiplied by the number of times each dollar exchanges hands (velocity of money, or V) must equal the prices of goods purchased (P) multiplied by the total purchases in an economy (Y). Manipulating the equation and changing the terms to changes in each variable, we rewrite as ΔP = ΔM - ΔY + ΔV. This states that inflation (represented by ΔP for change in prices) will rise if the supply of money is growing faster than the growth in output, unless this is offset by a decline in the velocity of money.

While many worry that the rapid rise in the Fed’s balance sheet — roughly 135% year-over-year since the start of the crisis — will invariably result in a rapid rise in the money supply in the real economy, this simply hasn’t been the case. Rather, most of the purchases intended to pump money into the real economy have actually sat idle with the Fed as excess reserves (Figure 3). A simple analogy would be the Fed’s printing one trillion dollars in $100 bills, and
rather than dropping the notes from a helicopter for lucky recipients to spend, the Fed instead buries the cash in a secret location on a distant island. The Fed has created little spendable currency and thus has contained the growth rate of money. In fact, M2, which is a broad measure of money in the real economy, has been rising at roughly 6.1% year-over-year since the onset of the crisis; this is well within non-inflationary historical context and a far cry from the rapid rate of expansion in the Fed’s balance sheet.

Data via the Federal Reserve and the Bureau of Labor Statistics

A Dramatic Decline In The Velocity Of Money

We have seen that money growth itself has been contained. Let’s return to the equation ΔP = ΔM - ΔY + ΔV, in which we stated that price levels would rise (inflation) if the money supply were rising faster than the growth in output unless offset by a decline in the velocity of money. If we assume that the money supply is growing faster than output (albeit much less than many fear) as shown in Figure 4, then why have we not already seen a rapid rise in inflation?

It turns out that the velocity of money has dropped precipitously and remains at historical lows (see Figure 5). This is one reason the Fed has been right to worry not so much about rising inflation, but more about outright declines in the rate of inflation and even possible deflation. This fall in the velocity of money has resulted from many things: the crash of so-called financial innovation, consumers paying down debt and increasing savings, decreased bank lending, and a fall in real wages. The average citizen and business, quite simply, prefers to hold cash and save rather than spend. While the Fed has been heroic in its efforts to reflate the economy, we have avoided a period of significant inflation thus far due to the decrease in the velocity of money, along with an increase in excess reserves held on deposit with the Fed, and containment of the growth in money supply.

Data via the Federal Reserve, sourced through Bloomberg LP.

The Overhang Of Excess Reserves

With such a large pile of excess reserves on deposit with the Fed, the threat of inflation remains a real concern. We turn to the tools available to the Fed to limit a significant rise in both the supply of money and/or the velocity of money.

Since the crisis, the Fed has gained the ability to pay banks interest on deposits at the Fed — primarily as a tool to control the interbank lending rate and thus the supply of money to the general economy. Theoretically, if a bank faces a decision to loan to an individual or to the Fed, and both are willing to pay the same rate of interest, the bank should loan to the more creditworthy borrower, the Federal Reserve. By paying interest on excess reserves, the Fed is able to manage the amount of money that seeps into the real economy. In this way, it harnesses a powerful tool in managing the money supply by being able to attract or discourage reserves from banks. The Fed also retains the ability to raise interest rates in the real economy, both by raising the Fed Funds rate from its current zero level, and by the potential disposal of assets currently on its balance sheet. Both measures are powerful tools designed to enable the Fed to push up real borrowing costs and slow a fast-growing economy. The Fed has demonstrated creativity in its approach to spur economic growth and in preventing deflation, and we believe it will likely prove equally creative in keeping inflation at reasonable levels, in accordance with its dual
mandates to foster maximum employment and maintain price stability.

The Delicate Balance Of  Policy Goals

It is certainly true that significant inflationary forces remain, though we believe that the Fed has sufficient tools to manage a possible threat. We believe the main threat lies in either the potential for policy mistakes in managing the looming inflation threat, or in the incentive to “run” inflation slightly higher than the Fed’s current 2% soft target. Many market participants expect the latter development, and we remain cautious, given the strong incentives to “inflate away” America’s debt problems. We believe the Fed will likewise stay cautious in risking its inflation-fighting credibility. We will continue to be watchful for future policy changes. For investors worried about an erosion of real purchasing power, there are few alternatives to provide a stable and safe source of income while maintaining a positive rate of nominal interest.

As bond investors, we worry about a possible rise in inflation. However, we do not yet see the conditions that would warrant strong concern for the immediate future. It is important to remain vigilant against both the threat of rising inflation and against continued risk of deflation and a renewed downturn in the global economy. We at Thornburg Investment Management will continue to guard against a potential rise in inflation while seeking to provide an attractive source of income and return, given the climate. While the market has rallied, a bond manager’s cushion for error has grown smaller and smaller. It
is more imperative than ever for us to stay focused on serving clients and on meeting the objectives of our strategies.

Jeff Klingelhofer, CFA, is an associate portfolio manager for Thornburg Investment Management; he joined the firm in 2010 and works on the fixed income team.  Klingelhofer  earned a BA in economics with a minor in business from The University of California at Irvine, and an MBA from The University of Chicago's Booth School.