Occasionally, BestCashCow likes to conduct thought exercises that explore various economic theories and topics. The article below explores the Barro Gordon concept of "surprise inflation" and how the Fed may want to turn to it should inflation rates and the economy remain depressed.

Since its rollout in 2008, Quantitative Easing, or QE as it’s known, has been met with mixed to negative reactions among the economic community. One goal of QE was to raise long term inflation expectations (increase inflation means an increase in interest rates to compensate), which happened initially but has tapered off in recent months. The Survey of Professional Forecasters shows inflationary expectations holding steady around 2%, but you have to take that with a grain of salt as it relates to extrapolating those expectations outwards onto the entire population. In either case, neither set of expectations displays the increase The Fed was hoping to achieve. This is quite extraordinary. Since the financial meltdown in 2008, despite all of its heroics, the Fed has not been able to successfully increase the inflation rate and is still in many ways battling with a deflationary environment.

In my last semester at Penn I took an economic theory course on money and banking where we took a model by Robert Barro and David Gordon on inflation and adapted it to talk about optimal debt levels and policy. The original 1983 Barro-Gordon Paper, “Rules, Discretion and Reputation in a Model of Monetary Policy,” deals with the government’s incentives and policy options as it pertains to manipulating the inflation rate. There’s a lot more to the model than I’ve included below, and it’s worth checking out if you’re interested, but I’ve tried to capture the flavor of the paper in a concise manner. The paper provides a theoretical framework for one way that the government can stimulate the economy.

If the government believes that distortions, from items such as income taxation and unemployment compensation, have lowered production and the amount of privately-chosen work below acceptable levels, the government may want to take action. By raising the inflation rate above expected levels (“surprise inflation”) the government can depress the value of real wages and theoretically stimulate economic growth. Additionally, surprise inflation lowers the government’s future real expenditures for interest and repayment of principal, essentially allowing it to “raise” money without having to resort to taxation. The tradeoff here is that in using surprise inflation, the government takes a hit to its reputation and receives “punishment” for a given length of time, resulting in a less than desirable and more costly equilibrium since people adjust their expectations. Which route the government chooses depends on a few different factors, namely the punishment interval they must endure before their reputation is restored, the last of which Barro-Gordon indicates in an optimal contract with the people, would be for finite amount of time.

The argument could be made that by using surprise inflation, they could, as the paper suggests, stimulate economic growth, lower debts in nominal terms, and increase long term inflationary expectations (one of their original goals). Whether they meant to or not they did induce a recession (they were not solely to blame, but their complacency played a large role) which lowered inflationary expectations, so the government has set itself up to “cash in” on their “investment”, or “biting the bullet” as Barro-Gordon refers to it. Obviously there are a lot of factors present here that aren’t included in the theoretical environment and the punishment interval as well as the benefit parameters are not clear.

One way or another, the Fed is going to have to find a way out of this monetary, low inflation ditch. The question is what the chances are that the government actually does initiate surprise inflation, and if they do how would they do it and how would it affect your savings? For starters, there doesn’t appear to me be a historical precedent for this type of operation, and it’s not as if the Fed would willingly admit they were looking to surprise the public. So, don't look for new Chairwoman Yellen to discuss surprise inflation.

As for how the government would increase inflation, there would be a few different ways they could go about it:

1. Hand out loans to member banks: This doesn't appear as feasible because most banks today have plenty of cash. They are not lending because of a lack of capital or deposits, but rather out of caution and fear of a weak economy, as well as weak loan demand.
2. Monetize government debt: The Fed is able to create money without printing a bill. They have the ability to buy Treasury Department issued bonds with a check, essentially flooding the economy with the dollar amount of the bond purchase. This is similar to QE, but instead of commercial and private lenders, the Fed is buying from another part of the government.
3. Lower the reserve requirement: A slightly more risky proposition, the Fed lowers the bank reserve requirement that banks must keep on deposits. Theoretically, this stimulates more lending. In the past, the reserve requirement has almost never changed because of the perceived fear of disrupting financial markets that can come with a change. Still, if stuck in a bind, the Fed may decide to try it.

