Rising Inflation – Are Inflation Expectations ‘Bubbling Up’?
THE INFLATION DEBATE
Some investors and economists who think the U.S. is in for a bout of rising inflation — perhaps a serious one — started 2021 with some fresh ammunition for their arguments.
Vaccines hold out the prospect of an end to pandemic restrictions that could bring consumers roaring back. This is what economists call pent-up demand — a label that applies quite literally in today’s climate. The Biden administration is seeking to prop up household spending with more financial aid. And in the background, the dollar has been weakening and commodity prices rising steadily for months.
All this has pushed bond-market measures of expected inflation higher. The so-called breakeven rate on 10-year Treasuries climbed above 2% in this year to the highest since 2014.
Still, the predominant view among economists — including, crucially, at the Federal Reserve — is that it will be years before the U.S. has to worry about rising inflation.
So is inflation on its way back? Here are some of the key arguments on each side.
The Case for Rising Inflation
Fiscal spending has been the engine of recovery from the coronavirus slump, and U.S. President Joe Biden — who is promising to do more of it — has a clearer path to seeing his plans realized. Many commenters expect further pandemic aid in the coming weeks or months.
Help at Hand -- Demographic control of Congress opens the way for $750 billion of extra pandemic aid, Goldman Sachs estimates
Sources: Goldman Sachs Global Investment Research
“Biden’s agenda is back in play, which means even more fiscal expansion in the near term,” says Aneta Markowska, chief economist at Jefferies. She expects 10-year Treasury yields, which edged above 1% last week for the first time since the pandemic arrived in mid-March, to hit 2% by year-end.
Even as the COVID-19 shock fades, COVID-19 era policies are likely to remain prevalent. Additional monetary aid is being negotiated for disbursement, and the government’s monetary policy should also remain accommodative. However, unlike the previous cycle, when the Fed had tightened monetary policy well before inflation reached 2%, they are not expected to hike rates preemptively at the first uptick in inflation. This is part of a newer policy framework, Average Inflation Targeting, whereby the Federal Reserve “seeks to achieve inflation that averages 2% over time”. As a result, the Fed is expected to allow inflation to run above 2% to compensate for inflation running below its 2% target ever since the Great Financial Crisis. All-in macro policies should remain highly reflationary even as the economy makes good progress towards its pre-COVID path, setting the stage for inflation to rise.
Morgan Stanley economists expect “a sharp rebound in demand, especially in Covid-sensitive sectors like travel and tourism,” as vaccines get a wider rollout in the spring. They forecast that core inflation, which strips out the prices of things like food or gasoline because they’re more volatile, will hit the 2% threshold this year and overshoot it in 2022, when we may observe rising inflation.
A recent article published in Business Insider stated that in the first round of the fiscal stimulus package alone, 75% of the unemployed received more than the wage income they would have earned. Personal incomes are already 3% above pre-COVID levels, and wage compensation has reached 99.7% of pre-COVID levels.
In total, household net worth has increased by $5.2 trillion since 2019, and households hold $1.4 trillion of excess savings — which, according to Business Insider, is estimated to rise to $2 trillion if further fiscal stimulus is passed. Many consumers have been saving extra cash, not because they are risk averse, but because their spending options have decreased as a result of the pandemic. As a result, some consumers are in a good place financially and are expected to resume spending increasingly once more COVID-19 restrictions are lifted.
Filling the Gap -- Fiscal aid stopped incomes from falling like they usually do in recessions
Sources: Bureau of Economic Analysis
STRONG V-SHAPED RECOVERY
According to Chetan Ahya, Chief Economist and Global Head of Economics at Morgan Stanley, a strong V-shaped recovery is already in progress. Mr. Ahya states that while the second quarter of 2020 saw the deepest quarterly GDP contraction on record, 2020 will not register as the deepest recession in US history thanks to the sharp rebound from the third quarter onwards.
Mr. Ahya further argues that as warmer weather sets in and vaccines are distributed to protect vulnerable segments of the population, the US economy will get another uplift from March 2021 onwards, especially in COVID-sensitive sectors like hospitality and travel. Morgan Stanley’s 2021 GDP growth forecast of 5.9% is a full two percentage points above consensus. They project that US GDP will achieve pre-COVID levels in the early second quarter of 2021 and will also return to its pre-COVID path (in other words, where GDP would have been, absent the pandemic shock) by the fourth quarter of 2021. Most others expect GDP to reach pre-COVID levels later in 2021.
HEALTHY PRIVATE SECTOR BALANCE SHEETS
Since the recovery is accelerating, Chetan Ahya at Morgan Stanley is less worried than consensus about longer-term scars on the private sector's willingness to invest or take on risk. This difference is key to their expectation that inflation will return more quickly than consensus believes. COVID-19 produced a shock more akin to a natural disaster than the typical end of a business cycle. Private-sector balance sheets were in relatively good shape when the pandemic began, as was the financial system.
RISING SHIPPING RATES
Rising demand for goods from consumers forced to work from home as businesses grapple with the COVID-19 pandemic, combined with a lack of ships and containers to transport those wares, has sent freight rates soaring at the start of this year.
“No one in the industry was prepared for this spike. We know logistical budgets have been blown out because of how unprepared importers were,” said Sri Laxmana, vice president of global ocean product at C.H. Robinson, a freight forwarder which handles 18 million shipments annually.
That, in turn, has raised concerns among some economists that import-dependent businesses faced with a rise in “pipeline costs” will pass them down to the consumer through higher prices, adding to the cocktail of inflationary pressures some fear is brewing in the economy.
