Understanding Money Supply and the Federal Reserve

I have to disagree with the talking heads I've seen on television recently, warning investors of hyper inflation. According to these 'experts' a serious bout of inflation is imminent due to the tremendous injections of liquidity by the Federal Reserve. I believe these pundits are overlooking one of the most basic factors in economics and I fear some of the talk is more politically motivated than financially motivated. While it is true that the Federal Reserve has been pumping money into our economy, the important thing these pundits miss is the 'why'.

There are two components to the effective money supply in the US economy. One is the amount of cash flowing through the economy, and the second is the velocity of the cash flowing through the economy. Of the two, the velocity of money is the more important.

If you studied economics is college you will recall that the velocity of money is normally a function of bank reserve requirements, which are set by the Fed. Simply put, if the reserve requirements are set at 20% then each dollar does the work of five dollars (100/20). If the reserve requirements are set at 10% then each dollar does the work of $10 (100/10).

I say under normal conditions because what we have seen during this credit crunch is anything but normal. Usually banks lend as much as they are allowed to lend based on the reserve requirements. That is how they make profits. However, because of loose lending standards in the past and questionable reserves, lending in our economy has slowed to a virtual crawl. Couple this decreased lending with increased reserve requirements for non bank financial entities such as Merrill Lynch, Morgan Stanley, and Goldman Sacks and you have created a serious speed bump for the velocity of money in our economy.

As lending contracts, the velocity of money in our system contracts. Because velocity is usually a multiplier of the physical currency in circulation any contraction in velocity reduces the effective liquidity in our economy many times.

The Federal Reserve's policy of providing liquidity to our ailing economy is not currently inflationary, it is simply an attempt to offset the slowing velocity of money. Without this infusion of liquidity there is a real danger of deflation, which is much harder for the Fed to fight than inflation. It is easier to slow the economy down than it is to speed the economy up.

The Federal Reserve will need to be vigilant as the economy eventually improves. The liquidity injected into the system could become inflationary as the velocity of money through our economy accelerates. But that won't occur until the credit crunch abates, which is a problem we would all like to see come sooner rather than later. Until then investors should not be overly concerned with inflation. Coming to the party too soon is nearly as bad as staying too late.

Inflation In Your Life

I have posted about the price of a first class stamp as a proxy for measuring inflation before, but this graph I ran across at Swivel sums it up pretty clearly.

Is The Forever Stamp A Good Investment?

Absolutely not. Since 1971, postal rates have increased more slowly than the actual inflation rate, as measured by the Consumer Price Index. In fact, this pattern must hold—as a matter of law. In December, President Bush signed the Postal Accountability and Enhancement Act, which ensures that future price increases will be kept below an inflation-based ceiling. See full story in Slate.

Stamps Prices Increase Again This Month

The US Postal Service has announced yet another increase in the price of a postage stamp. This is old news but I bring it up to illustrate how inflation can erode our buying power. Take a look at the images on the left. In 1976 a first class stamp cost only 20 cents, later this month it will reach 41 cents. That is a little over double the cost in the last 31 years. Some of you may remember all these stamps, for some it will represent a span of time longer than their years on earth. No matter, the point is this period of time represents relatively benign inflation rates. A postage stamp has averaged just a 2.3% inflation rate over this last 31 years yet
your cost of living has doubled. Even small inflation rates can be
devastating over the span of a human life. So what can you do
to protect yourself?

You should understand that real return (gross return after taxes and inflation) is the true measure of your progress. If you are currently earning 5% on a CD or money market account your after inflation return is about 2.5%. If you earn 10% from a stock investment your after inflation return is about 7.5%, about three times the after inflation return of a fixed income investment.

If you are retired and living on a fixed income portfolio you can only spend around 2.5% of your portfolio value each year. The rest has to be reinvested just to keep you even with inflation, or else you should
expect to eat half as much 31 years from now!

Converting your investments from the accumulation phase to the income phase does not mean things get easier, in fact providing a reliable long term income stream from your investments is more challenging than accumulating those assets to begin with.