This document discusses inflation and monetary policy. It begins by defining average inflation over the last 50 years as around 4% according to the Consumer Price Index. It then notes that the market currently expects future inflation to be around 2%, in line with the Federal Reserve's target. However, it expresses concern that monetary policy interventions in response to the financial crisis, which dramatically increased the monetary base, could sow the seeds for higher inflation in the future if banks begin lending out excess reserves more aggressively. Fiscal policy interactions with monetary policy are also flagged as a potential issue to monitor regarding inflation.

1. SEPTEMBER 2009
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Introduction Examining Present and Future Inflation
What is Average Inflation?
What does the market expect infla-
tion to be? Introduction
Monetary Policy In a swift reaction to the tech bubble, 9/11, and significant corporate scandals
that rocked the integrity of many public corporations, the Fed took decisive ac-
Fiscal Policy: Making it Reconcile tion and significantly cut interest rates. Although, coupled with other govern-
Interaction between Fiscal and ment interventions, the Fed’s actions seemed to be warranted and even ap-
Monetary Policy plauded. However, one of the most scathing criticisms of Alan Greenspan was
that he left interest rates too low for too long and by doing so exacerbated the
……………………………… recent financial collapse by facilitating easy money and subsequent credit. As the
US economy stabilizes from the crisis of the last two years, can a reasoned argu-
WHAT IS OCCAM’S RAZOR? ment be made as to whether this intervention is sowing the seeds for the next
recession?
Occam’s Razor is a principle
attributed to William Occam, Right now the counter argument to “the economy seems to be recovering” is
a 14th century philosopher. He “yeah, but wait until inflation kicks in.” This article will try to detail why this
counter argument is being made and whether there are valid reasons for being
stressed that explanations must wary of inflation in this environment. Although we will not address it now, a
not be multiplied beyond what follow up article will detail how we intend to accommodate for various scenarios
is necessary. Thus, Occam’s Razor within the context of your investment portfolio.
is a term used to “shave off” or
dismiss superfluous explanations Before beginning this article I will also like to point out that our clients are the
for a given event. This concept intended audience. Hence in the interest of readability, I will try and simplify and
is largely ignored within the at times err on the side of comprehension. As long as our clients can understand
investment management landscape. the logical stream of events and their significance, than I am willing to sacrifice
This newsletter will “shave off ” being completely precise in my explanation of economic theory. (The data for
popular investment misinformation this article was derived from DFA’s L. Jacobo Rodriguez, Will Exiting From the
and present what is important for
Great Recession Take Us to the Great Inflation?)
achieving long-term investment The problem with inflation is that it erodes the purchasing power of money. In
success. the last 15 years, a period during which inflation in the United States has been
low and stable by most standards, the purchasing power of $1 has decreased by
DISCLOSURE The Company only transacts nearly one-third. It now takes $1.50 to purchase what $1.00 used to buy.
business in states where it is properly registered, or
excluded or exempted from registration
requirements. Please click below to see our
disclosure page on our website for further detail. What is Average Inflation?
………………………………
There are two types of inflation measures, a general measure and a core measure.
This newsletter is published by: General inflation measures are based on an average basket of goods that can be
McLean Asset Management Corp. purchased from one year to the next by a consumer. For example, if your trip to
8200 Greensboro Drive Target, the Safeway, and Chevron is more expensive this year than last year, you
most likely had inflation. The core measure of inflation excludes food and en-
Suite 1150 ergy. So if you just went to Target and it was still more expensive then the previ-
McLean, VA 22102 ous year, you experienced core inflation.
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2. Over the last 50 years, inflation and core inflation has been in the low 4%, as
measured by the Consumer Price Index (CPI). But this is not a static average rate.
The mid 1960s and early 1980s were periods of considerably higher-than-average
inflation; and the early 1960s and 2000s were periods of lower-than-average in-
flation. Also, differences between the general and core measures of inflation have
also differed considerably for periods of time. This may occur if gas and or food
prices deviate significantly from the basket of goods. It is because of this down-
turn in the core headline measures that many thought that, in the short term, pos-
sible deflation was a bigger problem than inflation.
What does the market expect inflation to be?
