By: Tim Hayes Financial Advisor - posted in: Economy, Markets, and Interest Rates - Last updated Nov 29, 2018

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Economists Warn Investors about Inflation, Again

by | Economy, Markets, and Interest Rates

Over the past few years, some highly respected economists have been alarming investors with their predictions that the Federal Reserve’s quantitative easing (QE) program fuels inflation. When inflation heats up, interest rates rise, and investors who own both stocks and bonds see the value of their bonds fall. However, contrary to these predictions, inflation has remained low.

The first thing the Federal Reserve (Fed) did in response to the financial crisis was to cut the rate at which banks borrow money, slashing it from 5.25% to zero. “Banks borrow money?” you may ask. “I thought banks lent money!” They do both. Banks lend more money to the public than they have, and whenever they don’t have enough money to process a customer’s loan, they borrow from other banks.

Quantitative Easing

Even with this rate at zero, the economy languished. With only one tool left—QE—the Fed, with a click of a mouse, created trillions of dollars to buy longer-term bonds from banks, pension plans and asset managers, hoping those purchases would lower longer-term interest rates and spur more bank lending.

The banks that sold bonds to the Fed received money they then deposited at their bank, namely the Fed. Those bank deposits are called reserves. From August 2008 to December 2014, excess reserves rocketed from $1.9 billion to $2.6 trillion.

Excess Reserves: Oceans of Cash

The Money Multiplier

The economist worry that, because banks lend more money than they have, if banks multiply that $2.5 trillion into loans—say, by a factor of two—that is $5 trillion that could enter the economy and fuel inflation. In 2013, one of the most prominent economists in the U.S., Harvard professor Martin Feldstein, warned investors, “The banks can use these excess reserves to create loans and deposits, which will increase the money supply and fuel inflation.”

John Taylor of Stanford University, another highly acclaimed economist, also in 2013 cautioned investors, ”When the economy begins to heat up, the Fed will have to sell the assets it has been purchasing to prevent inflation. If its asset sales are too slow, the bank reserves used to finance the original asset purchases pour out of the banks and into the economy.”

Q/A Financial Advisor Tim Hayes

Inflation Remains Low

Excess reserves fueling inflation hasn’t happened—nor will it, because banks can only lend them to other banks. Consumer and businesses demand, not reserves, determine loan amounts and frequencies. During the housing boom, banks had almost no excess reserves, but everyone and their brother got a loan.

During these past five years—the time period QE was being implemented­– the inflation rate has remained low and the Barclays Capital U.S. Aggregate Bond Index, a proxy for the U.S. bond market, increased 4.41% a year.

Inflation Warnings Continue

However, it only took a few months after the Fed ended QE for Professor Feldstein to repeat his inflation warnings. On March 30, 2015, he wrote, “The Fed should accelerate its projected rate increases and communicate the new projections explicitly to markets. Unless this is done, the combination of rising inflation and increasing real interest rates may expose the economy to an unnecessary risk of financial instability.

If, in the future, relentless inflation does return, investors with bonds can carry out fallback strategies: adding shorter-term bonds, inflation-protected bonds, and/or emerging market bonds. (Asset allocation and diversification strategies cannot assure profit.)

Financial Bubbles

But the dangerous side effect of QE is not inflation, it’s that risk assets, such as stocks, get pricey. Many of the asset managers and pension plans that sold bonds to the Fed used their proceeds to purchase risk assets. Those purchases propelled those assets higher, and higher prices entice speculators who borrowed money to buy those same risk assets. The public, frustrated by the low-interest rates, also purchased those assets.

Are We in Another Financial Bubble?

Bonds can help reduce that risk. During the last bear market in stocks (Oct 2007-March 2009), when the S&P 500 lost 56%, the Barclays Capital U.S. Aggregate Bond Index was up 6.97% in 2007 and 5.24% in 2008. (Indices mentioned are unmanaged, do not incur fees, and cannot be invested into directly.)  So, unless an investor’s risk-tolerance or goals change, it is unwise for investors to react to inflation fears or rising stock markets by changing the percentage of their portfolio invested in bonds.

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