WHAT SOME HEDGE FUND MANAGERS ARE SAYING
Paul Singer — a frequent critic of U.S. monetary policy — said in an interview on Grant Williams’s podcast that the combination of “trillions and trillions” of dollars in Covid-19 relief spending, wage pressures and rock-bottom interest rates has the potential to shock markets. Bond-market indicators of future inflation have risen sharply over recent months, with 10-year breakeven rates — derived from the gap between yields on inflation-linked and ordinary Treasuries — climbing above 2% to the highest since 2018. That’s up from a low of 0.47% last year at the onset of the pandemic. Singer, whose Elliott Management Corp. first opened in 1977 and is one of the more tenured hedge funds in the industry, said that holding longer-term bonds is “senseless” at current yields.
“We are in a flood of money and credit that is lifting most asset prices,” says Ray Dalio, founder and co-chief investment officer of Bridgewater Associates, the world’s biggest hedge fund by AuM. Indeed, with interest rates at rock bottom as they are today, “there’s no good reason that stocks couldn’t trade at 50 times earnings”. But there’s a downside. Speaking to viewers of an “Ask Me Anything” session on social-media website Reddit in December 2020, Dalio warns that the scale of the flood is also “threatening to the value of our money and credit”. As a result, it’s more crucial than ever to diversify. “Put your savings into a well-diversified mix of currencies, countries and asset classes so that your savings will not depreciate in value.”
Sources: Bloomberg. Jan, 2021. “The Inflation Debate That’s Roiling U.S. Markets Faces 2021 Test.” ; Business Insider. Jan, 2021. “Get ready for the return of inflation.” ; MarketWatch. Jan, 2021. “Surge in shipping costs adds to inflation worries.” ; Bloomberg. Jan, 2021. “Singer Says Long-Term Bonds Are a ‘Senseless’ Speculative Trade.” ; MoneyWeek. Dec, 2020. “Ray Dalio: flood of money threatens its value.” ; Schroders. “What does average inflation targeting mean for investors?” ; Twitter. Feb, 2021
The Case against Rising Inflation
GRADUAL DISAPPEARANCE OF INFLATION
The gradual disappearance of inflation is one of the most entrenched trends in economics according to Bloomberg. And the all-hands-to-the-pump policy response to the pandemic isn’t entirely unprecedented. After 2008, the government and Fed also injected money into the economy, causing many to forecast inflation which never arrived. Fiscal spending has been bigger this time — but so was the hole in the economy that it had to fill, so the result will not necessarily be overheating.
So far, this decade looks much like the last one, says Ben May at Oxford Economics. “Deficient demand has been countered by looser monetary and fiscal policy. This has boosted asset prices, but underlying consumer price inflation has remained weak.”
Source: Bureau of Labor Statistics
However, some people believe that unemployment will remain high and hold down inflation. Their belief is that that if people are out of work, the lack of demand won't push up prices.
Even optimistic forecasters say it will likely be years before the U.S. is employing as many people as it was in 2019, when the jobless rate was the lowest in half a century.
An economy that isn’t using all of its available resources, such as labor, typically has some room to grow without triggering inflation. And a key lesson from the long expansion of the 2010s was that those resources were deeper than previously thought.
That may be true for the post-pandemic economy, too. Goldman Sachs, for example, raised its growth forecast after the Georgia election and now sees the economy expanding 6.4% this year, recouping all the Covid losses and then some. But it still does not expect core inflation to edge above 2% — triggering higher interest rates — until 2024.
Room to Run -- The decade before Covid-19 showed the economy could keep creating jobs without triggering inflation
Source: Bureau of Labor Statistics
ONE-TIME PRICE INCREASE OR PERSISTENTLY HIGH INFLATION?
According to Bloomberg, the sudden plunge in the price of some services in the spring of 2020 will disappear from year-on-year calculations in the coming months — pushing inflation up even if those prices don’t go back to normal.
But for some monetary economists, higher prices should only be treated as inflationary when they fuel expectations of even higher prices in the future, generating a snowball-like momentum that may become hard to control. Indeed, Fed Chair Jerome Powell recently told reporters that this was America’s experience in the 1970s but may not likely occur again until the pandemic ends.
When asked about the risks from pent-up demand, Powell said the Fed would be predisposed to view any resulting surge in prices — of air tickets, for example — as “a one-time price increase, rather than an increase in underlying inflation.” That’s not something that would spur the Fed into action.
The Federal Reserve left interest rates unchanged on Jan 27, 2021 and assured investors that there are no near-term plans to raise them. Interest rates are expected to stay at current record lows for the foreseeable future to facilitate this recovery, and the central bank isn't concerned that inflation pressure will get in the way of that. US inflation has been stubbornly low for many years, said Fed Chairman Jerome Powell during Wednesday's news conference. There could be a burst of spending activity when the economy reopens, which might bump consumer prices up. But the Fed expects these effects to be transient.
"We know what to do with higher inflation," Powell said, adding that low inflation was much harder to deal with from a policy point of view. He said he doesn’t want to put a timeline on tapering the U.S. central bank’s $120 billion-a-month in asset purchases.
“In terms of tapering it’s just premature,” Powell said. “We said we’d want to see substantial, further progress towards our goals before we modify our asset purchase guidance. It’s just too early to be talking about dates. We need to see actual progress.”
"Worry about the Fed tapering its stimulus is premature right now, as the slow Covid-19 vaccine rollout will likely delay any kind of Fed stimulus withdrawal until well into 2022," said Danielle DiMartino Booth, CEO and chief strategist of Quill Intelligence.
Alternative investment strategies that may be poised to take advantage of the potential rise in inflation include long/short equities, macro (commodities, natural resources, interest rates), real estate/assets and cryptocurrency (alternative store of value).
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