Investor fears about looming inflation are overblown
There is little evidence that recent monetary and fiscal interventions will stoke price rises
Inflation rates have dropped in most countries in the wake of the Covid-19 shock, but many investors still worry that the crisis will ultimately lead to soaring prices and a regime shift away from the “Great Moderation” that has delivered relative stability for decades.
Some point to medieval pandemics and subsequent periods of rising prices and wages, due to shortages of labor and goods, as evidence of looming inflation. Others suggest that the massive monetary and fiscal stimulus rolled out in response to the pandemic constitutes a first step towards a new inflation regime. And some consider the sharp rise in the value of gold to be a harbinger of such a shift.
"I doubt any of these signals will provide investors with a clear-cut answer. It seems more promising to focus on the penultimate factor: a politically driven loss of central bank independence."
Even though inflation is far below central bank targets almost everywhere, its potential resurgence tops investors’ worry lists — and understandably so. Major shifts in these dynamics have a significant influence on investment returns. Past bouts of soaring prices have obviously undermined bond returns and at times hurt equities, too.
But a shift to notably higher inflation is, at most, a tail risk, because the threat of socalled fiscal dominance — a prerequisite for such a development — is considerably lower than often presumed. Meanwhile, market signals, macro indicators or standard models of inflation are unreliable or even outright misleading.
A case in point is gold’s recent rally. While the precious metal rose sharply during the inflationary 1970's, its climb from 2001 to 2012 occurred during a prolonged period of extraordinarily subdued inflation. And the forecasting quality of market-based inflation expectations is not much better, because they are too strongly influenced by short-term price developments such as oil price movements.
The same goes for monetary aggregates (the monetary base): since the money multiplier is highly unstable, the growth of central bank balance sheets is an inappropriate inflation predictor, as Milton Friedman taught us.
Similarly, the link between nominal gross domestic product or inflation and the growth of credit aggregates (bank lending), is weak and unstable. The recent surge in this indicator is particularly misleading. It was essentially triggered by the extensive provision of government guarantees for corporate loans.
In combination with sharply higher household savings, this caused the massive rise in monetary aggregates. Neither implies that the nominal growth of aggregate demand will be sustainably higher in coming years and trigger a sustained increase in inflation.
Finally, most investment professionals know that the “workhorse model” of economists, the Phillips curve — which intends to show the relationship between employment and inflation — has failed quite spectacularly to predict the evolution of inflation in past years. Thus, finance or economics-based approaches do not seem to provide a clear answer to our question.
"A better approach may be to focus on political economy."
Persistently high inflation has required outright fiscal dominance over monetary policy, with central banks effectively forced to finance vast government spending. The key question to ask is whether the Covid-19 pandemic puts us on the brink of such a regime change.
To draw this conclusion is premature. Fiscal and monetary authorities enjoy strong political support to shore up the economy and provide assistance to those most affected by the crisis, but this should not be interpreted as a consensus favoring a subjugation of monetary policy to narrow political ends.
In the eurozone, it is hard to envisage such a regime change given the European Central Bank’s constitution and northern states’ anti-inflationary stance. Some might cite Japan as the prime example of fiscal dominance, but fiscal and monetary authorities there have jointly sought to stimulate growth and — so far unsuccessfully — inflation.
A more interesting case is China, where the government has the authority to order its central bank to provide whatever funds are deemed necessary to finance Communist party projects. Yet caution in China prevails even in the midst of a severe global recession. It appears Beijing recognizes the risks that rising inflation could pose, as such instances in the past have proved destabilizing socially and politically.
That leaves the United States. Should we expect a shift towards fiscal dominance there? Despite its staggering government deficit and the huge volume of assets the Federal Reserve is buying, it is far too early to tell. Of course, a re-elected Donald Trump might seek to undermine the Fed’s independence, or a left-leaning Congress elected on the coat-tails of Joe Biden could pressure the central bank into funding outsized social programs.
Yet both scenarios would meet considerable resistance, with the political center seeking to ensure that the Fed adheres to its low-inflation mandate and stays independent. The consensus might yet swing back to funding fiscal programs with tax revenues rather than debt bought by the Fed.
Former Fixed Income Portfolio Manager
4yHaven’t we already witnessed massive inflation in stock, bond and alternative asset prices since March ?