Inertia Creeps
The US publishes its last inflation data for the year on Thursday. The anticipation is that numbers will continue to be in line with the controlled outcomes to which the country has become accustomed. As this will be a column on the risks of a resurgence, it is important to start by making clear how utterly anchored inflation has been in this century.
For 10 years, core inflation and inflation expectations have been anchored
Neither has ever exceeded the Federal Reserve’s upper range target of 3%. Actual inflation dipped below the lower limit of 1% for a few months in 2010, in the aftermath of the Great Recession, while expectations briefly dropped below that level during the worst months of the global financial crisis and the Covid shock. Both times those deflationary shocks were over within weeks.
So, with the economy still struggling to find its legs, and the last wave of Covid likely to dampen economic activity for months to come, why would anyone worry about inflation? Here is the case.
First, there is the housing market. It has roared back. Homebuilding companies are saying these are the best conditions in more than three decades (including, therefore, the bubble that blew up into the GFC). Their share prices are now above their pre-GFC peak, although this surge is plainly not as overdone as in 2005:
Homebuilder stocks are on their best run since the pre-GFC bubble
More ominously, people are starting to use their houses as ATMs again. This is what is happening to US home equity withdrawal (in a chart from Chris Watling of London’s Longview Economics):
And there is every reason to think that the homebuilding boom can continue. As this chart from Watling shows, house prices tend to appreciate as mortgage rates fall — and mortgages are now very, very cheap:
That implies there will soon be more money to be withdrawn from Americans’ brick-and-mortar ATMs. But it looks as though Americans don’t particularly need to go to the ATM, because the money they already have on deposit has shot up since the first lockdown. This chart is from Strategas Research Partners:
At this point many jaded readers will want to point out that there was a housing boom more than a decade ago, and it led to a deflationary crash, not inflation. There is a critical point of difference. When the property bubble burst, American households were painfully overloaded with debt. That has steadily been rectified over a decade of deleveraging which, not coincidentally, was accompanied by disappointing growth. Now, household debt service ratios are at historic lows, as this chart from Watling shows:
Consumers are primed to spend money in a way they haven’t been for a generation. And the money is right at their finger tips. Monetarists would say that was the condition for inflation. After the privations of 2020, it is a safe bet that there is a lot of pent-up demand as well, so Keynesians should also brace for inflation.
If this seems unduly negative, to be clear, these numbers also suggest that the U.S. is ready for quite an economic boom. That should be something to enjoy, and might even go some way to leveling out the grotesque inequality that has built up over the decades of stable inflation. But some of the factors that have thwarted inflation in recent years are now absent.
Moving to the corporate sector, corporate treasurers also have plenty of cash on hand. Masses of it. As in twice as much as they have held on average over the last six decades, as shown in this Strategas chart, which uses Federal Reserve data:
Beyond the core measure, attention tends to be grabbed by headline inflation, which includes fuel and food and which, after all, represents the stuff that people actually have to spend money on. Next year could see a big change. For the post-GFC decade, oil prices have generally trended down. At any one point, gasoline prices have tended to be lower than they were a year earlier, neatly helping to reduce headline inflation.
While the oil market is still in a lot of trouble, and gasoline futures are still cheaper than they were 12 months ago, the chances are strong that that will change in the next few months. The base effects from this spring’s crash in oil prices should ensure that headline inflation starts to rise:
Base effects mean gas prices could push inflation up next year
Then there is the matter of the dollar. It is weakening. The currency ended its last depreciation cycle during the GFC and has trended upward for much of the time since. This reduces inflation by making imports cheaper. A weakening dollar turns this around and becomes a pressure for inflation to rise.
So far, the world has avoided “cost-push” inflation arising from the bottlenecks and supply shocks created by the first phase of the pandemic. But there are still a few months to go, at best, and prices of a number of commodities are rising. For the longer term, if globalization doesn’t pick up again, that tends to mean companies must source their goods with more expensive suppliers, pushing up prices.
On top of all this, the Fed is now in the business of telling everyone that it wants inflation to get above 2% and stay there. The central bank is targeting average inflation, which means that it will happily tolerate gains above target for a while. When Fed Chair Jerome Powell unveiled that new policy at the Jackson Hole virtual symposium this summer, I had fun likening him to the drivers of Reliant Robin three-wheeler cars whose fondest wish was that their car could go fast enough to get them a speeding ticket. There is much slack in the labor market, minimal belief in inflation, and still little in the way of coordinated fiscal expansion, thanks to US congressional gridlock. There is no reason to fear hyperinflation, or even anything on the scale of what was witnessed in the 1970s.
But it’s popular to expect a return to normality, and that would include a world in which economic expansions are accompanied by rising prices. Larry Hatheway and Alexander Friedman of Jackson Hole Economics, put the risks as follows. It is worth quoting them at length:
History suggests that inflation is typically slow to emerge. But when it does, it manifests inertia, as rising prices reinforce expectations of more to come. That’s why the Fed’s overshooting objective is risky. Once inflation exceeds thresholds, bringing it down could be difficult.
Which brings us… to the implications for asset prices. Rising inflation always undermines bond returns, with their fixed nominal coupons. But bond markets are much more vulnerable today, given significant over-valuation caused by central bank asset purchases and in the context of massive future supply due to unprecedented fiscal deficits. Bond markets will be in for a rude awakening if inflation accelerates.
Some argue that equities can withstand inflation because earnings and dividends rise with inflation. That’s simplistic and dangerous thinking.
As interest rates rise, so does the rate at which future earnings are discounted. Even more important, rising inflation increases economic risk. Central banks will eventually have to dampen spending to curb inflation. Accordingly, when inflation picks up investors require a higher risk premium to hold equities. Inflation de-rates valuations, which in some cases are already very high.
In sum, investors should care about rising inflation, which is now more probable than at any time in the past two decades. When it comes, it will be fast. Given that the consequences are huge for all investors, it is time to take notice.
(Bloomberg)
