Pray for Peace but Prepare for War: Inflation Edition
Author: Dr. Michael Dooley | June 25, 2021
Equity markets have rallied over the past year as the various COVID vaccines have proven effective and the global economy has begun to reopen, albeit in a piecemeal fashion. With the risks of a perpetual quarantine significantly diminished, financial markets have shifted their focus to the outlook for monetary policy from the world’s central banks. The difficulty for central bankers is two-fold. First, they must convince markets they will remain accommodative in the face of above-target inflation, something they see as temporary. Second, they must then actually do what they said they will and keep interest rates low. Much like flying near a storm, it is easier to have confidence in the flight plan while on the tarmac than it is after a sudden lurch downward at 30,000 feet.
We expect the central bankers are largely right and that a period of extended above target inflation is unlikely, but we think it’s easier said than done to stay the course and remain dovish in the face of the biggest inflationary shock in thirty years.
During the global lockdown central banks pushed interest rates lower both by lowering the overnight interest rate and by purchasing various financial assets. By lowering the rate of return on the assets they bought, these central banks indirectly pushed equity markets higher.1 The graph below shows the expansion of several central bank balance sheets, showing the large increase in assets held by these banks and, implicitly, the large increase in reserves used to finance the purchases.
Figure 1: Growth in Central Bank Assets. Note that the Federal Reserve was the only major central bank that had begun to shrink its balance sheet before COVID forced a reversal.
These measures did much to restore financial stability in the early days of the crisis. Importantly, they were complemented by targeted fiscal measures to help firms and households remain solvent through the pandemic. To say these measures were successful would be an understatement. Look at the graph below of personal income which actually went up even as millions of people lost their jobs:
Figure 2: Personal Income in the United States has moved sharply higher even as unemployment first increased due to transfer payments from the U.S. government.
With reopening gaining steam, especially in the U.S. (and with goods markets never seeing a dip, see our blog post on that here), there looks to be significant amounts of pent-up demand. If that increase in demand is not matched by a commensurate increase in supply, the only channel for markets to absorb the higher level of nominal spending is through higher prices. That has already happened in select markets; see the graph below showing spikes in markets as disparate as lumber and used cars in the United States. Central banks expect this; their fear is a persistent acceleration of price growth across a general set of goods and services, not just these outliers.
Figure 3: Reopening has seen supply bottlenecks send prices sharply higher in various sectors of the economy.
In the U.S., longer-term interest rates moved higher in the first quarter as investors built in expectations of higher inflation and moved up their expected timing of Fed interest rate hikes. This led to volatility in equity markets, especially the growth names that had performed well in 2020. Recently, however, interest rates have moved lower after a series of re-affirmations by the Fed that they are in no hurry to raise interest rates nor taper asset purchases as well as two jobs reports in a row that showed lower than expected job creation.
Figure 4: The 10 year yield on US Treasuries has moved lower after a large rise in Q1. Though we see a return to 3% unlikely in the near-term, we do think it moves higher through the rest of the year.
We have long viewed the combination of aging demographics and technological innovation as deflationary. We have seen the erosion of labor’s bargaining power over the last several decades and the expansion of offshoring labor from low-skill manufacturing to high-skill professional work. We have seen the inability of the Bank of Japan and the European Central Bank to generate inflation with large (for the time) quantitative easing programs and negative interest rates. We have thus had, and continue to have, a relatively benign view of inflationary pressures over the medium term.
Figure 5: Inflation has been hard to come by in the developed economies post-crisis.
However, we view the recent decline in interest rates with some skepticism. We think inflation will continue to surprise to the upside in the coming months. Jobs have traditionally been slow to come back, and while they have responded much more quickly in this recession, there is still a long way to go and it seems likely wage growth will accelerate markedly.
Central banks then have to make some choices. They can stay the course in the face of accelerating inflation and exercise restraint in raising rates or they can take a more hawkish stance. Even if they continue to try and convince markets the inflation is transitory (a view we, again, are in agreement with over the medium term) markets may not agree. Interest rates at these levels require an unblinking Fed, a market that agrees, and inflation that behaves. Without all three longer term interest rates will move higher. We will watch the data and the Fed’s response to it with interest over the coming months.
The channels by which central bank purchases of various fixed income assets lead to higher equity prices are not fully agreed upon given the difficulty in measuring cause and effect in an environment partially determined by expectations of the future that are themselves hard to measure.
The information contained herein is provided solely as general information about Figure and is a summary of certain information set forth more fully in documents that are available upon request. Neither this summary nor any other documents from Figure constitutes an offer to sell or a solicitation of an offer to buy securities or investment advice of any kind. Investment decisions should not be based on the provided information.