PM Perspectives: A new era of inflation?

This article originally appeared on the Insider Engage website on February 4, 2021.

The dollar has started to fall while the price of gold rises in recent months. We have also seen market based inflation expectations recover beyond levels set at the equity peak prior to the COVID-19 crisis.  These moves have sparked a great deal of debate around the potential for a new inflation regime in America. Peter Cramer, Senior Managing Director, Insurance Asset Management at SLC Management and Chris Zeppieri, Managing Director, Portfolio Management, Insurance at SLC Management, recently discussed the prospects of inflation and potential effects on markets.

Peter: I think it would help to first establish that the lack of inflation, or disinflation, has been a greater problem than inflation. Over the last decade, core inflation has only averaged about 1.6%¹, well short of the Fed’s 2%² target. This undershoot has been persistent despite massive amounts of monetary stimulus. Going forward, it appears that attainment of that 2% level may be even more difficult.

There are a few reasons why meeting a 2% inflation target may be difficult to reach:

1. Wage inflation tends to be a driver of self-sustained inflation but right now there is a lot of slack in the labour market. There is no need for employers to pay higher wages to attract workers. Recent history has shown that, even with very low levels of unemployment, wage inflation has been static. We see this continuing and perhaps even worsening as labour will be increasingly competing with technology.
2. Technology also helps us produce more for less, ultimately reducing consumer costs. Look what fracking has done for U.S. energy production. Shale technology has changed the energy landscape. Lately, there has been greater downside price risk to oil than anything that resembles inflation.
3. As many academic economists will tell you, population growth, particularly labour force growth, is perhaps the biggest driver of economic growth and the U.S. labour force growth is decelerating. This is unequivocally disinflationary.
4. With real and financial assets at very high valuations and with slow growth going forward, we see much more modest returns on investments. This will force higher savings to attain the same goals. As savings grow, spending declines and that too is disinflationary.

I’m not the only one that see these headwinds to inflation, this is the consensus expectation. Markets are reflecting the same outlook. As of now, market based indicators expect only 1.88%³ annualized inflation for the next 10 years. Although this is higher than it was 6 months ago, it’s still below the Fed’s target. Inflation is driven, in part, by expectations and expectations are not threatening right now.

Chris, I don’t think you necessarily agree that this is more likely a disinflationary environment?

Chris: I do agree, yes. It may sound confusing, but my inflationary concerns stem from a view of an economy facing increasingly disinflationary headwinds while the conventional monetary tool box has run empty.

Over the last four decades, we have experienced an incredible disinflationary boom characterized by progressively lower base interest rates which have allowed for asset value appreciation and debt expansion to significantly outpace economic growth. Although rates could go through the zero lower bound, there are reasons to believe that it would result in materially less net benefit to the economy. So, the way I see it, not only are the deflationary head winds rising, the growth and inflationary tailwinds are fading. The future appears deflationary, but that future simply can’t be allowed by policy makers. We have to imagine a deflationary environment as the extremely destructive force that it is. In a leveraged economy –and we have a highly leveraged economy – deflation has strong potential to spiral into a financial and economic collapse. Policy makers will do whatever it takes to avoid that scenario and will risk higher inflation as it is certainly the lesser of evils when deviating from price stability.

With conventional monetary policy exhausted and with unconventional monetary policies leading to value dislocations and wealth disparity, it appears fiscal stimulus will be taking a much greater role in staving off deflation. However, the indebtedness of the federal government and financial markets’ ability to absorb debt painlessly are in question. Therefore, we see a strong likelihood that this coming fiscal stimulus will be financed with freshly printed U.S. dollars. It is also very conceivable that this stimulus money will be dispersed more evenly into the population. This means more money in the hands of those with the highest propensity to spend.

The handoff from monetary to fiscal has another very important distinction. The Fed, the monetary policy makers, are an appointed group with a mandate to remain apolitical and independent. Legislators, the fiscal policy makers, are elected and extremely political. If a little fiscal expansion financed by printed fiat is good and consequence free, it seems likely that politicians will run on platforms for more of it. The inflationary consequence of free money, which is well documented in both economic theory and history, may be the only thing that slows the U.S. dollar printing press.

In this current crisis, we have seen massive deficit expansion, financed with an expansion of the Federal Reserve Bank’s balance sheet. The age of Modern Monetary Theory, MMT, appears to be here already. This does not guarantee inflation, but, in my mind, it adds some significant skew in the distribution of potential future outcomes toward high inflation.

Peter, how do you feel about this transition to fiscal expansion?

Peter: I think it would be a mistake to believe that there could never be another period of hyperinflation in the United States. If you open your mind to that, you can also imagine some of the catalysts that could bring rise to hyperinflation. Certainly, the growing perception of unconstrained fiat printing and a corresponding loss of confidence in that fiat would get us there. Legislation to spread wealth more evenly among working Americans, could bump inflation but not necessarily start a self-sustaining hyperinflationary economy. That said, neither one of us has a base case that we are on the precipice of either of these scenarios.  

I am confident that the next couple of decades won’t look like the last four. I see fatter tails in the coming years, meaning a higher potential for both deflationary and inflationary environments and we might experience wider and more frequent oscillation between the two. This will provide opportunities to actively position the portfolios and build performance. This will likely require some contrarian positioning when we see catalysts building. Like in all investing, timing is critical and right now we see symmetry in the potential for the next big swing.

Footnotes