Inflation Inferno? Maybe In 2013 And Beyond

by: Russ Koesterich, CFA

In a controversial new paper, a staff economist at the Federal Reserve Bank of St. Louis warns that conditions are ripe for a spike in inflation. The economist, Daniel Thornton, argues that the Fed’s policy of providing liquidity has “enormous potential to increase the money supply,” resulting in what the Wall Street Journal’s Real Time Economics blog calls “an inflation inferno.”

While I share many of Thornton’s concerns, I think it’s too soon to make significant changes to a portfolio based on inflation fears. Given the recent rise in bank lending, growth in the money supply and unprecedented nature of the Fed’s monetary experiment, inflation is certainly a significant risk. However, in my opinion, it’s not an imminent one and is more of a risk for 2013 and beyond.

While there is a healthy theoretical debate on whether increases in the money supply lead to inflation, I believe the logic is simple. As the supply of money goes up, the value of money drops, causing inflation.

To be sure, the Fed is likely to try to use tools in its arsenal to combat the reality of this simple theory. According to the Wall Street Journal, the Fed is considering implementing a new bond-buying program along with future possible stimulus to “relieve anxieties that money printing could fuel inflation later.” However, this possible approach, like other recent Fed tools, is untested and it’s unclear how it would work in reality if it were implemented.

What’s certain is that historically, rapid increases in the money supply have historically led to inflation in the United States, though there typically is a lag between money creation and inflation. Historically, it generally has taken two to three years before growth in the money supply has translated into a meaningful acceleration in inflation. Take the mid 1970s, when U.S. inflation spiked, despite a weak economy, after a double-digit expansion of the money supply between 1971 and 1973.

So far, the Fed’s asset purchase programs - QE1, QE2 and Operation Twist - have not resulted in inflation. This is because, until recently, the extra money the Fed created sat quietly on bank balance sheets as banks contracted their lending. Without bank lending, the money supply didn’t rise very much (although the monetary base, which includes bank reserves, has shot up).

The situation, however, has started to change. Outside of the mortgage market, bank lending has been rising since last summer. Commercial and industrial loans are now growing at 11% year-over-year, the fastest rate since 2008. As bank lending has risen, money supply growth has also started to accelerate; in January, M2 was up over 10% from the year before.

With M2 growth just starting to accelerate in late 2011, I’d be surprised to see a sharp spike in inflation this year. Of course, headline inflation is likely to rise in the near term due to higher oil prices. However, this should not be interpreted as the start of a broad spike in overall inflation, which over the long term will be about the same as core inflation. While higher near-term headline inflation will be a drag on consumers, it’s unlikely to change my inflation outlook unless rising prices spill over into core inflation.

Sources: Bloomberg, the Federal Reserve Bank of St. Louis, The Wall Street Journal.

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