Open an economics textbook, and you’ll find this fundamental principle: When the money supply expands—that is, when the government prints more money—higher inflation is often the result. This topic has, for good reason, been on investors’ minds lately. Since the pandemic began, the Federal Reserve has increased the money supply by several trillion dollars. So is higher inflation now inevitable? I see five possible answers to this question:
1. Yes, of course. Between 2010 and 2020, inflation averaged just 1.7%. But the three most recent readings—in June, July and August—have all topped 5%. For that reason, it seems like an obvious conclusion that the Fed’s actions have led to a sharp uptick in inflation. It’s just as a textbook would have predicted.
2. No, because this time is different. I’ve heard more than one concerned investor compare the Fed’s actions today to those of Weimar-era Germany. During that period, the German government printed so much new money that it resulted in hyperinflation. How bad did it get? To cite one example, the price of bread rose from 163 marks in December 1922 to more than 200 billion marks just eleven months later.
Citing the Weimar example certainly paints a dramatic picture, but it’s not an accurate historical analog. Eric Hilt, an economic historian at Wellesley College, provides this explanation:
“The Fed’s actions over the last 18 months have very little to do with what happened in Germany in the 1920s. The distinction is subtle but important. After World War I Germany…printed currency (paper money) to pay the government’s bills. As the amount of paper currency in circulation expanded, the value of the currency decreased, which meant that larger amounts needed to be printed to produce the same revenue, and the situation spiraled out of control into hyperinflation. None of that has happened in the U.S. The Fed has acted to backstop markets in new ways and has expanded its balance sheet, but it has done so not by increasing paper currency in circulation (printing money), but by adding to the deposit accounts of financial institutions—their reserve accounts. This is different from money in circulation because it is not going to be spent quickly.”
That last point is key: Yes, the Fed has printed an enormous amount of money, but it hasn’t all gone directly into consumers’ pockets, where it could be spent and thus contribute to driving up prices.
To be sure, some of the new money has found its way, indirectly, to consumers. That’s because the Fed helps to finance the U.S. government’s deficits. And during the pandemic, a large part of the deficit has resulted from programs like PPP loans that have bolstered consumers’ spending power. Still, Hilt makes an important distinction between the Fed’s actions today and the actions of the German government in the 1920s. Upon casual observation, they might seem similar. But they’re not the same—either in character or in magnitude.
3. No, though it’s natural to suspect fire when we see smoke. While the overall inflation rate has more than doubled in recent months, defenders of the Fed’s actions are quick to point out that there’s more than meets the eye. Foremost among these defenders: Fed chair Jerome Powell, who has argued that the recent inflation spike will be temporary.
To support his view, Powell points to a breakdown of this year’s inflation figures, which reveals that prices have not accelerated across the board. Instead, inflation increases have been limited to specific sectors. In most cases, these are industries which have experienced Covid-related supply chain disruptions. The price of lumber, for instance, rose sharply last year, though it has moderated more recently. And car prices—particularly used car prices—have also jumped, due to a global shortage of semiconductor chips. Modern cars, it turns out, require between 1,000 and 3,000 chips to manufacture.
In other words, the Fed acknowledges that inflation has been running hotter. But Powell’s contention is that it’ll cool off once the supply chain normalizes: “As these transitory supply effects abate, inflation is expected to drop back toward our longer-run goal.”
4. No, because the world economy has changed. More or less continuously since the 2008 financial crisis, the Fed has been engaged in “quantitative easing”—a technical term for printing money. And Japan has similarly been expanding its monetary base. And yet, in both countries, observers have noted that inflation remained quite low. In fact, for several years prior to the pandemic, the U.S. enjoyed both low inflation and low unemployment. This also defied textbook economics.
For those reasons, a group of academics and politicians have been making the case that today’s economy is different. And because of that, they think the traditional rules no longer apply.
Specifically, they believe the U.S. government can now, within reason, print as much money as it wishes. And that new money can be used to finance much larger deficits than ever before. According to this line of argument, then, there’s no reason to fear further inflation.
5. Maybe, but it depends on what Congress does next. It may be too early to tell. As recently as February, the monthly inflation reading was still below 2%. So Powell may very well be proven right that this is transitory.
In addition, Washington is working on a new set of initiatives which will, on the one hand, impose higher taxes, and on the other, increase spending. So it’s difficult to know how this will all net out.
As an individual investor, where does this leave you? As the saying goes, it’s clear as mud. But that, I think, is precisely the conclusion to draw. You might find one or another of the above arguments to be convincing. But ultimately, there’s no way to know where all the crosscurrents will lead.
My view: In the absence of definitive data either way, investors’ best strategy is to diversify. In the past, I’ve argued that stocks provide effective inflation protection. That’s still my view. And on the bond side, I recommend an allocation to inflation-protected bonds—either TIPS or I Bonds. Importantly, though, you want to maintain balance. Even if you have strong views on this question, take a moderate approach with your portfolio so you’re not unduly affected no matter which way this debate turns out.
