Stimulus = Inflation? Why It May Be Different This Time
With the Federal Reserve and the federal government providing massive stimulus to the economy in the face of the COVID-19 crisis, a persistent worry among investors is whether these policies will lead to inflation down the road. Once the crisis is over, how will all the excess money that is being pumped into the economy be absorbed? There is a concern that inflation will erode the value of bonds.
Our view is that deflation is a threat in the near term, and the risk of inflation in the next few years is limited. While we can’t entirely rule out rising inflation down the road, we believe it’s not the most likely outcome. A lot will depend on how quickly the economy rebounds from the steep decline caused by stay-at-home orders that have shuttered businesses and resulted in a spike in unemployment. A rapid rebound in the economy could potentially lead to inflation, but we think a slow recovery that keeps inflation moving lower and bond yields low is more likely.
The Federal Reserve’s big balance sheet
Many investors remember the 1970s, when inflation rose sharply on the back of expansive fiscal and monetary policies. As inflation and interest rates rose, economist Milton Friedman’s thesis that inflation is “always and everywhere a monetary phenomenon” drove the Federal Reserve to target money supply growth in the 1980s, bringing inflation down. Therefore, whenever the money supply rises rapidly it seems reasonable to assume that inflation must be around the corner. However, in order to produce inflation, the money has to be loaned and/or spent, and must drive up the demand relative to supply. If it sits on the balance sheets of banks or is saved by consumers, then it doesn’t necessarily drive up prices for goods and services. In the words of another old adage, inflation results from “too much money chasing too few goods.”
Currently, quite the opposite is happening, due to the mitigation efforts for the coronavirus. Demand for many goods and services has dropped sharply as consumers remain at home. Business inventories are rising as consumer spending falls amid soaring unemployment. In the first half of the year, it’s likely that gross domestic product growth (GDP) will decline at its fastest pace since the Great Depression in the 1930s. Even the most optimistic of forecasters don’t expect the economy to fully recover for a few years.
In response, the Fed and Congress are providing relief to build a bridge between the current economic downturn and the potential recovery. The goal is to fill the gap that has been created by the downturn. Referred to as the “output gap,” it’s the difference between the economy’s potential growth rate and its actual growth rate. In order to generate inflation, the gap would need to close and growth would need to exceed its potential for an extended period of time. We see that as unlikely in the near term, and far from certain in the longer term.
Mind the gap: GDP growth is falling far below its potential growth rate
Source: U.S. Bureau of Economic Analysis, Gross Domestic Product (GDP) and U.S. Congressional Budget Office. Nominal Potential Gross Domestic Product (NGDPPOT), Gross Domestic Product, and the Gross Domestic Product Forecast. Quarterly data as of Q1-2020 with forecast through Q4-2020, provided by U.S. Congressional Budget Office.
The longer the current downturn lasts, the more risk there is to the economy’s ability to bounce back, because recessions tend to destroy productive capacity. Some businesses will not reopen, some people may not get back into the workforce, and unused resources, such as structures and equipment, as well as skills, become outdated. While a rapid rebound is possible, it seems more likely that it will take time to close the output gap, let alone get far enough beyond it to create a lot of inflation.
Inflation expectations are low
Moreover, it’s tough to generate inflation if people don’t believe in it. After all, why would anyone “chase” goods if prices stay the same or fall? Delaying consumption could mean getting a discount later. There may be some price increases for certain goods that are in short supply due to supply chain issues, but widespread generalized price increases appear unlikely. Currently, inflation expectations are plumbing the depths of all-time lows. Whether it’s survey-based or market-based measures, the signs still point to falling inflation expectations. So self-sustaining demand-driven inflation seems unlikely any time soon.
Consumer inflation expectations have fallen
Source: Bloomberg. University of Michigan Consumer Expectations Index. Monthly data as of April 2020.
Market expectations for inflation are also low
Notes: The 5-year 5-year forward rate is a measure of the average expected inflation over the five-year period that begins five years from the date data are reported. The rates are composed of Generic United States Breakeven forward rates: nominal forward 5 years minus US inflation-linked bonds forward 5 years.
Source: Blomberg 5-year 5-year Forward Inflation Expectation Rate (USGG5Y5Y Index). Daily data as of 5/11/2020.
But what about the long term?
After all, the current wave of inflation worries has been sparked by the unprecedented increase in the Fed’s balance sheet, along with the fiscal measures enacted by Congress. Once the economy “re-opens,” surely all that money printing will result in inflation down the road, won’t it?
