Drop money from a helicopter History not repeating itself on inflation

It is considered one of the bedrock beliefs of conservative economic orthodoxy.

“Inflation is always and everywhere a monetary phenomenon,” the University of Chicago economics professor Milton Friedman declared in providing an academic explanation for why consumer prices were rising so rapidly in the guns-and-butter days of the late 1960s.

Friedman’s reference to “a monetary phenomenon” suggests a tight and continuing relationship between money and inflation. Yet despite massive money printing by central banks worldwide, the goods and services inflation that Friedman referenced is nowhere to be found. While sound-money advocates remain steadfast in their belief that the inflationary genie will soon escape the bottle, most economists are baffled by the continuing lack of inflation in a U.S. economy that is at or near full employment.

The question of whether inflation is always and everywhere a monetary phenomenon is of more than academic interest to investors, since many Americans have some of their life savings in financial assets that are expensive, if not outright frothy.

Historically, equity market valuations have moved inversely to interest rates, which would rise sharply if inflation took off. In the inflation-ridden 1970s, U.S. stocks sometimes traded at 10 times trailing earnings. If that valuation were applied to the S&P 500 today, stocks would be 60% lower. Even at its longrun average of 15 times earnings, the Dow Jones industrial average would be trading at about 1600, or almost 30% below its current level.

The monetary expansion of recent years was intended as a last resort.

With short-term interest rates at zero during the Great Recession, the Ben Bernanke-led Fed was desperate for another monetary conduit to resuscitate the flat-lining U.S. economy. Years earlier, Bernanke had suggested, somewhat tongue-in-cheek, that if super-low benchmark rates ever became ineffective, the government could always print money and drop it from a helicopter.

In November 2008, two months after the Lehman collapse nearly cratered the global financial system, Bernanke figuratively loaded the Fed’s choppers with $100 billion of newly minted coin and ordered them airborne, a down payment on a multi-year program of quantitative easing that only now is being slowly wound down.

Over the past eight years, the Fed’s balance sheet ballooned from $800 billion to $4.5 trillion. Combined with the European Central Bank and the Bank of Japan, each of which have engaged in massive quantitative easing programs of their own, the combined balance sheets of the three largest central banks has more than doubled to over $13 trillion.

Which begs the question: With the money presses going full tilt, why is global inflation still disconcertingly low, not dangerously high? Core inflation in the U.S. is running at just 1.4% and has undershot the Fed’s 2% target during each of the last five years. Decades after revving up its own fleet of helicopters, Japan’s inflation rate is still below 1%.

It’s complicated

Does persistently low inflation prove that Friedman was wrong?

Not necessarily. Consumer inflation might be even lower — perhaps below zero — without the Fed and other central banks creating money out of thin air. Technology, demographics and globalization have exerted downward pressure on prices, as has the emergence of a servicebased economy dominated by lower-paying jobs. Against that deflationary backdrop, global quantitative easing triggered asset inflation, though elevated stock and bond prices come with their own set of risks.

The trillions of dollars created over the past eight years could still represent dry timber for inflationary fires at the consumer level if economic activity accelerated enough to generate robust demand for credit.

That’s why investors should be leery of significantly faster economic growth, which would push up unit labor costs. When that happens, the economic cycle that began in the aftermath of the Great Recession will have entered its final phase. Over the near term, however, structural headwinds should offset the inflationary implications of bloated central bank balance sheets.

It’s the job of monetary policy makers to know when to hit the gas and when to apply the brakes. Next year, a new set of officials at the Fed could be making those decisions. Only devotees of Friedman’s strict monetarism could deny that the new leaders will have a tough act to follow.