Inflation: When and Where?

“Inflation is always and everywhere a monetary phenomenon.”

These words, spoken by the esteemed economist, Milton Friedman, reflect his thesis that inflation occurs when the country’s money supply rises faster than national income. No one will dispute that national income has fallen woefully short of the rate at which the Fed and other developed-country central banks have been printing money. So why has inflation remained so tepid?

Friedman’s monetary theory assumes that an increase in money supply will circulate throughout the economy and consumers will bid prices up when they get their hands on that money. Systematically, the Fed “prints” money that is then channeled through the banking system where it is meant to find its way to businesses and consumers. However, consumers and businesses with sufficient cash flow are “deleveraging” and have not been looking to borrow money.

While loan demand is plentiful from less credit- worthy borrowers, the near collapse of the banking system in 2008 caused fear in the regulatory environment as well as tighter lending practices, the combination of which has resulted in a severely constricted flow of capital to businesses and consumers on the financial margin. The result has been well over $1 trillion (with a T) that has yet to find its way into the economy.

So, is Friedman’s theory wrong? Not necessarily. It could be that he is correct, but the manifestation of his theory is just delayed. The bigger question is, does a significant delay in the predicted outcome make the thesis wrong? The situation in Japan informs us that economic stagnation can last a lot longer than one thinks. Bill Gross, of PIMCO fame, now espouses the “New Neutral,” which he describes as a lasting period of sluggish global growth that will keep interest rates and inflation low for much longer than currently expected.

While we believe that, in time, Friedman’s theory will be correct, it will likely take a number of years before inflation raises its ugly head. Luckily, we are not in the timing business. Rather, we are in the business of allocating capital with a view towards economic value and safety and creating for our clients diversified portfolios that stand the test of time. We will continue to do so, notwithstanding inflationary ebbs and flows.

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