August 28, 2020
Ironically, inflation's long dormancy makes it more likely now.
Ever since the U.S. government began running large deficits in the early 2000s, warnings of imminent inflation were sounded by economists and politicians alike (remember the Tea Party). These warnings have been put to the test for a number of years now by ever-larger government deficits.
Yet, since the 1970s, inflation has held steady at relatively low levels.
The chorus of inflation warnings grew even louder after the Financial Crisis once the Fed started to massively increase its balance sheet (a form of new money in the system) and combine that with rock-bottom interest rates.
The accepted explanation for the lack of inflation so far has been twofold. The first is the decreasing "velocity of money" which can be simply interpreted as a decreasing amount of bank lending. The more velocity there is, the more money circulates through the system as new loans. This has trended down relentlessly even while government deficits and more recently, the money supply ramping higher.
The second reason generally accepted now for the lack of inflation has been the decreasing rate of worker productivity.
Focusing in on this year, those potential drivers for inflation have been supercharged by the government's bold reactions to the COVID crisis with much bigger deficits and much faster expansion of the money supply.
Still, the velocity of money has not yet increased nor has productivity. In fact, both have dropped even more sharply during the crisis. This pattern of declining inflation for many years in the face of actions that most believed should have done the opposite has convinced many fed governors, politicians, and economists that the economy can withstand much larger deficits and much greater expansion of the money supply without any meaningful inflation developing.
So why should we expect a different outcome this time?
The reason to be concerned is because everyone is convinced inflation is dead. This confidence is inspiring the Fed and politicians to go much further expecting nothing bad to happen. The Fed is open to create a lot more money. They do not have qualms about using that new money to buy federal debt in massive amounts. The politicians are becoming more and more eager to take that money received by issuing more debt and give it directly to people. People that will spend the money. This is what greatly increases the likelihood of inflation.
The direct deposit payments to people earlier this year and the extra money added to unemployment insurance are examples of this process. These policies in some form make sense considering the nature of the current crisis, but the risk is that the availability of more money in this fashion in the future is now an option taken for granted. There was very little debate about the risks or potential downsides this year.
What is different now than after the Financial Crisis is that this new money is circulating. It is being spent. Besides direct payments to people, the government has directly distributed loans to businesses (who will spend that money too). PPP loans are an example, the banks distributed them, but under the instructions of the government. They are fully backed by the government so there is no exposure to the banks. Most will not be repaid adding more money to the system. This is different than during the years after the Financial Crisis when newly created money went to the banks and was generally not lent out and spent.
Everyone now expects either party after the election to enact huge infrastructure bills. There will not be nearly enough tax money to pay for the size of the expected spending plans. The same circular path from Fed printing to politicians' spending is likely to be used again. This path is available in the future for all kinds of programs preferred by both parties - healthcare, green deal, rural broadband, 5G, electric grid, tax cuts. Additionally, if the economy or the markets become weak again (due to the virus or otherwise), the odds are high for more direct payments and loan guarantees too.
These events dovetail right into the Modern Monetary Theory (MMT) debates that have been going on in recent years. MMT is based on the thinking that deficit government spending and the size of the money supply do not matter. Which is exactly where the group think is going now without actually calling it MMT. (Note, MMT does believe that if inflation does come, it can be tamped down by increasing taxes substantially to reduce spending; possible in theory but hard to imagine happening in actuality.)
There are some prominent economists and investment experts that believe the risk of inflation has increased. One is Russell Napier who has been a significant voice in the investment community for the last couple of decades pointing out the primary risk has been deflation (which was correct for a long time). He has changed his view now and expects inflation for the same reasons outlined in this post. Lacy Hunt of Hoisington Investment Management, an economist and former Fed official, has been a confident voice expecting deflation for decades now (and produced fantastic returns for his bond fund because of it). He still believes deflation is the current trend, but now thinks that hyper-inflation would quickly be the result if the Fed and politicians go further with the process of direct transfer of newly created money to the people.
How will markets react if this time is different?
If there is really is inflation, markets would definitely react. Currently, market prices expect almost no inflation out into the distant future. If you are wondering how there can be inflation when so many parts of the economy will probably take many years to recover from the COVID crisis, you are correct. The typical thinking about inflation is too much demand drives prices up. This is one type. What I am expecting is different, higher prices because the currency itself becomes less valuable ("debasement"). In economics, these two types are commonly referred to as "good" and "bad" inflation - unfortunately the latter is the risk of the day.
As for the markets, long-term interest rates would probably rise meaning bond prices would go down. Because the government and private sector have such huge debts outstanding and cannot afford higher interest rates, the Fed has already alluded that they might cap any meaningful rise in long-term interest rates. They would probably do this by printing whatever amount of money would be needed to buy Treasury bonds in the marketplace to keep the price up (and therefore interest rates down).
Gold has already risen on expectations for "bad" inflation, but could potentially rise much more if it really comes. The capping of interest rates by the Fed would probably supercharge the gold price even more. Commodities and real estate might also appreciate, but there are a lot of other factors to consider if the economy is still struggling ("stagflation"). Equities are likely to go up too, but would probably falter if inflation got out of hand.
The important message here is not to create panic, but just not to be complacent about inflation risks. There are many things that can be done to protect your portfolio by planning ahead. Keep an open mind, just because there has not been inflation for a long time does not mean it can not happen again. In a world with "once in a lifetime" events that seem to be happening all the time, taking some extra precautions with your investments makes sense.
This blog article nor my advisory entity is not making any recommendations, only pointing out strategies for consideration. Investors should do their own research and consult their advisor before making any investment decisions.
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