Is Mr. Market Thinking About Inflation?
Inflation breakevens, the difference between nominal and real yields (TIPS1), are a useful market-based indicator that represents current investor expectations for inflation. Breakevens fell off a cliff at the beginning of March, as the virus began to spread from China to Europe and the US. As investors grappled with the economic ramifications of the virus, breakevens moved as low as 14bps for 5Y in the initial panic phase of the selloff. They have since widened back out to about 86bps and 117bps respectively for 5 and 10 years, but still clearly reflect investor expectations that this crisis will lead to lower price levels.
5Yr–5Yr Fwd Inflation (4/8/19–4/7/20)
Groundhog Day: QE and Inflation
During the Global Financial Crisis (GFC), many bearish investors were clamoring that quantitative easing (QE)2 was going to lead to hyperinflation and cause the next Macrogeddon. Well, that didn’t happen. In fact, since Federal Reserve Chairman Ben Bernanke set the 2% target in January 2012, core personal consumption expenditures (core PCE)3 – a measure of the prices paid by consumers for goods and services minus food and energy – has only run at or above that target in 10 out of the ensuing 99 months. That drops to six months when you exclude the first four months after the target was set and inflation was already running above it. In short, inflation was never a problem, let alone hyperinflation.
So where did the bears go wrong? Vast portions of the market simply don’t understand the mechanisms by which banks and central banking work. The classic fractional reserve banking system taught in Econ 101 sounds great, but it’s not how the banking system works. Understanding why QE doesn’t inherently result in inflation really boils down to three key concepts.
First, capital reserves are endogenous – a closed system. They cannot be and are not lent out. They always stay within the fed funds system. Secondly, banks create credit – not the Fed. Lastly, credit is a function of risk appetite. What does this all mean for inflation? QE and increasing excess reserves aren’t inflationary unless there’s demand for credit, which is driven by risk appetite. Unless you and I have risk appetite to borrow and banks have risk appetite to lend, then reserves just sit there as excess reserves. Investors – bearish or bullish – shouldn’t expect that to change any time soon.
QE isn’t the only measure being implemented by the Fed in light of the COVID-19 pandemic. They’ve thrown everything – including the kitchen sink – at this crisis: repo facilities4 to money markets, commercial paper, primary dealer credit facilities, primary and secondary market corporate credit, and asset-backed loans. These facilities are all aimed at preventing credit markets from seizing and ensuring the flow of credit to corporates, households, and municipalities. These measures are intended to keep financial markets functioning efficiently. As opposed to inflationary, these actions could arguably be deflationary by helping keep companies in business, thus reducing the potential supply shock and ensuring price competition.
Stimulus vs. Relief
We’ve argued that the natural reflex to call the measures announced under the CARES Act “fiscal stimulus” is misguided. It’s not stimulus. This is relief. Essentially, it’s income and cash flow replacement. Bridge financing, not outright stimulus. The federal government is attempting to create a bridge over a crisis that has caused incomes for individuals and businesses to disappear as a result of behavioral changes and rolling lockdowns to flatten the infection curve.
To the extent that fiscal measures remain focused on relief, this is unlikely to be inflationary. Even with the potential for more outright stimulus, such as infrastructure spending, the short to medium-term impact is unlikely to be significantly inflationary. An infrastructure package is by no means a guarantee, as the concept remains fiercely divisive among legislators. Furthermore, any potential package would likely be some sort of public-private partnership arrangement, meaning less of it would be outright fiscal spending. That is, less inflationary. And finally, it would take years to actually deploy these funds, making such a package not only less effective in combating the current economic fallout but also pushing any potential inflationary effects well into the future.
The one caveat is timing. If additional fiscal relief measures come at a time when demand is recovering but the supply side is still constrained, then this could be inflationary. But the key ingredient, once again, is risk appetite. Without it, confidence and demand are still dented and inflation likely remains elusive.
At the end of the day, in our view, these monetary and fiscal measures are not intrinsically inflationary.
Supply vs. Demand
What about all the other factors at play in the US and global economy? That story is a bit messier – and there are plenty of other crosscurrents at play here. The COVID-19 pandemic is both a supply and demand shock. Sudden economic stops result in demand evaporating as consumers batten down the hatches and many more are laid off, as well as supply destruction. Not every job can be performed at home in either the manufacturing or services industries. The result will be lots of supply destruction with these rolling shutdowns. The question thus becomes, how do supply and demand move in relation to each other? Let’s go back to Econ 101 again and think about the aggregate demand – aggregated supply (AD–AS) model.
Science vs. Art
The AD–AS model explains price level and output through the relationship of aggregate demand (AD) and aggregate supply (AS). In a negative demand shock scenario, the AD line moves down and to the left. Assuming the supply curve remains constant, then output (i.e. real GDP5) will fall and costs and prices will fall. This is deflationary.
Pricing the Basket
Remember all those doomsday bears that called for inflation after the GFC. Now their views run the gamut from deflation to a debasing of the dollar as a result of the massive monetary and fiscal policy response. Here’s the important nuance to consider: Deflation is an outright fall in the level of prices, a potentially dangerous cycle that leads to further economic damage as consumers delay purchases in anticipation of prices falling further. Disinflation, however, is a decline in the rate of inflation. Prices still move up as they historically do, but do so at a lower rate. This would result in inflation falling further below the Fed’s 2% target, but not into negative territory.
Keep in mind inflation is all about aggregate price levels. Not individual items, but a basket of goods. Will there be areas of the economy where prices fall? Absolutely. Those sectors, such as travel, entertainment, restaurants are likely to face more demand destruction than supply destruction, but at the aggregate level we’re likely to simply see a slower pace of positive price growth as opposed to outright declines. And remember, headline inflation – a number that includes energy prices which have collapsed from both a positive supply shock and negative demand shock – is certainly deflationary. But the follow-on effects of lower prices in energy and other at-risk sectors help to put more money in consumers’ pockets and buffer demand in other goods. The result of these conflicting deflationary and inflationary pressures is likely to be disinflation in the short run as consumer confidence slowly rebuilds.
Wave of Disinflation
In summary, we see disinflation occurring in the short term. What does this look like on the other side? Oil prices rising on recovering global growth would pressure headline inflation higher. More importantly, inflation could certainly come back into focus to the extent that supply is so constrained, particularly as a result of layoffs and the lag time required to rehire and retrain. Demand could also be more resilient as a result of income replacement from unemployment insurance and other government relief measures. This could be exacerbated by the type and timing of additional relief measures, as mentioned above. But one also has to assume that demand recovers quickly coming out of the slowdown, which may not be the case.
At the end of the day, this all comes down to risk appetite. Until risk appetite recovers, disinflationary pressures likely prevail and inflation remains a pipe dream. With that said, we are in uncharted territory and the future is very much path dependent upon how the public health crisis evolves. As we’ve come to learn through this crisis, almost anything is possible, but inflation fears should be of little worry at the moment.
2 Quantitative easing refers to monetary policy in which a central bank purchases government securities or other securities from the market in order to lower interest rates and increase the money supply.
3 The "core" PCE price index is defined as personal consumption expenditures (PCE) prices excluding food and energy prices. The core PCE price index measures the prices paid by consumers for goods and services without the volatility caused by movements in food and energy prices to reveal underlying inflation trends.
4 The term “repo” refers to a repurchase agreement, a form of short-term borrowing for dealers in government securities. In the case of a repo, a dealer sells government securities to investors, usually on an overnight basis, and buys them back the following day at a slightly higher price.
5 Real gross domestic product is a macroeconomic measure of the value of economic output adjusted for price changes.
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