It’s possible, but recent history doesn’t support the idea that it will necessarily happen. There were similar worries during the 2008-2009 financial crisis. However, despite the rapid and huge expansion of the Fed’s balance sheet at the time, inflation stayed muted. Asset prices went up, but that was the extent of the inflation.
Nonetheless, a lot of people remember the 1970s, when inflation was high due to a combination of loose fiscal policy and easy monetary policy. While there are some parallels, there were other factors at work back then. The expansive policies came on top of already-strong growth, so there was no output gap to absorb the extra liquidity.
Workers typically had wages indexed to inflation, so demand held up well. Also, the U.S. severed the last remnants of the gold standard in 1971, leading to a steady decline in the dollar. Finally, there were two oil embargoes in the 1970s that lifted the price of oil—a crucial commodity for the economy—resulting in higher prices for both industry and households.
Today, we’re looking at a different backdrop. Not only is there a wide output gap, suggesting excess supplies of goods and labor, but wages for many workers haven’t kept up with inflation for many years, partly as a result of globalization and outsourcing production to countries with lower wage costs. Perhaps that’s why there has been so little “chasing” of goods. On top of that, commodity prices have fallen sharply and the dollar has been strong, holding down prices of imported goods.
Falling oil prices have pulled overall commodity prices lower
Note: Chart shows the Commodity Research Bureau (CRB) Spot Index, which is an index that measures the overall direction of commodity sectors. The CRB was designed to isolate and reveal the directional movement of prices in overall commodity trades. The Spot Market Price Index is a measure of price movements of 22 sensitive basic commodities whose markets are presumed to be among the first to be influenced by changes in economic conditions. As such, it serves as one early indication of impending changes in business activity. The commodities used are in most cases either raw materials or products close to the initial production stage which, as a result of daily trading in fairly large volume of standardization qualities, are particularly sensitive to factors affecting current and future economic forces and conditions. The composition of the groups are as follows: Metals, Textiles and Fibers, Fats and Oils, Raw Industrials, Foodstuffs.
Source: Bloomberg. Commodity Research Bureau BLS/US Spot All Commodities (CRB CMDT Index). Daily data as of 5/11/2020.
What about the debt?
Another concern is the rise in government debt. Will the burden of debt lead the U.S. to try to cheapen the dollar to repay it? What if foreign investors, who hold nearly half of U.S. debt, demand higher yields in the face of rising budget deficits?
We can look to the WWII era for a parallel—one that is getting a lot of press these days. The U.S. had built up a large war debt. In order to finance the debt, the Fed agreed to cap short-term rates at 0.38% and long-term interest rates at 2.5%. It bought bonds for its balance sheet, amounting to about 25% of GDP, and engaged in a form of yield curve control—targeting interest rates instead of the quantity of bonds it would buy.
In the aftermath of the war, inflation did spike up as price controls were lifted and pent-up demand surged. Also, housing was in short supply and many goods, like coffee and gasoline, had been rationed. Most importantly, unemployment began to fall as returning soldiers found work in factories that were converting back to producing goods for households rather than weapons. Consequently, the burst of inflation in the late 1940s flamed out pretty quickly as supply caught up with demand.
The Fed had been under the thumb of the Treasury for most of the 1940s, holding short-term interest rates near zero and buying bonds for its balance sheet to help finance the war. Its balance sheet expanded to 25% of GDP—near the level it is now. The Fed regained its independence in 1951 and quickly began raising short-term interest rates. What followed was a stretch of solid economic growth, but crucially, bond yields didn’t recover to pre-war levels for eight more years. Inflation and interest rates trended higher, but took a long time to reach levels seen before the war despite strong economic growth.
Bond yields were slow to rise after World War II
Source: St. Louis Federal Reserve. Long-Term U.S. Government Securities (DISCONTINUED SERIES) (LTGOVTBD), Percent, Monthly, Not Seasonally Adjusted. Shaded area indicate past recession. Past performance is no guarantee of future results.
Fast forward to 2020 and we also have a buildup of debt and a Fed that is keeping interest rates low and working closely with the Treasury Department to allow its balance sheet to expand rapidly.
The Federal Reserve’s balance sheet has risen sharply
Source: All Federal Reserve Banks: Total Assets, Trillions of Dollars, seasonally adjusted. Weekly data as of 5/6/2020.
