Fisher Investments Editorial Staff
Monetary Policy, Inflation

The Monetary Punch

By, 08/19/2009

Story Highlights:        

  • Ever since the Fed drastically increased the money supply last fall, inflation worries have been widespread.
  • But so far, we've barely seen any inflation at all—a sign monetary policy has been appropriate.
  • Future prices will depend on loan supply and demand—which should improve with better conditions, but needn't be too quick or abrupt.
  • With industry operating at a low 70% of full capacity and unemployment just under 9.5% (low labor utilization), there's room for growth without unchecked inflation.
  • Long-term interest rates (a good market-based predictor of future inflation) are still historically low too.



After the Fed doubled the money supply last fall, many worried it was too much, too fast—that rampant inflation loomed. The Feds' "punch bowl" was brimming over and soon the party would be too. (Whether the deleterious effects of said punch are from high sugar content or something more sinister remain a mystery.)


But who's been drinking the Fed's famous concoction? Have we seen heads or tails of unhealthy inflation yet? Any embarrassing dance moves? Nope. In fact, we've barely seen any inflation at all. July consumer prices, released last week, were flat compared to the month previous, and July producer prices, released Tuesday, fell a bit. Though rising or falling slightly month to month, that's pretty much been the story these days—underscoring the suitability of expansionary monetary policy.


But won't prices explode with all that money floating around, and soon? Isn't inflation always and everywhere a monetary phenomenon? Yes, but it's not solely a question of how much the monetary base has expanded. The question is how much of the monetary base is being put to work (i.e. loaned out and spent)? So far, wider monetary measures have yet to mimic the monetary base's quick growth—velocity is low. The Fed can hope to spur velocity by lowering interest rates (which it has). But otherwise, bank willingness to loan and consumer willingness to borrow determine how fast the Fed's monetary expansion hits the real economy.


Though the financial system is healthier as a whole, banks are more cautious about who they're lending to, and borrowers fretting the future (standard in a recession—even with low rates), aren't as inclined to take out as many loans, or, if they do, spend and re-spend the money. So, money supply is bigger on paper, but it's so far only begun to trickle into the real economy. This should speed up a bit as conditions improve—but won't be immediate.  


What happens when money gets back to work? That's when inflation hits right? Not so fast. We must consider at what fraction of full capacity firms are operating. In recessions, companies shrink production to match lower demand and find earnings—seen in dwindling inventories. Though businesses may slow production, their potential to produce more hasn't vanished. Think of it this way: If bakers efficiently cut expenditures, they don't need to sell their ovens to get by. When bread lovers return, idling ovens can quickly increase production at no extra cost. And anyway, until demand strengthens significantly, producers just don't have much pricing power. Prices can't rise—not much.


Giving us a clue the economy isn't at full capacity, July industrial "capacity utilization" (albeit a small part of the whole) remained under 70%, implying there's room for growth before we need fret inflation there. And with unemployment near 9.5%, labor utilization is low too. Further, what does the market think? Long-term interest rates, a good (but not perfect) market-based predictor of future inflation, remain historically low.


So far, the Fed's monetary punch has been appropriately mixed. With prices under control, the Fed needn't drastically alter the recipe—so they haven't. For now, the stimulatory effects should safely boost stocks and the economy.


*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.


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