Milton Friedman Was Wrong About Inflation

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I have a lot of respect for the late Milton Friedman. I really do. His unapologetic defense of the free market was — and still is — a breath of fresh air amidst the constant drone of calls for the government to “do something” to fix all of our problems, real or imagined.

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But when it comes to inflation — the subject about which Friedman is most often quoted — he was dead wrong. Inflation is not “always and everywhere a monetary phenomenon.” Other factors, such as demographic change, can and do overwhelm central bank monetary policy when they reach extremes.

I tackled this subject two years ago in a piece that tied Japan’s chronic deflation to its aging and shrinking population. I’m not the only voice in the wilderness. Harry Dent has made the same basic demographic arguments for over twenty years and his views have gone a long way to shaping my own.

The Impact of a Greying America

Now the Federal Reserve appears to be coming around. Earlier this year, the Federal Reserve Bank of Richmond published a piece that asks: Will the Graying of America Change Monetary Policy?

Here is an excerpt:

“Despite the certainty of the oncoming demographic change, little is known about how it is likely to affect the Fed’s policy tools. Some policymakers and observers have expressed concern, however, that the Fed’s ability to stimulate the economy may decline for demographic reasons, if it hasn’t already done so. For example, New York Fed President William Dudley suggested in a 2012 speech that ‘demographic factors have played a role in restraining the recovery,’ in part because spending by older Americans is ‘less likely to be easily stimulated by monetary policy.'”

It’s called “pushing on a string,” and it’s something I addressed recently in an article on secular stagnation. Keeping interest rates artificially low will not encourage older Americans to buy more on credit. In retirement, most of us trade down to smaller homes rather than trade up. We also drive less and replace our cars less often. And we already own all of the big-ticket items that consumers generally buy on credit, such as furniture and appliances.

The fact is, the older a society becomes, the less effective monetary policy is in spurring consumption.

Japan: A Case in Point

Need evidence? Look east to Japan. The Bank of Japan has had some of the loosest monetary policy in the world for the better part of two decades. The bank stepped it up several notches recently with an expansion of the quantitative easing program in October. That program was already the largest in the world.

So far, it’s all been for naught. Japan is officially in recession again.

A Return to QE Infinity?

So, what does the Richmond Fed see going forward? In short, the Fed will get a lot less bang for its buck with traditional levers for monetary policy. The Fed may be forced to make “bigger interest rate changes for the same amount of stimulus or tightening it wishes to apply to the economy.” Alternatively, it could be forced to revisit large-scale bond-buying (i.e. “quantitative easing”) programs again. The Fed wrapped up “QE Infinity” in October.

I’ve been talking in generalities. Let’s drill down to some real numbers. The Richmond Fed continues:

“The Census Bureau estimates that the old-age dependency ratio in the United States will rise by 14 percentage points from 2010 to 2030…  [That] would imply a 1.4 percentage point drop in the Fed’s ability to affect inflation and a 4.9 percentage point drop in its ability to affect unemployment. Over the course of a 20-year period, such a change might be perceived as modest from one year to another, but cumulatively it would amount to a strong negative effect indeed.”

I should also point out that all of this assumes we’re in a “normal” interest rate environment. The target Fed funds rate is still at zero, and the 10-year Treasury yields 2.2%. If we were to follow Europe and Japan into another recession — even a mild one — the Fed has almost nothing in the way of policy tools to draw on. Pushing longer term yields from 2.2% to, say, 1% just isn’t going to make that big of a difference.

Charles Lewis Sizemore, CFA, is the chief investment officer of investment firm Sizemore Capital Management. Click here to receive his FREE weekly e-letter covering top market insights, trends, and the best stocks and ETFs to profit from today’s best global value plays.


Article printed from InvestorPlace Media, https://investorplace.com/2014/12/milton-friedman-wrong-inflation/.

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