However, there are two important differences between today and the post-war period. The U.S. economy has a much slower potential growth rate due to the aging of the population, and there is an overhang of debt at the corporate level. These are factors that will likely mean that the recovery is slow. The unemployment rate has soared to double-digit levels, suggesting that there is likely to be a lot of excess labor supply for quite some time. While many workers will get their jobs back, some will not as temporary layoffs become permanent. That should hold down demand in aggregate. Even workers who return to their jobs may need to recoup some of the money they drew out of savings during the lockdown period.
The civilian employment to population ratio fell to the lowest point since tracking began
Source: Bureau of Labor and Statistics. Civilian Employment-Population Ratio, Percent, Quarterly, Seasonally Adjusted, data as of April 2020.
The overhang of debt means that every additional dollar of debt produces less output. The Fed’s relief programs are largely providing corporations with loans. Companies can add debt to their balance sheets with these loans, but when there’s too much debt the marginal return on an additional dollar of debt declines. Given the high levels of debt already on corporate and local government balance sheets, it seems unlikely that the added debt will add much to growth. Rather than a burst of inflation when the economy re-opens, we might be looking at another stretch of soggy growth and low inflation.
The role of the dollar
Investor Warren Buffett said summed up the situation very concisely at his annual meeting: “You can finance a deficit as long as your currency holds up.” It’s about debt sustainability. With 10-year Treasury yields at about 0.68% and 30-year yields at 1.30%, the U.S. can sustain high debt for a long time—unless investors lose confidence in U.S. policy.
That’s why we believe a crucial indicator to watch is the dollar. Despite fears of inflation and “money printing,” the dollar has remained strong. There are few signs that investors are losing confidence. Because currencies are measured in relative terms, the dollar benefits from a lack of good alternatives. Japan and Europe are in the same boat as the U.S., only with lower yields and older populations. The U.K. is hardly looking very stable these days amid its attempt to separate itself from Europe. China’s currency isn’t even freely convertible.
More importantly, the world’s financial system is more dependent on it than ever. The vast majority of global transactions take place in U.S. dollars. Central banks around the world hold U.S. dollars—and therefore Treasuries—for these transactions. Over time, the debt issued in U.S. dollars has grown sharply—especially debt issued by emerging-market countries and corporations. All of these factors keeps the demand for dollars firm.
At some point, investors could lose confidence in the U.S. and shift out of dollars. The administration has made it clear it wants a weaker dollar for trade purposes. However, in the current environment, it’s hard to see what will replace it as a safe haven or a means of transactions any time soon. There is room for it to decline from its recent spike, but a lasting decline would be needed to stoke inflation longer term.
The Fed will also be important to watch. One reason yields have stayed low in the face of expansive monetary policy is the belief that the Fed would react to signs of rising inflation by tightening policy. Confidence in the Fed’s inflation-fighting ability is an important factor limiting inflation expectations.
Outlook for interest rates
Over the next one to two years, we believe that deflation is probably more of a risk than inflation. We expect that the recovery from the COVID-19 downturn is likely to be slow, keeping inflation and interest rates low. As the economy mends, the Fed will gradually unwind some of its emergency lending. As loans get repaid, the Fed will let some of its holdings roll off its balance sheet, and start lifting interest rates—perhaps two or three years from now. We expect the Fed to keep the federal funds rate pegged near zero for at least two years, and ten-year Treasury yields to remain under 1% in 2020 and under 2% in 2021.
For those who are still concerned about the risk of inflation and higher interest rates, it would make sense to reduce average fixed income portfolio duration. We favor a lower-than-normal allocation to long-term bonds, because yields are so low anyway. However, the risk is that the downtrend in inflation continues for a few more years and long-term bond yields continue to fall (while prices rise), causing a short-duration portfolio to underperform in relative terms.
Another strategy would be to shift some treasury holdings to Treasury Inflation Protected Securities (TIPS). TIPS are designed to keep pace with inflation. However, there is a price to be paid for this protection. TIPS yields are negative for most maturities. That means you’ll have to pay up now for insurance against inflation down the road.
Overall, a diversified portfolio with the majority of holdings in core bonds—Treasuries, higher-rated investment-grade corporate and municipal bonds—is our favored approach to bond investing in the current environment. For investors willing to take more risk, adding some aggressive income investments such as high-yield bonds and preferred securities can produce more income, but we would limit the allocation to about 10% of an overall portfolio.