One can observe market expectations of inflation by observing the yield difference
between a government bond and an equivalent government bond that is indexed
for inflation. This means that if a government bond is yielding 5% and a similar
government bond indexed for inflation is yielding 2%, then the 3% difference
between the two bonds is the markets expectation for inflation. This TIPS spread is
often used as a market-based proxy of inflation expectations. Currently, the spread
remains firmly anchored around the Federal Reserve’s unofficial inflation target of
2%, and although slightly higher, survey-based measures of near-term inflation
expectations generally support this figure.
So if recent readings of inflation have been moderate and the market’s expectation
of future of inflation is well anchored near 2%, why should we be worried about
inflation?
There are three reasons to keep an eye on possible inflation.
Monetary policy- the government’s ability and processes in controlling the
amount of available money, and thus the cost of money (i.e., interest rates).
Fiscal policy- the government’s ability to influence the economy through govern-
ment spending and revenue collection (i.e., taxes).
Serving two masters. Although the Fed’s focus has traditionally been monetary
policy, it has crossed into the realm of fiscal policy and thus could compromise its
independence and limit its ability to promote stable inflation in future years.
Monetary Policy
Keeping a controlled money supply is a good thing because it enables government
fiscal stability. If the amount of money in circulation increases significantly, so
will the prices of goods. Therefore, long run changes in the money supply deter-
mine changes in the price level—that is, the rate of inflation. As Milton Friedman
put it, “inflation is always and everywhere a monetary phenomenon, in the sense
that it is and can be produced only by a more rapid increase in the quantity of
money than in output.”
In a nutshell, traditional monetary policy works as follows: The Federal Reserve
has a policy target for the short-term nominal interest rate and for inflation. To hit
those targets, the Fed trades government securities with the public.
When the Fed buys government bonds, the sellers are flush with cash and subse-
quently bank reserves increase. All else being equal, the fed funds rate falls because
there is no incentive to pay high interest rates. The increase in bank reserves in-
creases the amount of potential money in circulation.
Before the fall of 2008, banks lent out their reserves into circulation because banks
had no incentive to keep any excess reserves deposited at the Federal Reserve,
where they earned no interest. As the financial crisis worsened, from September
2008 to December 2008, banks needed to drastically increase their reserves.
Through various Federal Reserve programs, the monetary base increased from
approximately $850 billion to over $1.6 trillion, from September 2008 to June
2009, to accommodate a bank’s increasing need to offset potentially toxic assets
with cash. That increase has had a limited impact on the amount of currency in
circulation because the banks kept it in their books. Excess bank reserves increased
from about $2 billion in August 2008 to over $750 billion in June 2009.
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3. In normal times, banks would not keep a large amount of excess reserves—
certainly far less than $750 billion—sitting idly at the Federal Reserve. They
would have loaned out those reserves, which would have led to a massive increase
of the money supply, which in turn would have been very inflationary. But, given
the extraordinary conditions in the fall of 2008, the increase in excess reserves
most likely reflected a sharp increase in money demand that was accommodated
by the Federal Reserve. Hence the phrase, “Banks are not lending money.”
To try and prevent banks from eventually flooding the market with “consumer
loans” that will work its way into the money supply, the Fed started paying inter-
est on reserves in order to incentivize the banks to hold excess cash reserves at the
Fed. In essence, the Fed is aiming for controlled growth. In addition, Fed asked
the Treasury to borrow money on its behalf. Through June the amount was about
$200 billion. By lending money to the Treasury and not to consumers banks are
able to lend money and the Fed keeps the money supply in check.
As the economy improves, the Fed will have to ask itself: How high will the rates
paid on excess reserves have to go to prevent undesired increases in bank lending?
This payment of interest in reserves creates a second complication- it essentially
continues to increase in those reserves. So, while the payment of interest on excess
reserves may make the Fed’s job more manageable in the short term, it could ac-
tually make it more difficult in the long term.
There are still other options available to the Fed for reducing bank excess reserves.
1) It can turn those reserves into term deposits with different maturities and inter-
est rates- like CDs.
2) The Fed could sell securities from its portfolio to those institutions and agree to
purchase them back at a later date at a higher price- essentially buying back the
toxic assets that the government bought from them in the first place.
3) The Fed could ask the Treasury to issue more debt on its behalf and deposit the
proceeds with the Federal Reserve- have the banks use their cash reserves to buy
government bonds.
