July 7, 2020 – As published on Chief Investment Officer.
Unlikely. Here’s why, despite all that federal money sloshing around in the system, price rises should stay tame.
Washington has pumped a torrent of liquidity into the economic system. Won’t that spell an inflation spike, once the present nasty pandemic recession has ended? Maybe a muted one, if anything. Nowadays, with 11.1% unemployment and surging coronavirus cases in many states, no one is raising prices. And they probably won’t much in coming years.
Inflation above the current minuscule level may blip up a bit, post-mess, maybe as much as 3% to 3.5% annually. Yet that was the level in the 1990s, and most people barely noticed it. “We’ve had years of powerful forces keeping prices down,” economist Ed Yardeni, head of Yardeni Research, said on a recent broadcast.
Going slightly above 3% for a spell is a widespread expectation amid asset managers, although many economists think it won’t rise much past the 2% pace the nation has seen for much of this century. How much prices ascend has important implications for how institutional investors, and individuals, too, will allocate their capital.
After all, low inflation means continued low interest rates, not good over time for fixed-income investors. If anything, that could induce more portfolios to foray further into stocks, although the COVID-19 threat and uncertainty might give some pause. The continued move into alternative assets, particularly private equity, may well keep going. If anything would propel such a 3% inflation bump, the massive government stimulus would be a prime cause. The Federal Reserve has expanded its balance sheet by $4 trillion to buy bonds and provide other aid. The executive branch, with Capitol Hill’s blessing, has expanded the federal deficit by $1.9 trillion this fiscal year, up from $700 billion the year before.
“Maybe 18 months out, in the beginning of 2022, and the world’s back to normal, we’ll see the liquidity moving around the system,” said Luis Maizel, co-founder of LM Capital Group, referring to the government stimulus cash. “Then there could be 3% to 3.5% inflation, although nothing like” when Jimmy Carter was president.
Inflation? What Inflation?
Notice that nobody is leery about double-digit price increases, a la the Carter-era 1970s. “We’re not worried about inflation,” said Sam Masoudi, CIO of the Wyoming Retirement System ($8.5 billion in assets), because all the new debt Washington is piling on to fight the slump “is deflationary.” Fed Chair Jerome Powell, for his part, believes inflation is a non-issue. “We didn’t see any problems with price inflation,” he told a news conference June 10. Reason: The US had an expansion of more than 10 years and only once breached the 2% inflation level (as measured by the Fed’s preferred method, personal consumption expenditures, or PCE) that the central bank has set as a target.
Tellingly, the bond market agrees with him, at least as expressed in the price of Treasury inflation-protected securities (TIPS). The cost of insuring against inflation, using these bonds, “has never been cheaper,” a UBS Global Wealth Management client note read.
To James Bianco, president of Bianco Research, a slight chance exists that inflation could kick up higher than the low single digits once the economic bad times have passed. In a recent podcast, he noted that the White House has a lot of say about the special stimulus programs the Federal Reserve is running. “This means that Donald Trump, who wants the Dow to go higher to get re-elected, will make them keep running the printing presses.”
In an unsettling era like today’s, disruptions on goods production will occur that send some spot prices skyward. For instance, washing machines are more scarce and thus expensive lately. Rich Sega, global chief investment strategist at Conning, pointed out that “you can’t buy a washing machine on the East Coast.” Yet those are temporary price distortions brought on by a diminished manufacturing output.
In the 12 months through May, the consumer price index (CPI) increased a mere 0.1%, the lowest year-over-year rise since September 2015, a lot of that owing to plunging oil prices. Core prices, which exclude volatile food and energy, rose 1.2% on the year, the US Bureau of Labor Statistics said. And PCE, which uses a broader measure of inflation than the others, was up 1.0%.
And long-term, the Philadelphia Federal Reserve Bank’s economists’ survey projected the rate will be just 2.1% in 10 years, around what it has been for the past decade-plus. Worldwide, the picture is much the same. The 37-nation Organization for Economic Co-operation and Development (OECD) showed inflation slowing to 0.7% in May, from 2.2% in February, before the virus erupted.
