Investing Lesson 8: Inflation Wasn't, and Isn't, Inevitable
Larry Swedroe, Director of Research, The BAM Alliance, 1/29/19.
Lesson 8: Inflation wasn’t, and isn’t, inevitable.
One of the most persistently asked questions I’ve received since 2009 is some version of the following: “What should I do about the inevitable rampant inflation problem we’re going to face because of the huge fiscal and monetary stimulus that’s been injected into the economy?” While that risk has existed, the fact is, since 2008, we haven’t had a single year in which the CPI exceeded 3%. In fact, 2011 is the only year it exceeded 2.5%.
A related myth persists among many investors as well. I frequently hear concerns about the exploding growth rate of our nation’s money supply. This belief likely has been fueled by certain commercials—the ones that recommend buying gold because central banks are printing money like we’re experiencing Weimar Germany all over again.
The fact is that M2, a broad measure of the money supply, hasn’t been growing at rates that suggest rampant inflation should be expected. For the 10-year period from Dec. 8, 2008 through Dec. 7, 2018, the Federal Reserve Bank of St. Louis reports that the rate of growth in M2 was 5.9%.
Since, as Milton Friedman, one of our greatest economists, noted, “inflation is always and everywhere a monetary phenomenon,” the factual data doesn’t support the view that we should have expected rampant inflation. In fact, despite the fears of many investors who seem certain that we will see massive inflation, neither the bond market nor professional economists are expecting anything of the kind.
We can at least get an estimate of the market’s forecast for inflation by looking at the difference between the year-end 2.68% yield on 10-year nominal bonds and the roughly 0.97% yield on 10-year Treasury inflation-protected securities, or TIPS. The difference is just 1.71 percentage points.
Clearly, investors, in aggregate, don’t appear concerned about rampant inflation. As for economists’ expectations, the Federal Reserve Bank of Philadelphia’s Fourth Quarter 2018 Survey of Professional Forecasters has a 10-year forecast of inflation averaging just 2.2% at an annual rate. Again, they don’t believe rampant inflation is likely, let alone inevitable.
Don’t get the wrong idea—the risk that inflation could increase dramatically is still present. It hasn’t happened so far because, even though the monetary base has been increasing rapidly (as the Fed’s balance sheet expanded through its bond-buying program), the velocity of money (as measured by M2) has fallen pretty persistently from about 2.0 at the end of 2007 to about 1.5 at the end of 2018, a drop of approximately 25%.
That said, there remains the risk that if or when the velocity of money begins to rise, inflation could increase. Of course, the Fed is well aware of this risk and would likely act—reverse its bond-buying program and raise interest rates—to prevent inflation from taking off.
- Investing Lesson 1: Active management is a loser’s game
- Investing Lesson 2: Diversification is always working; sometimes you like the results and sometimes you don’t
- Investing Lesson 3: The mistake of recency
- Investing Lesson 4: Your Discipline Will Be Tested
- Investing Lesson 5: The Stock Market and the Economy are Different
- Investing Lesson 6: Crystal Balls are Cloudy
- Investing Lesson 7: “Sell in May and go away” is the financial equivalent of astrology
The BAM Alliance is an active community of more than 140 independent firms dedicated to delivering true wealth management. As Vermont's only member of the BAM Alliance, Copper Leaf Financial is very pleased to have access to all of the organization's resources and industry thought leaders including Larry Swedroe. Larry is the well-respected author of 16 books on personal finance, and has at times shared his insights directly with Copper Leaf clients.