With policymakers aggressively 'printing money', many worry that a burst of inflation is imminent. However, we believe that neither monetary nor fiscal stimulus will have enough power to send inflation out of its multi-decade disinflationary regime.
Monetary phenomena aren't 'always and everywhere' inflationary
Monetary policy has been expanding consistently for 40 years via lower rates. The Fed even ceased targeting money supply in the early nineties – but inflation has been largely under control (Figure 1).
Figure 1: Inflation has been under control even as the Fed has cut rates1
For years now, QE has failed to spark inflation (both in the US and abroad) despite the ‘money printing’ involved. This is partly because QE is a type of money printing that tends to stay locked inside the financial system, rather than circulating around the real economy (unless it inspires banks to lend a great deal more – something which post-2008 banking regulations have made less attractive to them).
As a result, QE has essentially created inflation in financial assets but not the real economy. As central banks buy assets – the supply of tradable financial assets available to other investors falls, putting upward pressure on prices.
That’s one reason why we experienced a combination of booming asset markets while in the midst of the most tepid economic recovery on record since the 2008 crisis (Figure 2).
Figure 2: Real asset price returns have risen substantially since QE was introduced2
Even in Europe and Japan – where QE is reaching its limits – inflation is running at zero or negative levels, respectively1. For us, it’s unlikely to be an immediate driver of inflation.
Central banks are, in fact, running increasingly low on ammunition. Monetary policy originally considered ‘extraordinary’ and ‘temporary’ (such as zero-bound interest rates, QE and yield curve control) are looking increasingly normal and permanent. The continued deployment of these policies indicate that central banks hardly feel threatened by runaway inflation.
Fiscal stimulus will potentially not be aggressive enough
If not monetary policy, many contend that fiscal stimulus measures have a better chance to spark inflation – as fiscal policy injects money more directly into the real economy.
As central banks run low on ammunition, fiscal policy is becoming a more important economic management tool (see our neofiscalism paper).
We believe that low yields will need to be a key feature of the neofiscal era as well – central banks will likely play an important role known as ‘financial repression’ keeping a lid on borrowing costs in the face of larger fiscal deficits.
However, with divisions in US politics, agreeing on fiscal stimulus policies will be highly challenging. Democrats and Republicans do not see eye-to-eye on how much stimulus is warranted and where it should be spent.
As such, we expect President-elect Joe Biden’s fiscal stimulus ambitions will be cut down from what would have been ~$2trn to less than ~$1trn over 10 years. In our view – this is perhaps a ‘Goldilocks’ level, not too cold that it will not aid the economy – but not ‘game changing’ enough that it makes inflation a realistic threat.
Secular trends at play are almost universally disinflationary
Any inflationary impulse will need to somehow overpower the fundamental disinflationary forces that the economy has faced for decades. These secular factors include aging demographics, technological changes and globalized supply chains – all of which have conspired to help keep inflation in check in recent years. The pandemic has also arguably accelerated some of these trends, such as the more rapid uptake of technology.
Even just before the pandemic, inflation was tame. And this was when unemployment was running below 4% (around record lows) and companies were competing for workers. The pandemic caused the unemployment rate to rise sharply, and the output gap to spiral up. As we do not expect the US economy to reach pre-COVID levels of GDP until the end of 2021, we do not expect the output gap to close again until 2022 or maybe even 2023 at the earliest which implies that inflation is, at best, years away.
What if we're wrong?
In the event of an unexpected inflation spike above the (new ‘average’) 2% inflation target , we would expect the Fed to be able to continue to deploy the same playbook that has successfully contained inflation since the 1980s.
Furthermore, we believe that the upper bound for US interest rates would be limited by both the reach for income domestically and also the demand for higher yields by investors in countries with low or negative interest rates. We believe such a move would likely be a buying opportunity, for fixed income assets if timed appropriately.
Future pricing dynamics by sector may be more interesting than the inflation question
Even in the absence of a sustained rise in the overall level of inflation – as measured by CPI or the Fed’s favoured measure, PCE – pricing dynamics within sectors may be relatively dramatic as the post-pandemic economy evolves.
Table 1: The components of inflation3
|Food at home||7.9|
|Food away from home||6.3|
|Household furnishings and supplies||3.8|
For example, COVID-19 has had deflationary impacts on energy, but potentially an inflationary impact on household furnishings as the pandemic inspired swathes of people to invest in their homes, where they have spent more time since the pandemic began.
Shelter costs in the cities have been held down, in part, by shrinking demand for hotels, ‘Air BNBs’ and college dorm rooms. Meanwhile, the price of business attire has suffered as remote working makes the phrase ‘white collar’ an increasingly poor description of the office worker. It is entirely possible that office attire will continue to be more casual as workers dribble back into the office, if they return at all.
So perhaps, more interesting than the question of ‘will we see inflation anytime soon’ is instead the question of ‘within which sectors can we expect to see inflation, disinflation, deflation or no change’.
Understanding those dynamics may help fixed income investors position better within sectors and also, better understand the inflation dynamics of the entire economy.