Positioning for Disinflation in the Fall and Winter
To understand the root cause of the recent acceleration in inflation and to formulate a view on where inflation and the financial markets may be headed next, I’d like to take an aerial view and provide an historical perspective that I think will be helpful for investors.
In turbulent times such as today, I strongly believe that a long-term orientation is the best place to find smooth air. I also believe that the bond market’s repricing has created reasonable long-term value and that the table is currently being set for the worst of the inflation ordeal to wane.
For context, I quote Thomas Paine, a Founding Father of the U.S., who in 1786 warned of the dangers of a paper currency system, the sort that may be at the root of today’s inflation problem:
“Paper notes given and taken between individuals as promise of payment are one thing, but paper issued by an assembly as money is another thing.”
Paine’s warning is aimed at the nation’s fiscal and monetary authorities, yet his message is often lost. That is what happened in 2020 when fiscal prudence was cast aside, leading to a fast-moving and volatile economic cycle.
Throughout U.S. history, deviations from the guiding principles of two acts of Congress — the Sinking Fund Act of 1795 and the Federal Reserve Act of 1913 — have often harmed economic growth outcomes. In contrast, adherence to their principles has tended to be beneficial, and that is what appears to be unfolding at present. Let me explain.
Keynesian economics clash with Hamilton’s principles
The Sinking Fund Act of 1795 continued a policy begun under Alexander Hamilton in 1790 as a means of establishing the nation’s credit standing. The act essentially established a commitment to the payment of the public debt, which for the most part held up until the advent of the Keynesian revolution a century ago. That’s when appropriations to the fund stopped and prudence toward fiscal matters was eschewed in favor of the frequent use of debt to solve economic problems.
The response to the 2020 pandemic is the latest example of Keynesian economics. That’s when, out of necessity, the nation’s fiscal and monetary authorities deviated from the bedrock principles established by the Sinking Fund Act and provided financial tinder that led to an explosive outburst in inflation.
Unlike the aftermath of the 2008 financial crisis, when inflation remained tame, this time fiat money moved from bank balance sheets onto those of households and businesses to a far greater extent, with the Federal Reserve accommodating the large fiscal transfers through its bond buying.
Today, fiscal and monetary policy are moving into reverse. As a result I believe that investors are likely to feel better about the macroeconomic and investment outlook by the fall and winter months. I therefore believe that now is the time to position for those conditions, albeit with a great deal of caution, prudence, and a dose of patience.
The Federal Reserve’s role
Hamilton’s piggy bank was emptied long ago and filled instead with IOUs, many written to the Federal Reserve, which was created by the Federal Reserve Act in 1913. Ever since then, and in particular since World War II, the Fed has facilitated spending by the nation’s fiscal authorities with the use of its printing press.
To be sure, absent the Fed’s printing press the world would almost certainly be in a far gloomier place, particularly because of the Fed’s essential role in preventing the ravages that accompany debt liquidations. In that process, identified by economist Irving Fisher in 1933, banks shrink their balance sheets, sapping households and businesses of credit, leading to distressed sales of assets and a decline in economic output that feeds upon itself. It is a problem that only the Fed can solve.
In 2020 and 2021, in its attempt to solve a different set of problems and assist the nation’s fiscal authorities in their response to the pandemic, the Fed may have overreached, though it could not have known it at the time. Now it is backpedaling, which seems likely to stymie the acceleration in inflation in the months ahead.
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The good news: Hamilton and Friedman are back in charge
On June 1, the Fed began shrinking the size of its $9 trillion balance sheet, an effort that will drain the U.S. economy of one fuel that has contributed to the deterioration in inflation dynamics over the past two years. Many other factors are responsible for the problem, but a major component of the acceleration is now working in reverse.
All told, the equivalent of about 450-500 basis points (or 4.5-5 percentage points) of change to the Fed’s policy rate is expected, which well exceeds the average of about three percentage points in cycles dating back to the late 1980s. Those 450-500 basis points are comprised of about 375+ basis points from the cumulative increase expected in the federal funds rate and the equivalent of an additional 75-100 basis points from the $3 trillion in balance-sheet reduction that is anticipated over three years’ time.
If you believe in economist Milton Friedman’s idea that inflation is everywhere and always a monetary phenomenon, then you should expect better news on inflation.
On the fiscal front, a substantial retrenchment is underway, which would make Hamilton proud. Data from the Congressional Budget Office (CBO) indicate that the nonpartisan agency expects U.S. fiscal outlays to decline by a whopping $1 trillion to $5.9 trillion in the current fiscal year. That will reduce the budget deficit to 4.2% of GDP from 12.4% in 2021, a massive negative fiscal impulse.
Signs of impact emerging
I believe there are plenty of reasons to believe inflation dynamics are now moving in the right direction. For starters, unfortunately, financial assets are in the midst of deflation. From wealth effects to capital costs to confidence channels, history suggests that the tightening of financial conditions will ultimately slow economic activity and douse inflation pressures.
Other signs of improvement in inflation dynamics include:
To my thinking, it is only a matter of time before those signs of change manifest a broader change in inflation dynamics.
Rise to smooth air by keeping a long-term orientation
Few phrases are better for investors to heed than “don’t fight the Fed.” Today the expression means believing in the Fed’s ability to control inflation and positioning accordingly, particularly if incoming data are supportive and valuations appear attractive. I believe they are.
Consider the yield on the Bloomberg U.S. Aggregate Index. It is now at about 4%, up from its low of 1.02% in August 2020 and 1.34% last August. With a duration (a gauge of sensitivity to interest-rate changes) of about 6.5 years, the yield would have to climb to over 5% for an investor to lose money over the next two years. Today’s yield level provides a positive real yield if you believe, as I do, that the Fed’s goal of ultimately achieving price stability is credible.
Moreover, if we focus on the idea that starting yield is the major determinant of future returns, today’s bond yields therefore look reasonably good relative to expected inflation. They also seem like an attractive entry point, especially for an asset class that in the long-run is likely to act as a diversifier, be a source of income, and help protect capital. Don’t let this year’s repricing dissuade you of that, despite how difficult it may seem.
Tony Crescenzi is a market strategist and portfolio manager at PIMCO and is also a member of the firm’s investment committee. Click here for more about Tony.
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