Any long-term investor knows that inflation is the enemy. A spike in inflation can drastically reduce your real investment returns, particularly for fixed income securities. At present, yields on many Treasury Inflation-Protected Securities (TIPS) are negative, a clear reflection of “financial repression.”
Officially, the Consumer Price Index, or CPI, has risen approximately 2% over the past 12 months, a rate of inflation that is near historical averages. Many economists—including those at the Federal Reserve—believe that, with unemployment high, we needn’t worry ourselves with the prospect of a significant rise in inflation in the years ahead.
However, as I blogged about in January, inflation is a non-issue only for those who don’t buy gas or milk, visit the doctor, or send a kid to college (in other words, not many of us). Drought in much of the country will put pressure on food prices going forward. When I look around, inflation seems to be everywhere except in the CPI.
But even if you think inflation is modest today, you may share the concern that inflation could take off in the next two to three years and face the high, double-digit inflation rates of the 1970s and early 1980s. Some believe that it’s not only a strong possibility—but that it’s also inevitable given the Federal Reserve Board’s aggressive monetary policy and our high national debt levels. Could such action to keep interest rates low and the money supply high in the near-term future create an inflationary backlash? If so, what would be the “canaries in the coal mine” that investors could monitor to tell them a repeat of the 1970s was coming?
The three bars to the left in the figure above are the “canaries” because they represent the mechanisms by which money on the Federal Reserve’s balance sheet can be transmitted onto the broader money supply. Things such as bank lending and wage growth—the factors that help determine the “velocity” of money. The chart clearly shows that the conditions in the 1970s were radically different from today’s environment. Money was burning a hole in Americans’ pockets in the 1970s; today, the velocity of money is low.
The bars represent two-year trailing average growth rates for each category. The blue bars combine the averages from 1972 to 1973 and from 1977 to 1978, and they indicate that inflationary pressures were building in the economy two years before inflation spikes. Two years before the gas lines, America had a big inflation problem. Businesses had pricing power because consumers could afford it. Pricing power meant that, when gas prices spiked in 1974 and again in 1979, businesses were able to pass on those costs, further accelerating inflation. It was a classic case of too much money (in the form of wages and lending) chasing too few goods.
Current fashion trends aside, the 1970s are hardly how I would characterize the environment today. Wages, lending, and home prices are all expanding modestly: 2% wage growth, 2% inflation. Which explains, not only the suffering associated with higher food and energy prices, but also the Fed’s aggressive posture. The Fed’s moves are designed to re-inflate a tire that the financial crisis drove a nail into. Somewhat remarkably, the Fed has been able to keep the green bars in the chart in positive territory—and avoid wage deflation. (Japan was unable to avoid that, it should be noted.)
Which brings us to QE3, the third round of so-called quantitative easing, under which the central bank will attempt to encourage borrowing by consumers and institutions by purchasing $40 billion worth of mortgage-backed securities for an unspecified period.
So, will QE3 work? If by “work” we mean driving inflation expectations above 2% and lowering already-slim mortgage rates even further, then likely “yes.” But if “work” is defined by a significant and sustained acceleration in job growth, then that is unlikely, especially if QE3 is unmatched over the next year by sensible, credible, and binding U.S. fiscal deficit reform. As Chairman Ben Bernanke noted, monetary policy is not a “panacea” to all of the economy’s challenges.
Personally, I am not a big fan of QE3, which we could call “QEternity” given its somewhat open-ended commitment to preserve the odds of further recovery. Why? As I blogged about in March, I am concerned about the potential for too strong of an influence on the decisions facing savers and investors. As Vanguard has noted for some time, we have already seen that, by reaching for yield, investors are taking on more risk and boosting asset prices. Should such trends continue, I worry about the “frothiness” of certain segments of the financial markets. The prices of high-yielding REITs and junk bonds come to mind.
So why is the Fed pursuing QE3 at all? I believe it is concerned about the near-term global economic outlook. The global economic recovery has clearly lost some momentum, partly due to uncertainty over how the fiscal cliff-hanger will be resolved. Should a global recession occur, the threat of deflation would rear its ugly head once again.
My biggest concern right now is not the threat of runaway inflation. Rather, I am concerned about market complacency. With the broad U.S. stock market up strongly over the past year, the financial markets are increasingly “pricing in” a vigorous U.S. economy in 2013—perhaps 3% real GDP growth or so. I hope the stock market is right in its assessment, although risks remain tilted on the downside.
While our long-held view for the U.S. economy has been one of cautious optimism, I find myself increasingly stressing the “cautious side” when discussing the financial markets with investors. Not because the U.S. economy isn’t resilient (it is). Rather, it’s because the markets never move upward in a straight line. No matter how much we all wish that they would. And no matter how large a central bank’s balance sheet becomes.
I would like to thank Casey Aspin and Charles J. Thomas for helpful comments and assistance in developing this blog post.
Notes: All investments, including a portfolio’s current and future holdings, are subject to risk, including the loss of principal. Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.