Of the three, the government can most covertly initiate the second and third options. For savers, the increase in the inflation rate would dilute the value of savings and make investments in things that will provide a hedge against inflation i.e. derivatives (options, swaps), precious metals, and real estate wise choices. This has the potential to create a very explosive rising rate environment and those savers that have money locked in low rate, long term CDs would see the value of their investments eroded. In such an environment, it makes sense to stay liquid.

Borrowers with fixed, low interest loans would fare well but those in any variable rate loan would see significant rate and payment increases.

Will the Fed pursue such a policy to shock the economy? Most likely not. But as we've seen with the multiple QEs, the Fed is trying to stimulate the economy and increase the inflation rate. Whether it will take even bolder steps to do this in the future remains to be seen. In general, the more talk you hear talk of deflation or a lack of inflation, the better the chances the Fed will take unprecedented and surprise moves to shock inflation back to life.

I recently renewed contact with an old buddy of mine from business school who now manages money for wealthy individuals. When we got down to discussing our career paths and my role as Editor-in-Chief of BestCashCow.com, he became insistent that holding cash in savings or money market accounts and short term CDs is a bad idea. I believe that he is dead wrong.

Of course, cash has dramatically underperformed a diversified stock portfolio and a diversified bond portfolio for the last few years. Since you cannot time the markets or the economy, nobody should ever move entirely into cash. I personally believe that an appropriate portfolio for even the most aggressive, moderately wealthy investor is 40-50% equities, 25% high grade municipal bonds or bank-issued structured notes, and 25-35% cash across accounts at top and well-known online banks.

My friend, however, suggested that instead of holding any cash, I take a look at a series of bonds, bank loans, hedge funds and managed future funds. He recommended that a moderately wealthy investor should open an account with a money management firm (such as his) and place all cash in the account, accessing a line of credit for any expenses. In particular, he proposed the following asset allocation as an alternative to FDIC insured savings accounts:

Global Bond Mutual Funds:

Templeton Global Bond Fund Adv 10.00%

Multisector Bond Mutual Funds:

Goldman Sachs Strategic Income I 10.00%

JPM Strategic Income Opportunity Select 12.50%

Osterweis Strategic Income Fund 10.00%

Bank Loan Mutual Funds:

Nuveen Symphony Floating Rate Inc 7.50%

Diversified Alternative Mutual Funds:

Avenue Credit Strategies Inst 5.00%

Driehaus Select Credit Fund 2.50%

Litman Gregory Masters Alternative Strategy 7.50%

Hedge Funds:

Morgan Stanley Absolute Return 15.00%

Directional Alternative Mutual Funds:

ASTON/River Road Long-Short I5.00%

Mainstay Marketfield Fund 5.00%

Neuberger Berman Long Short Institutional Fund 5.00%

Managed Futures:

AQR Managed Futures Strategy I 5.00%

The above portfolio, with an average annual return of 6.20% since 2009, would have slightly outperformed online savings rates over the last several years; it, however, would not have outperformed a five year CD initiated 2009 or most stock or bond portfolios.

The problem here is that the portfolio was down dramatically in 2008, and again in 2011. While it is diversified and conservative, some components have experienced negative quarters at other points in the last five years. In 2014, importantly, there is a real risk of underperformance again should interest rates rise or should emerging markets continue to falter.

Were those risks not present, ultra-wealthy investors (which I define as someone with over $50 million) would probably do well to invest a portion of their money in a series of funds like those presented by my friend. They can easily get into the proposed funds directly with the fund managers (paying only a management fee which is often reduced). They can ride out the shifts in the market. And, in the worse case, were one of the funds to fail, they would be able to absorb the loss as my friend’s model portfolio places no more than 15% in any single fund.

A moderately wealthy investor (someone with between $5 million and $10 million in liquid assets) does not have any of those luxuries. Moreover, without some sort of deep inside connections, they are likely placing their bets through a money manager who will charge a management fee. For example, a 0.70% management fee would cause the annual return on my friend’s recommended portfolio to fall to 4.60% since 2009.

