The inflation debate is overheating—but we believe that persistent inflation, while a risk to be monitored, is unlikely over the next two years. As the debate rages over the next year, we expect to see market overreactions create potential opportunities for fixed income investors to 'buy the dips' if markets react to near-term transitory inflation 'base effects'.
The coolest heads will prevail
The outlook for inflation has emerged as perhaps the fiercest economic debate of 2021.
With a light at the end of the pandemic potentially in sight, consumer spending will increase in many areas of the economy. At the same time, the Federal Reserve (Fed) is currently indefinitely committed to QE and the new Administration has passed a $1.9trn fiscal stimulus and is setting its sights on an infrastructure plan.
Many are worried that this means a game-changing spell of sustained and persistent inflation. However, for us – it looks more like a transitory flicker than a bonfire – potentially at least until 2023.
Money supply growth is not as scary as it looks at first glance
The main argument for persistent inflation is that the money supply is rising sharply – which is undeniably the case (Figure 1).
Figure 1: The money supply is spiking1
However, money supply only really tracked inflation during the 1970s. Since the 1980s (when the Fed first turned its attention to inflation) the correlation between core CPI and money supply has only been ~10%.
Also, when money supply is adjusted to only reflect money circulating in the real economy, its rate of growth looks far less alarming (Figure 2).
Figure 2: The money supply circulating in the real economy is not growing that strongly2
The M2 illusion explained
When we adjust ‘M2’ to exclude money held at the Fed, why does there appear to be no parabolic rise in the money supply?
It’s partly because a large proportion of the rise in money supply has been a result of QE, which involves ‘printing’ fresh bank reserves that circulate within the banking system (at banks’ accounts at the Fed), but not the real economy.
QE’s inflationary potential is more indirect – by incentivizing commercial banks to lend more (which effectively ‘prints’ new money into the economy3). However, QE has not proportionately stimulated private credit growth – largely as the US consumer (worth ~70% of the economy) has been firmly deleveraging since 2008 (Figure 3).
Figure 3: M2 relative to the Fed balance sheet shows QE having a proportionally muted effect on private credit growth4
The US Treasury has also been holding more cash at the Fed, partly as dry powder in case of unexpected crises and partly to pre-fund the administration’s fiscal stimulus plans, as well as other requirements. Ultimately, while the Treasury’s balances are set to fall, a decent proportion will transfer to another account at the Fed. So, while we expect the two green lines in Figure 2 to converge, we do not anticipate a wider money supply gamechanger.
The 'output gap' indicates inflation could yet be years away
Most investors now look at the output gap rather than money supply as the primary indicator of inflation, which has correlated ~50% with core CPI since the mid-1980s5 (Figure 4).
Figure 4: The output gap has a better correlation with inflation than money supply6
The 'output gap' explained
The ‘output gap’, describes the difference between ‘actual’ economic growth and ‘potential’ growth. Potential growth assumes ‘full employment’.
If the output gap is ‘open’ – the economy is running below potential – meaning unemployment is above its ‘natural’ (or ‘non-accelerating inflation’) rate (‘NAIRU’). Inflation should fall.
By contrast, if the output gap is ‘closed’ (or positive), inflation should rise. The intuition is that when unemployment is below the natural rate, there’s a shortage of workers. Employers will therefore compete for workers – by raising wages – which will feed through into higher inflation.
Given a slowing recovery in unemployment, we do not expect the output gap to fully close until the end of 2022, potentially not until 2023. It may take even longer. The output gap is notoriously difficult to estimate. We believe official estimates may understate the output gap (Figure 5).
Figure 5: Official estimates potentially understate the output gap7
But what if official estimates are instead understating the output gap? Even if this is the case, we do not believe there will be a lasting inflationary impact. The ‘Phillips Curve’, which measures the sensitivity of inflation to changes in unemployment, has been flattening dramatically since the 1970s (Figure 6). This means that as unemployment has fallen, inflation has been reacting by a lesser extent.
Figure 6: The ‘Phillips Curve’ has been flattening8
When unemployment is over 5%, as we expect it will be over the course of 2021, core inflation will likely run below the Fed’s 2% target. Don’t forget that unemployment was running at ~50-year lows in 2019, and this still failed to meaningfully stimulate inflation.
Make no mistake, we are in a secular disinflationary trend - which the pandemic likely exacerbated
A large reason the Philips Curve may have been flattening since the 1970s is the fact that the US, like most advanced economies, has been stuck in a disinflationary9spiral since then (Figure 7).
Figure 7: The US is in a secular disinflationary trend10
There are three long-term secular factors driving this:
1. Aging demographics
The baby boomer generation – once a massive driver of US growth – is entering retirement, and so the working share of the population is shrinking.
Many also decided the pandemic was a good time to retire earlier than planned, resulting in falling labor force participation. Retirees tend to prefer income-paying assets, continually increasing demand for fixed income thus helping reduce long-term bond yields.
