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.

First « 1 2 3 » Next