Risk and reward.

• Author: Kirby, Jim
• Position: Investing strategy

Inflation is often only an afterthought when it comes to financial planning. And if it is considered, it's assigned a small constant value. But the risk of inflation, like the possibility of a sudden loss in the market, forces planners to consider how a portfolio would come through on the other side.

A History of High Inflation

Hyperinflation, which occurs when all confidence in a nation's currency is lost, is an extreme form of high inflation. High inflation, however, is a risk that can affect any currency. Even the United States in the 20th century has gone through periods when the rate of inflation went above 10 percent annually (1917-20, 1946-48, 1974-73 and 1979-811.

Economists want to understand why the rate of inflation changes. G.T. McCandless Jr., an economics professor at the Universidad de San Andres in Buenos Aires, Argentina, and senior research officer WE. Weber at the Federal Reserve Bank of Minneapolis did a thorough statistical study of 110 countries over the period 1960-90.

Among the "long-run monetary facts" they found in the data: "There is a high (almost unity) correlation between the rate of growth of the money supply and the rate of inflation." ("Some Monetary Facts," P.2, Federal Reserve Bank of Minneapolis Quarterly Review, Vol. 19, No. 3, Summer 1995, pp. 2-11) They found that this held true regardless of the definition of the "money supply" (what they call Ml, M2 and so on) that they used.

An Increasing Supply of Dollars

The money supply in the United States has increased dramatically in the past few years, a consequence of the policy known as quantitative easing. The Treasury inaugurated this policy in 2008 to breathe life back into the economy after the financial crisis. These measures have led to an increase in the money supply (or "funds that are readily accessible for spending," as the Federal Reserve Bank defines the M1 money stock).

As illustrated in Figure 1 (source: Federal Reserve Economic Data, Federal Reserve Bank of St. Louis: Monetary Base; Total; Board of Governors of the Federal Reserve System; accessed April 17, 2014), the money supply has increased more than 300 percent since 2008.

In 2013 alone, the Fed increased the money supply by an amount greater than the entire increase from 1913-2007.

Not everyone is concerned about these changes. Some believe that the factors that could cause inflation are already balanced by the deflationary factors inherent to a recession. They have a good point, at...