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Investors Should Assume That Inflation Will Exceed The Fed's Target

January 17, 2013

We believe that investors worried about inflation uncertainty should assume that the Fed will try to limit inflation but will probably be willing to err on the side of allowing inflation to exceed its target more than it allows it to fall below its target.
-Gary Thayer, chief macro strategist, Wells Fargo

The Federal Reserve has two mandates, price stability and maximum employment. Recent policy statements from the Fed suggest that policymakers consider 2.0% inflation to be price stability while an unemployment rate below 6.5% is consistent with maximum employment. Of course, the unemployment rate at 7.8% in December was well above the Fedís maximum-employment threshold. As a result, the Fed continues to follow a low-interest rate policy, buying bonds in order to push both short-term and long-term interest rates lower. This policy has worked, and interest rates are near historic lows. However, many investors are worried that the Fed has gone too far and is pumping too much money into the economy, creating an increased risk of inflation.

History shows that inflation is caused by too much money chasing too few goods. The amount of money in the economy has increased significantly since the financial crisis in 2008 and 2009. Consequently, many investors are increasingly worried about inflation. However, the amount of money alone does not cause inflation. It is a combination of too much money chasing too few goods. There may be a lot of money in the economy but it is not chasing a limited supply of goods. In fact, the rate of turnover or velocity of the money in circulation is at its lowest level in more than 50 years. This suggests that the risk of inflation is still relatively low, despite the abundant supply of liquidity in the economy. The risk of inflation would be significantly higher if velocity of money was increasing because consumers and businesses were spending the extra liquidity at a rapid rate. That is not happening now.

This week's chart shows the velocity or turnover rate of a broad money measure that the Fed calls MZM. The velocity of MZM is the ratio of the current dollar value of U.S. gross domestic product divided by the MZM money supply. MZM consists of cash, checking accounts, and other zero maturity deposits in the U.S. financial system. This chart clearly indicates that the current low velocity of money is still more consistent with the low inflation environment of the past decade than the high-velocity, high-inflation environment of the 1970s and early 1980s. In other words, many consumers and businesses are sitting on large cash-like balances as a precaution against unexpected events. They are not spending that money at a rapid rate. We believe the risk of inflation remains low as long as the velocity of money remains low.

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