The average cost of labor and production declined rapidly as supply chains globalized over the last 40 years.
The pandemic may continue this trend. China has notably emerged quicker than other nations from the pandemic, by providing a fiscal boost to its state-owned enterprises and infrastructure. This increased productive capacity contributes to increasing slack in the economy. Slack leads to disinflation, and so we expect China to continue exporting disinflation to the West via lower-cost exports.
3. Technological change
Advances in hardware, and more recently, software have allowed machines to augment or replace human labor over time, further reducing labor costs. Continuing advances in areas such as artificial intelligence and machine learning mean these trends are unlikely to reverse.
The pandemic may accelerate technological change in some areas – particularly remote working. More full-time remote working may also allow for some workers to relocate to lower-cost areas, which could also result in proportional wage cuts as a result.
Inflation will appear to go up in 2021 - but don't overreact, it's mechanical
Upcoming CPI and PCE figures are almost guaranteed to look relatively high in 2021 – due to the so-called ‘base effect’ – which the Fed has indicated it will ignore.
The 'base effect' explained
Inflation figures (whether PCE or CPI), as commonly reported are ‘year-on-year’ calculations – i.e. calculated relative to exactly a year ago.
Most prices (toilet paper excepted) will register an increase on the anniversary of the strictest lockdowns. Remember, WTI oil futures traded at negative prices in April 2020. In a hypothetical world in which this transmitted into the economy, even a price of zero would register as inflation.
Leisure spending will also help drive transitory inflation
As we enter the ‘new normal’, we expect a burst of spending on leisure (such as that first family vacation, reunion, concert or dining experience), particularly as personal savings rates spiked to highs of 20% to 30% during quarantine, compared to more normal levels of ~7.5%.
However, many things have changed for good. Business travel will potentially be permanently reduced, and retail will continue to shift towards online.
Other trends will measure as deflationary. The housing market boomed in the suburbs, leaving rent and real estate deflation in the big cities. Due to sampling methods, urban properties factor more in inflation statistics than those in suburbia11.
Healthcare costs will register as inflationary in 2021, but potentially deflationary thereafter as pandemic-related price increases stabilize or reverse and Medicare add-on payments and physician fee adjustments introduced under the CARES Act expire.
Conclusion: Consider buying the dips
Speaking in January 2021, Fed Chair Powell stated: "The kind of troubling inflation people like me grew up with seems unlikely in the domestic and global context we’ve been in ... there has been significant disinflation pressure for some time".
In our view, the 1970s are not coming back. So why then, have rising long-term rates been the big financial story of 2021 so far? In our view, it is instead mostly due to an improving economic outlook – and less driven by uncertainty caused by the pandemic. As we know, a stronger growth environment is naturally favorable to risk asset classes, such as corporate credit.
Do not forget that even if we are wrong, the Fed has all the tools ready to control inflation if it rises beyond levels the central bank is willing to tolerate. It has a compelling record of keeping inflation tame since the 1980s (when managing inflation became a priority for the central bank). The Fed is also incentivized to keep bond yields low – to keep the Treasury’s rising debt load affordable. It has yet to enact a ‘yield curve control’ or ‘operation twist’ strategy to keep a lid on long-end rates – and we certainly wouldn’t rule such a policy out. Don’t fight the Fed.
If markets overreact to transitory inflation – causing, for example, intermittent sell-offs in Treasuries – there is plenty of cash on the sidelines ready to buy the dips (Figure 8) and when US yields rise it generally tends to attract foreign investors.
Figure 8: Money market volumes indicate plenty of cash on the sidelines waiting to buy the dips12
Playing inflation expectations in credit
We believe in closely watching how markets react to CPI and PCE prints over 2021. If investors do occasionally over-extrapolate short-term transitory inflation trends into long-term projections, markets have the potential to whipsaw periodically – largely driven by retail investment flows. Therefore, we believe that trading credit spread duration could offer the potential for outperformance.
One of our key metrics to watch will be the MOVE index – which tracks Treasury market volatility. When it trades at levels below 50 (currently it is over 60), we would consider it a sign that investors are potentially starting to be overly complacent about persistent inflation risks, and it may be time to tactically reduce credit. Conversely, we would see spikes in the index as potential opportunities to buy the dips and add credit spread duration.
We will also pay close attention to the details of inflation reports. In our view, high inflation in the ‘shelter’ and ‘healthcare’ components of the inflation indices would be most indicative of persistent inflation. Absent a rise in these components, it would indicate to us that inflation will remain transitory – signalling an opportunity to add credit spread duration.
In our view, investors waiting for persistent inflation could miss opportunities to lock in compelling yields as markets re-price growth expectations in 2021. As the inflation debate overheats – we expect the coolest heads will prevail.