Despite the recent spike in inflation being largely regarded by the US Federal Reserve (the Fed) and markets as transitory, there are strong grounds for a less sanguine view.
Once inflation gathers pace, it can create a momentum of its own. History shows that once the inflation genie gets out of the bottle, it is difficult to contain, and putting it back in the bottle in a timely fashion almost impossible. This was shown starkly with the oil price shocks of the 1970s when government policy was to simply accommodate the increase in oil prices.
If supply shocks manifest themselves in higher inflation expectations, that can have an impact on purchasing behaviour, putting increased pressure on limited supply.
While the current circumstance is not completely the same as what took place back then, it is arguable that there may be a couple of inconvenient parallels.
1. Fiscal stimulus
First, the fiscal stimulus appears to have been a multiple of any measure of the “output gap” that is why Obama-era Treasury secretary (and sometime chief apostle of fiscal stimulus), Larry Summers, has called the current stimulus “excessive”. Indeed, Mr Summers stated recently that he sees inflation at 5 per cent at the end of this year and that he “doesn't see the basis for policy makers’ serenity”.
2. Savings are up
Second, there are latent demand pressures arising from the US$2 trillion-plus in savings that Americans have accumulated during the pandemic.
3. Equity and housing prices have soared
Third, that equity and housing prices are soaring is not news – but what is often missed from the conversation is that it is these are the economic conditions that create demand tailwinds.
4. Globalisation and Baby Boomers are moving markets
Fourth, there are structural currents driving inflation arising from the reversal of the two great structural trends that account for the deflationary tendency of the past three decades:
Both of these are on the cusp of reversal. Again, taking a lesson from history, it was the fall of the Berlin Wall in 1989, combined with a number of other dramatic impacts that led to a global supply shock. This included a dramatic increase in prominence of key emerging markets, particularly China, a strong cohort of Baby Boomer participation in the workforce, as well as a sharp increase in female participation (Baby Boomer or otherwise).
The end result was a decline in real wage growth and a structural deflationary trend that had a global impact. As Baby Boomers leave the workforce the flow-on economic effects will be all too real. Add to that a backlash against globalisation of markets, re-regulation and supply chain constraints, and it may well be that structural forces are no longer as powerful in keeping inflation dormant.
Of course, there are still structural inflation suppressors such as technology and demographics but certainly the structural risks now begin to look a little more “two-way”, and certainly not necessarily operating to keep inflation dormant.
5. Persistent supply shock
Fifth, and of particular note is that supply shocks are ongoing: PMIs continue to indicate demand growth outstripping supply growth; rising materials costs and diminished inventories; and the impact of inflation expectations on purchasing behaviour.
6. Presidential push
Sixth, the Biden agenda, including higher minimum wages, strengthened unions, increased employee benefits and strengthened regulation – while replete with laudable intent – all push up business costs and price.
For the time being, perhaps reflecting its own “inflacency”, markets (including the bond market) have given the Fed the benefit of the doubt and have bought the transitory inflation narrative.
However, if by embracing an “outcomes-based” framework for monetary policy the Fed is late in acting on price pressures, there may be a substantial dislocation for markets down the track. An outcomes-based approach may lead the Fed to act only when only inflation persistently surprises on the upside. By then however, the inflation genie may well be out of the bottle.
The result may be the Fed jamming on the monetary brakes too late in the piece, leading to sharp upward movements in bond yields and a resulting significant correction in equity and bond markets.
This scenario is increasingly looming as a major challenge for investors. The challenge for multi-asset investors will be how they react to a potential reversal of long-held assumptions on risk and return asset class correlation.
Stephen Miller, investment strategist, GSFM