Where’s the Money?
An implosion in the quantity of money was the chief factor in bringing on the Great Depression, wrote economists Milton Friedman and Anna Jacobson Schwartz in their landmark book, A Monetary History of the United States. Fed chief Powell didn’t want to fall into that snare, so he poured money into the economy at the fastest rate in the past 200 years.
Hence, the money supply (broadly defined by the moniker M2) has expanded massively since the Fed, with the help of Congress, firehosed vast amounts of liquidity into the system. M2 hit $17 trillion, up from $15.4 trillion prior to the epidemic’s onset.
Trouble is, banks are less eager to lend, consumers are lowering their borrowing, and people’s spending has ebbed, especially since the recession’s arrival. So the velocity of money, the rate at which it circulates through the system, has drooped. Velocity is the vital cog of prosperity.
By the count of the St. Louis Federal Reserve Bank, velocity shrank to 1.37 at the end of the first quarter, meaning the money supply has turned over in the past 12 months just 1.37 times. That’s down from 1.43 at year-end 2019, and 2.0 right before the 2008 financial crisis. “If you are sitting on a lot of cash,” said Jeff Klingelhofer, co-head of investments at Thornburg Investment Management, “that doesn’t mean you have to go out and spend it.”
In other words, a lot of the Washington provided liquidity is trapped in bank coffers or in financial assets. Which is another way of saying that it’s not going to house or auto buying, vacations, college tuitions, or other uses that were common four months ago and built fat gross domestic products. For example, airline ticket costs have plummeted 15%, said Jeanette Garretty, chief economist at Robertson Stephens Wealth Management. “No one is flying. Demand has just weakened.”
When government manna lands in someone’s wallet, it often ends up someplace where it can’t be consumed, like a five-course meal can. “With loan demand and consumer demand suppressed, all that money swirling around will go into investments,” said Pete Lannigan, senior managing director at Newfleet Asset Management.
These days, with the Fed buying corporate bonds along with government debt, “you get downward pressure on interest rates,” said Conning’s Sega. All the purchasing tends to push up bond prices, which move in the opposite direction from yields. Many goods, such as apparel, are cheaper due to the Amazon effect, as online ordering is less costly often than going to a store, which has to worry about paying rent and wages. A more long-lasting force is demographics. Baby Boomers, the nation’s largest generation, are retiring. As a result, they will be spending less money. In the 1970s, when they were coming into the workforce, the workingage population (15-64) was gaining 3% annually, observed Frank Rybinski, chief macro strategist at Aegon Asset Management. Hordes of them were out buying homes, cars, and all the other stuff that juices the economy. Now, the figure is 0.5%.
Another influence keeping prices down is globalization. Producing goods overseas, an emerging markets especially, is usual cheaper than in the US. Offshoring those jobs, however, may be on the wane, although the question is how much.
The pandemic has demonstrated the weakness of globe-spanning supply chains. Much of the world’s medical equipment and a lot of its medicines are made in China. Beijing has given its own population preferential treatment in distributing vital health care goods. Even before the outbreak, tensions amid the trade war underscored the weak position the US and the West are in vis-à-vis this rising nation with big ambitions and few scruples.
On the other hand, repatriating those complex supply chains would prove to be a daunting task. And let’s face facts, labor costs in China and emerging markets around the world remain a lot less than in America.
A nightmare for the Fed, especially amid the 2008-09 financial crisis, has been deflation, where prices overall go down. This development is toxic for promoting economic growth since people would postpone purchases until the prices got even cheaper, thus crushing corporate revenues. Such a travail beset Japan in the 1990s, not to mention the US in the 1930s.
The deflation scare birthed the Fed’s 2% inflation target, Aegon’s Rybinski said. “They made 2% the sweet spot because 1% is too close to zero, flirting with deflation,” he said. And 3% to 4% seemed on the road to double digits. “Inflation is about expectations, and now these are stable.”
Indeed, one element militates against inflation moving up in any meaningful way. Said economist Yardeni, “People have gotten real used to low prices.”