After the relaxation of the inflation target by the Fed, investment experts are rushing to predict a sustained rise in inflation. But for now, there’s no sign of inflation at all. Last week it even turned out that, for the first time since 2016, price levels in the eurozone had actually fallen.
‘The major government stimulus packages, the absence of austerity and the trend towards deglobalisation that may be exacerbated by the coronavirus crisis make it more likely that inflation will rise than during the previous economic cycle›, says chief economist Erik Weisman of the US asset manager MFS. ‘That’s why I expect inflation to be higher at some point than the market is currently pricing in.’
Negative output gap
For the time being, however, inflation remains low, Weisman notes. ‘In order to get inflation at all, the economy must first sustain its recovery. The negative output gap resulting from the recession must disappear before inflation can rise.’
And that negative output gap, certainly in the US but also in Europe, is rapidly narrowing, he says. ‘Many companies depleted their supplies from February to April, and now in many cases consumer demand exceeds production. That should be a signal for producers to step up their production again.’
As a result, the need for capital is increasing and the liquidity provided by the central banks in recent months can be put to work. But after the previous crisis, the central banks also pumped unprecedented amounts of money into the economy. At the time, however, this did not lead to inflation. Why could it be different this time?
‘During the previous crisis, we saw the financial sector deleveraging. This is not the case now, and that’s why I think the transmission mechanism will work this time,› says Weisman. This, combined with the fact that governments continue to pursue expansionary fiscal policies, with no major cuts of the kind we saw after the previous crisis, should increase the amount of money in the system, he argues. ‘This could raise inflation above 2% for a number of years in a row,’ Weisman adds.
US is not Japan
However, in a country like Japan the government has been able to issue almost unlimited debt at very low interest rates for over a decade, propped up by extreme quantitative easing and bond buying by the central bank, but this did not lead to high inflation.
‹Japan is facing extreme ageing, a shrinking population and is doing much more than the US, for example, in automating work processes. This has a dampening effect on wages because robots can perform tasks that were previously done by employees. The US also produces robots, but they are used much less in production,› says Weisman, arguing the different structure of the Japanese economy leads to much lower inflation pressure than in other countries.
According to Weisman, Europe is a half-way house between Japan and the US. ‘Europe is much more dynamic economically than Japan, the demography is not so extreme and the labour market is more flexible so there’s a higher inflation potential there than in Japan,’ he says.
But it is indeed the US that seems to be most likely to face high inflation. GDP growth is generally higher there, and consumers are in any case more inclined to spend any extra money directly, which means that inflation rises faster when growth picks up.
Then there is the recent fall in the value of the dollar, which could push inflation even higher. ‹If the dollar falls by a further 10% in value, that will have quite an impact,› says Weisman.
Yield curve control
The extent to which inflation can actually rise at the end of the day also depends to a large extent on the next steps that the Fed is going to take when inflation expectations actually start to rise. After all, investors are unlikely to be satisfied with the current low level of interest rates on US bonds once inflation starts picking up. However, the (long-term) interest rate cannot rise too much to continue allow the US federal government to finance its enormous debt burden.
The question is whether the Fed will actively use yield curve control, like Bank of Japan, and on which part of the curve it will focus this policy. Weisman points out that this would not be a unique course of action. ‘In World War II, the Fed controlled the entire yield curve, creating incentives for investors to continue buying bonds by guaranteeing a certain steepness of the yield curve. This is how investors can benefit from carry.’
Weisman expects the Fed to opt for this solution once again. The curve is now extremely flat, with a 10-year Treasury yield of 0.65%. ‘The Fed could lock in the short end of the curve, which they are in fact already doing by promising to keep interest rates low for a long time and gradually increase long-term interest rates,’ he says. ‘Once the curve is steep enough, it may become interesting for institutional investors to enter again. Thanks to the carry, they can then achieve a positive total return despite a negative real return.›
But the question is, of course, what will happen in the intervening period. ‘There will indeed be a time when Treasury investors will have to reduce their risk exposure,’ Weisman says, pointing out that inflation-linked bonds (Tips) do offer protection against inflation but also generally have a (very) long duration. ‘If you buy Tips, you increase your duration at the same time. That is why investors need to combine this with reducing the interest rate sensitivity in the rest of their portfolio.’