Investor fears about looming inflation are overblown

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.

Daniel Sheard

Former Fixed Income Portfolio Manager

4y

Haven’t we already witnessed massive inflation in stock, bond and alternative asset prices since March ? 

To view or add a comment, sign in

More articles by Michael Strobaek

  • Inflation: The moment of truth

    Inflation: The moment of truth

    The surge in inflation is one of the more problematic economic consequences of the pandemic, and stands in sharp…

    4 Comments
  • Living forward in a post-pandemic world

    Living forward in a post-pandemic world

    With the COVID-19 pandemic, the year 2020 provided one of the biggest challenges in a lifetime, but it also turned out…

    5 Comments
  • Learning to live with the virus

    Learning to live with the virus

    The COVID-19 pandemic is a defining moment for the world – for our way of living, our values and principles, and for…

    2 Comments
  • Financial markets stay fragile

    Financial markets stay fragile

    We believe it is still too early to reenter risk assets in any significant manner because the sell-off is likely not…

    2 Comments
  • Fear should not drive investment strategy

    Fear should not drive investment strategy

    The coronavirus outbreak and related shocks to the economy have unsettled financial markets in recent weeks, a…

    4 Comments
  • Making sense of market sell-off amid virus concerns

    Making sense of market sell-off amid virus concerns

    Financial markets have been roiled this week as the coronavirus outbreak took on a global scale. Major markets such as…

  • United Kingdom: A big Conservative majority

    United Kingdom: A big Conservative majority

    The Conservative Party has won the 12 December UK general election emphatically, with a projected majority of 78 seats.…

  • Further upside in equities

    Further upside in equities

    Recent weeks have provided yet another reminder of how rapidly things can turn – while August brought about a sudden…

    2 Comments
  • Too good to be bad: the misplaced focus on recession risks

    Too good to be bad: the misplaced focus on recession risks

    Risk/reward balance in equities remains tilted towards the latter Many investors are so focused on monitoring potential…

  • Slower Fed tightening poised to revive risk assets

    Slower Fed tightening poised to revive risk assets

    Last year was challenging for most investors. It started with known unknowns, in particular uncertainty over the exact…

    1 Comment

Insights from the community

Others also viewed

Explore topics