Fiscal Policy: Making it reconcile
Until now, we have alluded to the budget situation of the US government without
providing any detail on how it is related to the Fed’s job or how it could impact
inflation. A brief review of public finance will make our task easier. The valuation
equation for government debt states that the net present value of the government’s
tax revenues and the revenue from printing money must equal the net present
value of its expenditures plus the real value of its total outstanding debt.
The government must raise sufficient revenue, in today’s value, to pay for its fu-
ture planned expenditures and repay its existing debt. When the government has
current outstanding debt, the government must run, in today’s value, primary
surpluses in the future. Those surpluses can be obtained by adjusting the level of
taxes, expenditures, or printing money. Hence the budget equation is made
whole through either- taxes, spending, or printing money. If legislators are reluc-
tant to raise taxes or make cuts to popular government programs, they are more
likely to pressure the Federal Reserve to produce inflation to bring the fiscal valua-
tion equation into balance. And inflation essentially becomes a tax that everyone
bears.
Are we in a precarious state? Depending on the time of day or what cable channel
is on, these numbers may differ drastically but according to the federal budget and
if the President’s policy proposals are implemented in full for fiscal year 2010, the
federal government’s deficit is projected to be 13% of gross domestic product in
2009, a peacetime record. For 2010, the deficit is projected to be equal to almost
10% of GDP. As a result, the debt held by the public will rise from 41% of GDP in
2008 to 57% of GDP in 2009 and to 82% of GDP in 2019. (I will leave it at that as
the numbers don’t get any better.)
Time will tell if and when the federal government reaches its fiscal limit, but it is
clear that the fiscal position of the United States is more precarious now than it
was before. Will the Fed be able to withstand the pressure?
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4. Interaction between Fiscal and Monetary Policy
The historical evidence indicates that central bank independence is an important
factor in promoting low and stable inflation. Although a strong argument can be
made that it was needed, many of the actions undertaken by the Federal Reserve
during the financial crisis are likely to have compromised its ability to conduct
monetary policy independently of political pressures and short-term political
considerations in the future.
Although we do not know whether high inflation is inevitable in the medium or
long term, there are valid reasons to be concerned about such a scenario. The
Federal Reserve has increased the potential monetary base on an unprecedented
scale; the Fed’s exit strategy may be more difficult to carry out successfully than
the Fed anticipates; and, in the process of responding to the financial crisis, the
Fed has compromised its independence. All these factors make it more difficult
for the Federal Reserve to be able to fulfill its primary mission of creating an en-
vironment of low and stable inflation. In addition, the fiscal position of the US
government is rather uncertain. There is considerable evidence that large, persis-
tent deficits cannot be financed without inflation. To prevent high inflation in
the future, the Fed must go back to focusing on price stability rather than credit
allocation, the Fed must be able to conduct monetary policy free of political pres-
sures, and policymakers must take steps to put the fiscal balance of the United
States on a sustainable path.
A follow up article will detail how we are preparing for various scenarios within
the context of your investment portfolio.
REFERENCES
1. For other recent Dimensional studies that address the topic of inflation, please
see David G. Booth, “Asset Allocation,” Dimensional Fund Advisors white paper,
June 2009; and James L. Davis, “Inflation, Living Standards, and Returns,” Purely
Academic, Dimensional Fund Advisors secure site, available at https://
my.dimensional.com/articles/purelyacademic/2009/08/inflatio/.
2. For more information about monetary policy, fiscal policy, and the interaction
between the two, see, for instance, Carl E. Walsh, Monetary Theory and Policy, 2nd
edition (Cambridge, MA: The MIT Press, 2003). For an analysis of the current US
macroeconomic situation and the federal government’s response to the financial
crisis that uses the fiscal valuation equation, see John H. Cochrane,
“Understanding Fiscal and Monetary Policy in 2008-2009,” available at http://
faculty.chicagobooth.edu/john.cochrane/research/Papers/
fiscal_crisis_princeton.pdf.
3. Congressional Budget Office, “An Analysis of the President’s Budgetary Pro-
posals for Fiscal Year 2010,” June 2009, available at http://www.cbo.gov/
ftpdocs/102xx/doc10296/06-16-AnalysisPresBudget_forWeb.pdf.
4. See, for instance, Alberto Alesina and Lawrence H. Summers, “Central Bank
Independence and Macroeconomic Performance: Some Comparative Evidence,”
Journal of Money, Credit and Banking 25, no. 2 (May 1993): 151-62.
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