How to Hedge Against Inflation

10/19/2012 10:30 am EST

Focus: MARKETS

William Strauss

Senior Economist and Economic Advisor, Federal Reserve Bank of Chicago

William Strauss discusses how you can hedge against the risk of inflation and protect your portfolio.

We’re at The World MoneyShow in Chicago, and I’m here with William Strauss.

William, I guess one of the things that people always talk about especially at The MoneyShow is inflation hedges especially now on the heels of QE3. There are a lot of people and we have an election coming up on top of it, so gold and other inflation hedges such as that people start buying them.

You can already see it in the market place where small stocks and junk bonds and all these things that people buy when inflation is about to come and that they hedge their investments with. They’re really moving at this point. So you’re the expert on quantitative easing and explain to me how this is going to work if inflation really is a threat or what the real mechanics are.

Well, from the Fed standpoint, we really don’t see inflation over the near–term horizon—the next several years—as being much of an issue. When you look at economies not just in the United States…which I guess the good news is that the United States appears to be the strongest economy in the world.

The bad news is that the United States appears to be the strongest economy in the world. You have Europe in a recession. You have Asia’s growth slowing. Where is this inflationary pressure going to come from?

People look at the Fed’s balance sheet, which has risen quite dramatically. Before the financial crisis, we were about $800 billion. Now we’re at $2.5 trillion. With Quantitative Easing 3, what the market calls, we call it the Large Scale Asset Purchase (LSAP), we’re going to be adding to that a net amount of $40 billion more each month going forward.

People look at that and they’re like wow, the Fed has tripled its balance sheet. Isn’t that going to be inflationary? Well, first of all, the futures markets are not budging with regard to that. They seem to be all in all well–anchored. The blue chip forecast has inflation next year at 2.1%, with the fourth–quarter number being basically in line with any of the other quarters next year. So they don’t see an upward trend occurring there.

You know, you’re meeting here in Chicago, and everybody knows Milton Friedman. Professor Friedman famously said that inflation always and everywhere is a monetary phenomenon, and that’s the key part you need to keep an eye on.

We understand the fact that a lot of what’s struggling in this economy, holding it back, is the fact that we had this financial crisis. The financial market is still all restrained. What the Fed has done is to increase its monetary base. People talk about well, you know, the Fed is printing money like it’s going out of style. Well first of all, the Fed doesn’t print money.

Right, right.

The US Treasury does. We buy it from them at cost and I have to pay par. I don’t get a discount. You know, when the Fed does its actions, we are creating money.

So when the Fed creates money, we’ve created from that $800 billion, we’ve increased it up to you know again $2.5 trillion. Guess what? The little–known fact that most people talk about is that every time a bank makes a loan, they too are creating money.

Your viewership should pick up an introductory textbook to macroeconomics or money in banking 101 and they’ll see that T–table that illustrates that when banks make loans, the money supply rises…and that’s the problem. Even though the Fed has increased the money supply from the monetary base quite significantly, the money supply, which is four times the size of our monetary base, is only rising gradually.

That’s a lot of water going through a small hose at this point.

Right, so basically had the Fed not done what we have done, we believe that you would not have gotten the money supply reaction that we’ve gotten at this point. Instead of having inflation rates where they are, they would be significantly lower and in fact maybe be deflationary. So we’ve averted that.

The question comes in is when the financial sector begins to behave in a more normalized fashion, when these excess reserves that the banking sector are holding get unleashed. Then we’ll see the money supply begin to grow at a more rapid pace. The question is, how quickly will that occur?

Given the forecast path that the Fed sees for the economy, which is growth, but growth that is all in all subdued. With the surveys that we’re doing and talking to through our Beige Book contacts, we are just not seeing this great rush to borrow and to lend, and markets still remain imbalanced.

If you look at the real estate market and you talk to businesses that continue to try to actually deleverage rather than expand, this certainly does not seem to be an environment that is fostering a great rush for inflation.

Right, because there’s a lot of properties on the banks’ books that they’re still deleveraging, and the corporations are still in the act of deleveraging to a certain extent, and so are consumers.

Right.

So if that’s the case, then you really don’t have to worry about the velocity of money increasing substantially.

You know, if in fact bank lending started to come in a little bit faster because what the Fed puts out there is what we think is going to occur, and therefore we suggest this is what our policy path will be. We talked about the fact that we’re going to keep interest rates very low through the middle of 2015, and then we’ll begin to increase those.

Well, if in fact the economy’s path for growth comes in a bit stronger than we were expecting, obviously we’re going to have change what our view is with regard to that outlook. We’ll have to change our view with regard to proper policy. We have promised that we will not let inflation get out of control. We ultimately control inflation, and that’s what we are guaranteeing to the American people.

Right, also the priority would be to lower the unemployment rate and if inflation went up slightly because of that, then so be it. Also, the corollary to that would be that if inflation starts to rise uncomfortably before 2015, you’re not going to sit there and say, well, sorry we have to wait until 2015 to raise rates.

Exactly. In fact, the Fed president in Chicago, Charles Evans, is basically talking about a rule where he would like us to think about putting some metrics on some of these. So we’re talking about a 2% inflation goal.

In fact, when you look at the Fed forecast, policymakers see inflation remaining at or below 2% whether you include both up line, which includes food and energy, or the core rate which removes food and energy prices. They’re saying inflation is remaining under control.

Charles is saying that it wouldn’t be a bad idea to basically keep the pedal to the metal with regard to policy until you see unemployment rates start to come down. He would like to see us remain very accommodative until unemployment rates hit 7%, at which point then as it gets closer to the natural rate, we can make adjustments.

Or if inflation rates, if 2% is your kind of target, your average, we’ve been running below that for quite a while. If we ran above it as you’ve said, so be it. He would not want to see it get much above 3%, because again ultimately we are the ones that are responsible for inflation, and we want to make sure that we keep those inflation expectations under control.

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