I’ve heard many people say they write so they can sort out their thoughts, learn something and ultimately arrive at what they think about a specific topic. That’s what I’m attempting to do today.
One of the great debates currently in the world of economics and investing is whether we’re headed for a sufficiently higher inflationary environment that will be disruptive to existing asset price trends or whether we will remain in a disinflationary environment that won’t have any meaningful or lasting impact on the trend that has been in place for over a decade now. Valid and convincing arguments for both sides exist and make it difficult to draw a decisive conclusion one way or another.
The Economists Who Cried Wolf?
After the Great Financial Crisis of 2008-2009 (“GFC”), there were a lot of well-known and respected professionals and academics calling for substantially higher inflation on the heels of an at the time massive fiscal stimulus package and ongoing monetary stimulus via the Fed’s various activities collectively described as quantitative easing. The spike in headline inflation never materialized but the eventual increase in asset price inflation could be categorized as stratospheric.
Fast forward to today, and many of the same people are calling for higher inflation after massive amounts of fiscal and monetary stimulus. Their arguments seem to be sound but it’s difficult to say if this time will be different than last time. I summarize what I consider to be the most coherent argument for higher inflation next.
Since the early 1980s, the US has been using monetary policy to manage the business cycle via targeting rates, asset purchases and other policy tools. Paul Volcker began the renaissance when he slayed the inflation dragon of the 1970s and early 1980s with substantial interest rate increases. Since then, rates have been steadily coming down and monetary policy has pretty much been the exclusive tool used to address business cycle issues and crises. It worked splendidly for a number of years but hasn’t been as effective since the GFC. Jerome Powell, the Fed Chairman, has made several calls in recent years for fiscal stimulus as it appears he recognized the waning effectiveness of the exclusive use of monetary policy to address our nation’s economic and business cycle issues.
A transition to more fiscal policy has been under way, at least in thought and conversation, for a few years now. COVID accelerated this transition which has led to very large fiscal stimulus packages making their way through Congress. Lyn Alden summed it up best by stating we’re in a transition period from monetary policy dominance to one of fiscal policy dominance. The purported end result of more dominant fiscal policy will be higher consumer prices as more money makes its way into the real economy. Under monetary policy dominance, money made its way into the financial system which resulted in asset price inflation.
Other arguments for higher inflation include de-globalization/protectionism and the Fed’s explicit goal of higher inflation.
The arguments against a higher inflationary environment are plentiful and make a lot of sense because they’ve been true for the past decade or more, making them convenient to recall and lean on when in doubt. Here are the most prevalent
- There’s far too much slack in the economy and job market for inflation to meaningfully increase.
- Current demographic trends are deflationary in nature.
- Technological advancement is deflationary in nature.
- Price trends, on average, are down due to globalization and the ease of manufacturing in the lowest input cost markets.
- We may have higher inflation but it will be transitory (temporary) because we continue to be in a secular deflationary environment.
- Recipients of fiscal stimulus use the money received to pay down debt and to save. In other words, the money from fiscal stimulus packages supposedly isn’t finding its way into the economy.
I find merit in the arguments for both sides and wonder if the ultimate outcome will be somewhere in between. Maybe we do get higher inflation but it’s not quite as high as what the inflationistas are currently expecting. We likely will only know who wins this debate in hindsight.
Out of curiosity, I put the following charts together to get a sense of where inflation is right now and what the overall trend looks like. Remember that government statistics are reported after the fact so the CPI and PCE are backward looking. The 5- and 10-year breakeven spreads reflect future inflation expectations.
The US Consumer Price Index for all items has bounced off the COVID-induced lows but has stalled and is still below the rolling five-year average. If it continues to accelerate to and through the five-year trend line then maybe we will get higher inflation, but will it be sustainable?
We see a similar pattern with the US Personal Consumption Expenditure index.
Inflation expectations have noticeably risen in recent months but are still only in the low to mid 2% range, the Fed’s former target, for both five and ten year time horizons.
Inflation is most certainly going to be higher on a year-over-year basis in the coming months as we hit the anniversary of the initial months of COVID. Will inflation continue to gain momentum from there or will it stall out and be just as transitory as other bouts of inflation we’ve observed since the GFC? There are strong arguments on both sides. I still don’t have high conviction in either direction.
Source for all charts: FRED