One of the many unusual things in the financial markets these days is the relationship between the growth in the money supply and inflation expectations. At the same time, as unprecedented growth in the balance sheet of the Federal Reserve is taking place, inflation expectations, as witnessed by the narrow yield spreads between inflation indexed treasuries and regular treasuries, are extremely low.
Low inflation expectations
Inflation expectation for the coming 12 months, as measured by a University of Michigan survey of consumers, have been coming down rapidly, from 5.1% last July to 1.7% in December. Given the current weakness in the economy and falling commodity prices, it is perhaps not surprising that people are expecting low inflation in the near term (although deflation fears seem to have diminished recently).
For inflation expectations further into the future, my preferred measure is the spread between Treasury Inflation-Protected Securities (TIPS) and regular, unindexed treasuries. Currently, 5-year TIPS are yielding 1.44%, only a quarter of a percentage point lower than regular treasuries. 30- year treasuries are yielding 3.4%. Unfortunately, TIPS are no longer issued in maturities longer than 20 years, but the 20-year inflation-indexed yield of 2.5% indicates that long-term inflation expectations are quite low.
One argument I have seen against using this spread as an indication of inflation expectations is that in times of financial crisis, investors seek liquidity as well as certainty of repayment. As TIPS are less liquid than regular treasuries, a small spread may say more about a preference for liquidity rather than low expectations for inflation. I would dismiss this argument for the following reason: TIPS have only been available since 1998. The only financial crises since TIPS were first issued are the collapse of Long-Term Capital management in 1998, and arguably the stock market bust of 2001-2002. These are not enough data points to base generalizations on. Besides, trading volumes in TIPS have not remained constant during this period. In 1998 the average daily trading volume of TIPS was USD 900 million. In 2008 it was 8.7 billion, having risen every year in between. The discount on TIPS, for this reason, should be steadily diminishing.
In any case, inflation expectations appear to be low in the short-term as well as the long-term. Recent developments in the money supply make those expectations implausible.
The money supply
For those of us who agree with Milton Friedman’s statement that “inflation is always and everywhere a monetary phenomenon,” recent growth of the money supply suggests unequivocally that it is only a matter of time until inflation will start to kick in. M1 (see Wikipedia entry for further explanation of terminology) has grown by 17% in the last twelve months and almost 40% in the last three months (on an annualized basis) and M2 has grown by 9.9% and 18.4% by the same measures, respectively. However, it is not until we get to the narrowest measure of the money supply, M0 or the monetary base, that things get really crazy. From September to December of 2008 the monetary base expanded from USD 905 billion to USD 1.65 trillion. This is mostly due to banks accumulating excess reserves with the Fed, where they can earn an interest rate equal to the fed funds target rate. Of course, there is little reason for banks to lend to each other when they can more safely lend to the Fed at the same rate. This has served to more than double the Fed’s balance sheet in the last year (for a more thorough discussion of this, see this article). Given current economic conditions, it seems likely that sooner or later banks will be discouraged from hoarding their cash with the Federal Reserve (for instance by not paying interest on those reserves).
Flight to safety…but safety from what?
It is clear that aversion to risk is currently very high and risky assets are being sold in favor of those that are perceived as being safe, such as cash and treasury securities. These assets are safe, if safety is measured in terms of avoiding large, negative numbers in one’s account statement. However, the fear of losing money can quickly be replaced by the fear of money losing purchasing power. If, and I consider this scenario very likely, inflation sets in, yields on treasuries can be expected to rise quickly. The same is true for the inflation premium on TIPS. Mispricings in the markets should not be seen as intellectually irritating, but rather as a profit opportunity. In this case, shorting unindexed treasuries, buying TIPS, or both, could be appealing. This is all easy to do with ETFs. For TIPS, there is iShares Barclays TIPS Bond (TIP), which has a duration between 6.5 and 7.25 years. For shorting non-indexed treasuries, Proshares has ultrashort funds for intermediate (7- to 10-year) treasuries (PST), and for long (20+ year) treasuries (TBT). As is often the case, timing is tricky and I would advise caution with the ultrashort funds.
Disclosure: No position in securities mentioned in this post.
