The Inflation Debate
With travel restricted and economies closing, inflation expectations dropped precipitously at the outset of the COVID-19 crisis. However, massive stimulus efforts and the reopening of economies in recent months has caused inflation expectations to rise. The chart below shows inflation expectations derived from the U.S. Treasury Inflation Protected Securities real yield information for the next 5 and 10 years, as well as the 5×5 forward rate.
Overall inflation has ticked higher due to the increase in the prices of energy, food, shelter, transportation, and medical. The 0.6% rise in March was the largest monthly rise since August 2012.
The factors behind rising inflation expectations are focused in part on historic stimulus measures in response to COVID-19. The level of monetary and fiscal stimulus worldwide during the pandemic has far exceeded that of the Global Financial Crisis, with much of it going directly to consumers and businesses.
Other key factors include potential supply chain changes, cyclical and structural factors in resource markets, and the Biden administration’s massive infrastructure plan. Higher inflation is likely over the next several months due to a weak base period in 2020 and rising oil prices. However, there is debate about whether the near-term increase in inflation is transitory or sustainable.
The table below summarizes some of the arguments on each side of the debate. In this report, we analyze some of the viewpoints on both sides.
Money Supply Factors
Monetarists believe that inflation stems from money conditions—specifically sharp increases in the money supply.
Although money supply has grown, those arguing that a rise in inflation will be temporary note the turnover of the money supply—the “velocity” of money— continues to trend lower. Velocity has declined steadily since the late-90s and is currently near at an all-time low, which helps keep inflation in check.
Household Income Factors
The unprecedented closing of the U.S. economy led to the government launching a number of stimulus measures, including mailing stimulus checks directly to consumers and enhancing unemployment benefits. The rise in personal income could stoke inflationary pressure if it causes a robust increase in consumer spending.
The counter-argument, however, is that consumers drastically increased savings rates during this time rather than spending their stimulus checks. Two quarters after the initial checks were issued, the savings rate remains elevated. At the very least, this is disinflationary and could become deflationary if consumers continue to hoard savings for precautionary reasons.
Slack Business Conditions
Fiscal and monetary stimulus will support businesses by increasing the incentives to keep workers on the payroll and take advantage of government-backed loans—this has the potential to stoke inflation. One clear representation of the historic level of stimulus is the Federal Reserve’s balance sheet, which grew to $7.4 trillion at the end of January 2021—well above levels during the Global Financial Crisis.
In addition to the lack of money velocity previously noted, slack business conditions is another key factor supporting the idea of inflation being transitory. Some key indicators of these conditions include: (i) a still relatively high unemployment rate, especially in pandemic-impacted sectors such as services; (ii) a stubbornly low employment-to-population ratio that never retraced its decline from the Global Financial Crisis and remains well below pre-pandemic levels; and (iii) a persistently low capacity utilization rate in the manufacturing sector. Combined with low money velocity, these factors should mitigate the risk that a spike in inflation will persist into long-term inflationary pressure.
Secular Trends & COVID-19 Impacts
The acceleration of the clean energy sector is one factor supporting a sustainable rise in inflation as some believe it could drive a new super-cycle in commodities, particularly in the metals and minerals category. However, this demand could be materially impacted by technological advances that reduce the commodity intensity of wind, solar, batteries, and electric grids.
Further, under-investment in oil and gas as a result of climate concerns and poor returns could create a prolonged period of high oil and gas prices before the transition to clean energy is complete. A potential re-plumbing of global supply chains (i.e. onshoring) as a result of COVID may also take years to accomplish. Along with more stringent safety and regulatory measures, this could put upward pressure on prices for goods and services.
Inflation will increase from pre-pandemic levels and there are reasonable arguments as to whether the high inflation environment will be extended or temporary. During the Global Financial Crisis, money supply and the Fed balance sheet were elevated, personal income was growing, unemployment steadily declined, and there were significant stimulus measures. However, forward inflation expectations remained below 3% but above the Fed’s 2% target, reaching a high of 2.9% in early 2013. In other words, inflation expectations seemed to be well anchored despite some fearmongering from inflation hawks.
Similar factors remain in place now and higher inflation is not a foregone conclusion. The Fed recently updated its Statement on Longer-Run Goals and Monetary Policy Strategy, which codifies its approach to monetary policy and serves as the foundation for its policy actions. In it, the Fed maintained a 2% long-term inflation target but did state that “following periods when inflation has been running persistently below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time.” This indicates the Fed will let the economy “run hot,” which could produce unanticipated inflationary pressure. There is a risk that once unanticipated inflation is experienced, it becomes anticipated—in other words, inflation expectations get set at higher levels than they are currently.
Inflation can come from a variety of sources and there is no perfect inflation hedge. However, real asset categories have the potential to protect from inflation while providing diversification and return enhancement. Compared to other asset classes, real assets have exhibited generally higher correlations to CPI. This was the case in the 1970s and early 1980s when commodities and resource equities sharply outperformed other asset classes.
While real estate, infrastructure, and TIPS markets have matured since the 1980s, this outperformance occurred during a period that predominantly saw low or declining inflation. Therefore, the relevant data is thin and not necessarily indicative of correlations during periods of moderate or high inflation. For example, gold has historically performed strongly during periods of high inflation, but has shown a low correlation to CPI over the last 19 years.
If inflation unexpectedly increases, potential inflation protection may come from the following sectors:
- Natural resources and commodities, including precious metals, energy, industrial metals, and agriculture, which may provide direct exposure to increasing input costs.
- TIPS, particularly short-duration TIPS, which have principal adjustments directly tied to CPI, and may provide direct protection.
- Real estate and infrastructure may capture higher rents and CPI increases (mandated or otherwise). These categories could also potentially benefit from higher replacement costs and barriers to entry or, in the case of infrastructure, a quasi-monopolistic position in a given market.
While it is impossible to predict the degree and path of future inflation, the best defense against this and other market risks is portfolio diversification and a dedicated rebalancing strategy . Please reach out to your client service team with any questions.