The inflation chain still missing links

The January Consumer Price Index (CPI) readings released today are emblematic of a conundrum that continues to challenge markets: Why is inflation not taking root, given the Federal Reserve’s $3 trillion outlay in quantitative easing over the past several years?

We believe one big reason is a persistently weak correlation between monetary policy and the volume of new consumer loans. We also note that commercial banks have become very independent — and more discerning — when making lending decisions. In sum, despite the Fed’s efforts to substantially increase the money supply, banks are not issuing credit very readily (certainly not as profoundly as they were before the global financial crisis). One lesson here is that without a substantial flow of credit, inflation has very little chance of ticking up.

Why have banks decreased the number of loans they write? Regulatory programs are a substantial part of the picture. Banks are adapting to a regulatory environment that imposes stringent capital and liquidity rules. Such rules aim to lessen the chances that big banks are caught with insufficient capital during a market crisis or a long period of stress.

Aside from weak loan volume (and the attendant regulatory conditions), a strong dollar is another source of downward pressure on inflation. It may be a lesser factor, but we think it bears watching, especially because supply-and-demand fundamentals currently appear to be supporting a continued run of dollar strength — potentially resulting in more deflationary pressure down the road.

Clearly, the Fed has expected to see signs of inflation by now. But historical relationships between monetary policy, loan generation, and inflation are not holding up in today’s market environment. We think this new reality is relatively well entrenched for the time being; because of that, it’s possible for low inflation to continue for most (if not all) of 2015.

The views expressed represent the Manager's assessment of the market environment as of February 26, 2015, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.

Investing involves risk, including the possible loss of principal.

Notes from the desk

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