A 4.60% annual return in a strong economy (versus close to 1% in the leading online savings accounts) is not only not guaranteed but it is just not enough of a premium for a moderately wealthy investor to justify the loss of liquidity, the volatility and absence of FDIC insurance. In fact, a prudent, yet aggressive, moderately wealthy investor would easily make up the 3.60% annual difference by taking on more risk in their other investment classes (something that they are more apt to feel comfortable doing if they have a cash portfolio, instead of an alternative portfolio of funds with fees on top of fees).

The fact remains: Cash – particularly in the form of savings accounts divided across several FDIC insured institutions - remains an important base to any portfolio and it is not replaceable by anything else or a collection of anything else. It is the part of your portfolio that isn’t to be risked. Having more of it allows you to sleep at night. It is liquid. It enables you to deal with life’s traumas (unexpected health care expenses due to loss of health insurance because of Obamacare, divorce, etc.) and to pursue life’s opportunities without stress (private investments, real estate opportunities, etc.).

Don’t pretend to be ultra-wealthy if you are moderately wealthy. Stick with cash.

For much of 2012 and 2013, a little known online bank offered an outstanding online savings rate that was well above that offered by the other major online banks. The bank, New York Community Bank (NYCB), operates two online banking brands, Amtrust Direct and MyBankingDirect.com. I, like many followers of BestCashCow, opened an account with Amtrust during this time and received an interest rate on my savings for more than a year from this bank several basis points above that which I would have received anywhere else.

In September 2013, however, the rate fell abruptly without notice of any sort to customers and all of the sudden depositors in NYCB brands were earning less in their online savings accounts than in accounts at more familiar names like American Express, CIT or GE Capital. This underscores the first peril of chasing rates: rates on savings accounts can always fall dramatically and without notice.

A second peril came to light when I tried to redeploy money from NYCB to a bank with higher rates. NYCB’s limitations on numbers of transfers and amounts of money that could be transferred out within a single timeframe made the process of winding down take two months for those who had deposited close to $250,000, the FDIC insured maximum on bank deposits.

To be clear, the bank’s abrupt rate change (during a period where their competitors were actually raising rates as bond yields were rising) and its obstacles to withdrawals were frustrating, but they were well within the bank’s rights. And, they were necessary and understandable risks that I and many others took to earn a higher savings rate over the period.

The third peril, however, was not one that I expected to encounter in the chase for the best savings rates. It arose when I stopped short of closing my account after withdrawing almost all of my balance with the bank. I thought I was being clever by leaving a couple of dollars in my account so that I would be able easily to move money back were they to raise the rate again. Two months later, however, I received a strongly worded note from NYCB stating that they had just instituted a $10 monthly account service fee, resulting in my account having a negative balance. The letter further stated that the negative balance, if not paid immediately, would result in a closure of my account and the bank reporting “information about your account to credit bureaus, such as Chexsystems” so that “defaults on your account may be reflected in your credit report”.

I was able to resolve this issue with the bank by phone, closing the account and avoiding any damage to my credit rating. Nonetheless, this experience underscores another and perilous pitfall in rate chasing.

You can, however, mitigate these perils. First, you must follow savings and money market rates closely, checking online with those banks where you have accounts and as well as checking with BestCashCow often to be sure rates have not changed. Second, you may want to avoid banks that do not allow you to move the balances out quickly (major banks do not impose undue obstacles, but some smaller banks do have monthly limits). Third, you should always be sure to close an account fully and immediately after you have received your final month’s interest in order to avoid a situation like the one I found myself in.

A Note on FDIC coverage: Some banks, such as NYCB, operate online banks under multiple online brands. BestCashCow.com follows an editorial policy of listing only one online brand associated with a single FDIC certificate. This policy avoids confusion and prevents depositors from unintentionally exceeding FDIC limits. Since both the Amtrust Direct and MyBankingDirect brands are covered under NYCB’s FDIC certificate, this site is only listed as Amtrust Direct in our rate tables.