Inflation is always a product of monetary policy. Given massive, unprecedented ballooning in the size of the Federal Reserve’s “balance sheet” since last fall, many are very concerned about the prospect for much higher inflation in coming years. That potential certainly exists and bears very close watching, but it is far from “baked in the cake” yet.
While the “Monetary Base” (currency in circulation plus bank reserves with the Federal Reserve) has nearly doubled since last September, money in circulation (M2) has only grown by 7.1% in the prior year. That’s not an excessively high rate, especially in an environment in which the CPI has actually declined each month from September through February and given the Federal Reserve’s goal of creating a “healthy” (small) amount of inflation. The money supply has not grown nearly as much as bank reserves simply because banks have been delivering – i.e., reducing their assets (including loans outstanding).
That may change quickly, and if it does, money growth could balloon in keeping with the monetary base. The Federal Reserve, of course, will then seek to put that genie back in the bottle by sopping up reserves to maintain a more reasonable growth rate in the money supply. They may succeed in that or they may fail. In the event they fail and the money supply balloons, we will be forced to change from an “inflation watch” mode to an “inflation warning” mode.
Note that deficit spending by itself does not create inflation if it’s financed by borrowing. That may result in higher real interest rates—another bad outcome—but not inflation.
Whether the specter of high inflation is looming or not we don’t know. What we do know is that the loss of purchasing power can be devastating to clients, particularly those who are retired. We have historically been so concerned about this issue that we have made a practice of addressing it in the first paragraph of client investment policy statements. Among the goals and objectives outlined in that opening paragraph, we typically include the phrase “growth sufficient to maintain purchasing power”. And as we have expanded the types of investments held in client portfolios, a number of the securities that we’ve added provide a hedge against the risk of inflation. They include:
Floating rate bonds. Known as floaters, the rate of interest these bonds pay resets periodically based on the change of some predetermined inflation index, such as the Consumer Price Index (CPI). As inflation increases, so does the rate of interest these bonds pay. On the other hand, the rate of interest regular bonds pay remains constant, which makes them vulnerable to inflation.
Real Estate and Commodities. Investments in hard assets such as real estate, gold, oil, etc., which have been added to client portfolios during the last few years, typically fare well in high inflationary environments.
International investments. The established and emerging market mutual funds held in client portfolios provide a good hedge against inflation to the extent it is accompanied by a weakening U.S. dollar.
In a recent interview Warren Buffet, while praising the efforts of Federal Reserve Chairman Ben Bernanke and others for their work in stimulating the economy, commented that the economy “can’t turn around on a dime”. “We are certainly doing things that could lead to a lot of inflation,” he noted. “In economics there is no free lunch.”
We don’t know if inflation is around the corner or not. What we do know is that high inflation presents a significant risk to client portfolios. So we have worked hard to structure portfolios to include securities that actually perform well during periods of high inflation.
Our job is not to predict the future, but rather to recognize its unpredictability and to prepare our clients for that uncertainty.