Understanding the Monetary Policy
In the first three parts of our inflation series, we explored the effects of supply and demand imbalances, globalization, and technological advancements on inflation. We also examined how these forces shape the economic landscape and influence inflation’s trajectory.
Central banks, like the Federal Reserve, attempt to control inflation through monetary policy. This policy enables central banks to manage the money supply by:
- Creating or destroying money within the system
- Raising or lowering interest rates (i.e., adjusting the benchmark overnight interest rate)
Monetary Policy Origins
To give you some context, these powers originated in the US in 1971 when the dollar’s gold backing was removed. This significant transition was driven by various factors, most notably by the lessons learned from the 1929 Great Depression. During this economic crisis, wealth and capital flowed out of productive assets and into “safe haven” assets like cash and gold. Consequently, the value of both the USD and gold (being linked at the time) increased while the value of goods, investment assets, and capital decreased. This deflation led to a vicious cycle where wealth holders were further incentivized to move their capital towards unproductive assets like gold, exacerbating the problem.
Liquidity Trap
This phenomenon, later defined as a “liquidity trap,” occurs when an entire economy can be halted due to limited liquidity in the system driving economic activity (production of goods and services, hiring, project investment, etc.). To address this issue, economies transitioned away from the gold standard, allowing central banks to counteract deflation by printing money or lowering interest rates to increase liquidity. As a result, central banks target inflation to ensure that wealth holders invest in productive assets such as factories, real estate, and equities or lend to others owning productive assets (e.g., bonds). Inflation, by definition, is a tax on unproductive capital.
Over time, interest rates have followed a downward trajectory, with near-zero interest rates persisting since 2008 due to a continuous outcome of low inflation. This has necessitated the use of quantitative easing, described as the steps taken to meet an inflation target by central banks to avoid deflation. This phenomenon can be explained by the deflationary pressures exerted by globalization and technological advancements, as discussed in Parts 2 and 3 of this series.
Conclusion: Inflation, A Look Ahead
Despite recent surges in inflation due to supply and demand imbalances and worldwide economic disruptions, deflationary forces, mainly driven by technological advancements reducing costs of labor, intelligence, manufacturing, and energy, will continue in the long run. As a result, we expect interest rates to decline again eventually.
In conclusion, understanding the interplay between monetary policy, supply and demand dynamics, globalization, and technology is crucial for predicting future inflation trends. As we navigate this complex economic landscape, staying informed will ensure you’re investing responsibly.
Frequently asked questions
Why do central banks target inflation rather than zero?
Zero inflation incentivises cash hoarding — if prices aren't rising, holding cash is risk-free and there's no penalty for not investing. That dynamic strangles productive investment and can spiral into deflation (the Great Depression precedent). A small positive inflation target (typically 2%) creates just enough pressure to keep capital flowing into productive uses.What is a 'liquidity trap'?
A situation where an economy stalls because wealth holders prefer safe-haven assets (cash, gold) over productive ones — even at very low or zero interest rates. The 1929 Great Depression is the canonical example. The defence against liquidity traps is central-bank willingness to print money or push real rates negative — both became possible only after the gold standard ended in 1971.Why have interest rates trended down for so long?
Because the underlying deflationary forces — globalization and technology — have been powerful and persistent. To hit a 2% inflation target against those tailwinds, central banks have had to keep rates low and use quantitative easing. The recent inflation spike was a supply shock, not a structural break in the disinflationary regime.Where do rates settle in the long run?
If the globalization-tailwind reverses partially (Part 2 of this series) but the technology tailwind continues (Part 3), the long-run real rate likely lands modestly higher than the 2010s zero-bound but well below the 1980s peaks. Concretely, a 10-year real rate in the 0.5%-1.5% range is a reasonable base case for the rest of this decade.What does this all mean for portfolios?
Three implications. First, cash is a portfolio leak at any positive inflation rate — keep it for liquidity, not for storage. Second, productive real assets (equities, real estate, infrastructure) are the long-run inflation hedge. Third, bond allocations should be sized for liquidity and ballast, not for growth — and biased toward shorter duration when the inflation regime is uncertain.
Related reading
More on Markets & macro
- InsightInflation Part 03: TechnologyHow technology is the most significant factor in the inflation story.
- InsightInflation Part 02: GlobalizationDeep dive into some of the critical ways that globalization has contributed to a low inflationary environment.
- InsightInflation Part 01: An Unfortunate Mismatch between Demand & SupplyIn this series of email memos, we will explore the various factors that are driving inflation (both in the short and lon