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APRIL 2009
In sum, the government’s reflationary efforts in current form are being used in an effort to stimulate aggregate demand
in hopes of pushing aggregated demand back up and to the right. If successful, this action would shift real GDP back
to the right, bringing the model to a new equilibrium.
So while these efforts are reflationary, the big question for investors is not if, but when the economy recovers and banks
lend again, can the Fed reduce its balance sheet, raise rates, and rein in its other lending programs quickly enough to
keep the velocity of money from spinning out of control, i.e., high inflation. To put the more recent past into
perspective, consider the future. Larry Summers, economic advisor to President Obama, has stated on more than one
occasion that it is much easier for policy makers to overshoot and deal with the after effects later than it is to not do
enough. 5 In considering how quickly the Fed has been able to act to rein in inflation following past recessions and past
countercyclical efforts, the team at Grant’s is again on the case. Noting that in the prior two recessions, which met with
considerably less monetary and fiscal stimulus than the current recession, those ending March 1991 and November
2001, the Fed removed its accommodative stance with a significant lag. Indeed, in the recession that ended March
1991, the Fed did not begin to raise rates until February 1994, and in the recession that ended November 2001, the Fed
did not begin to raise rates until June 2003. 6 While nobody knows the unintended consequences of what has become
the most epic of reflationary efforts in U.S. history, we believe that based on the past history of the Fed and the sheer
size and scope of the various programs put into place by the government, investors should be concerned with inflation
once the economy recovers.
What is Inflation?
Much like deflation is defined as too few dollars chasing too many goods, inflation can be defined as too many dollars
chasing too few goods. Also like deflation, there is a psychological component that can be self-reinforcing. Consumers
begin to believe that prices will increase and therefore increase aggregate demand. Retailers and manufacturers begin to
see this increase in demand and therefore begin increasing production, paying higher wages, and ultimately raising
prices. If deflation can lead to greater unemployment in an economy, then inflation can reduce unemployment in an
economy.
While fairly obvious to most economists and many market observers, a recent Bloomberg article posited that Federal
Reserve chairman Ben Bernanke is siding with economist, and well-known counter-cyclical intervener, John Maynard
Keynes against monetarist economist Milton Friedman, by flooding the financial system with money in an effort to
stimulate aggregate demand. Within this article, Allan Meltzer, the Fed historian and professor of political economy at
Carnegie Mellon University in Pittsburgh, noted that “if history is any guide, the Fed’s effort will end in tears and
inflation will be higher than it was in the 1970s. At the end of that decade, consumer prices rose at a year-over-year rate
of 13.3%.” 7
As mentioned earlier, the Federal Reserve has increased its balance sheet dramatically, and its subsequent monetization
of the government’s debt obligations through its Treasury purchases (known more fondly as quantitative easing) are
akin to printing money. Additionally, the M1 (currency, traveler’s checks, demand deposits, and other checkable
deposits) and M2 (M1 plus retail money market funds, savings, and small time deposits) money stock measures, as
reported by the Federal Reserve, have grown considerably on a seasonally adjusted basis since the beginning of the
recession. M1 has grown by 14.5%, to $1.6 trillion, and M2 has grown by 12.2% to $8.3 trillion. As economist Milton
Friedman said “inflation is always and everywhere a monetary phenomenon” and the growth of the monetary stock is
indeed on the rise and shows no immediate sign of slowing.
© 2009 Fund Evaluation Group, LLC