Why inflation is so misunderstood
Ken Fisher column.
Federal Reserve head Janet Yellen has misplaced inflation. And she just can’t find it. Oops! Her cabal thinks yearly Consumer Price Index increases of 2% are somehow “right.” They can’t fathom why what they do doesn’t create “enough” inflation.
Once you understand why this is stupid, you can plan, budget and invest better.
Inflation isn’t precise. Indexes like the CPI — a wonky lineup of antiquated goods and services — are misleading. Indexes are guesstimates, broad averages. There is no “right” average. Some prices rise much more, some less and some fall. Health care and education costs are rising. Electronics are falling. Energy costs have fallen fiercely since 2011.
Your experiences vary from others. Grandma feels health care costs more than young singles. Renters dread rising rents. Homeowners don’t. Undergrads munching McDonald’s fear food costs less than mothers of three.
Yellen, Powell & Co. misunderstand. Markets don’t. They value realities, not arbitrary indexes. Take stocks. They’ve done super despite inflation indexes being “too low.”
When I was young, the economist Milton Friedman was in his prime. Among the 20th century’s great thinkers, Friedman’s fame flowed from showing how money and inflation really worked. His 1963 opus, “A Monetary History of the United States” (co-author, Anna Jacobson Schwartz), detailed how changes in money supply affected growth and inflation, for good or ill. Few now recall his teachings. You should.
Here they are: Inflation follows from excess money supply growth. Deflation? From money supply shrinking.
Put another way, inflation is too much money chasing too few goods and services. Long term, money supply growth totals to real economic growth plus inflation. Contrary to common perception, we just grew the broad quantity of money, as formally defined, at the lowest rate of any economic expansion, ever.
Who grew it at this low rate? Banks did. Money, what we trade when buying and selling things, comes from banks. In Friedman’s day, it was cash and bank accounts, and it was called “M2.” Now money also includes credit cards, bank transfers, e-payment systems and some complex banking instruments. It’s called “M4.” Most of M4 is actually loans (like credit cards).
The money supply increases only when our banking system increases net outstanding loans. That’s how it works. More bank lending, more money. It’s that simple.
In our eight-year-long economic expansion, based on Federal Reserve data, M4 grew by 2% a year. As did our economy. Hence, low inflation. In prior expansions, M4 always rose at least twice as fast.
So inflation stayed low, despite gargantuan quantitative easing by the Fed. As I’ve always said, and Friedman would know, QE isn’t expansionary or inflationary, despite common belief.
Why? Because QE decreases bank lending and hence money supply growth. Why? Banks pay for short-term deposits to recycle into longer-term loans. That’s banking’s core business. Always was. Banks live off that spread between short- and long-term interest rates. When long-term rates rise relative to short-term ones, banks become more eager lenders because lending becomes more profitable. They gain a wider gross profit margin on future loans. So they lend more.
With QE, the Fed bought long-term debt securities. That pushed up their price, dropping their interest rates. Ms. Yellen, Powell & Co. stupidly think lower rates will cause inflation. Wrong. They never learned their Milton Friedman. Inflation needs more lending.
And lending decelerated this year, meaning overall inflation won’t rise much anytime soon. So don’t invest in things whose prices depend on big inflation. Skip natural resources, most commodities, gold and raw land. Home prices recovered from the housing crash and probably won’t see big gains from here. As inflation remains low, don’t envision interest rates returning to yesteryears’ higher levels that so many expect. Won’t happen!
From here, only a rapid unwinding of QE would goose inflation. What has been and will keep working for investors in this low inflation environment?
Rather obviously, the stock bull market. Enjoy it.