The Spectre of Rising Inflation

‘Sweet Spot’ Inflation

Inflation is defined as a broad-level increase in prices throughout an economy. A moderate rate of inflation is typically thought to be a sign of an economy that is showing healthy growth. The U.S. Federal Reserve, which as the central bank of the world’s largest economy sets monetary policy that can affect growth globally, considers 2 percent inflation as a “sweet spot”. Modest inflation is considered a positive because as an economy grows, demand for products and services increases and this pushes prices slightly higher.

Everyday workers benefit from this because modest growth would lead to a rise in labour demand, ultimately pushing wages upward. And rising wages means people have higher disposable incomes to purchase more produces and services, feeding into a “virtuous” cycle that promotes steady and sustainable economic growth.

On the other hand, inflation that is too high or too low can trigger a vicious cycle in the economy. Whereas falling prices signal lower demand that leads to slower economic growth, when inflation is unchecked and prices rise more rapidly than wages, consumers would see their disposable incomes fall, leading to lower demand for goods and services. Companies will also facing increased transportation costs (from the rise in the price of oil), and respond by reducing investment expenditures.

These factors can lead the economy to slow and unemployment to rise, and to a much feared combination of both rising inflation and unemployment often referred to as “stagflation”. In the U.S., the last time the inflation rate reached a high level was in the 1970s and 1980s when it hit double digits, leading to economic recession that caused great hardships.

Looking at events in recent years, Prof. Kitney notes that the spread of COVID-19 around the world in the first quarter of 2020 produced a massive freeze in global supply chains through the social distancing measures that were enacted which shut down factories and stopped the movement of goods. This happened concurrently with a substantial reduction in demand as people stopped or greatly curtailed purchases partly because nonessential shops were closed and people were discouraged or prevented from going out.

This reduction to production and substantially weakening in demand drove deflationary pressures which caused prices to fall, and would have led to the substantial increase in unemployment seen during that period.

By the middle of 2020, the world is starting to adjust to the disruption caused by the spread of the virus. This came in form of a limited policy stimulus response from the lowering of central bank policy interest rates, encouragement for banks to lend money to businesses, and the aggressive stepping up of quantitative easing (QE) programmes, a form of unconventional monetary policy where the central banks purchase government bonds or other financial assets in order to increase the money supply and provide banks with more liquidity. At this point, there would also have been some easing in supply chain disruptions as business slowly try to reopen despite the pandemic, but prices have yet to recover.

Unprecedented Stimulus

Fast forward again to 2021, and the world is witnessing the unveiling of economic stimulus packages on a scale that is unprecedented in history. “The U.S. Federal Reserve has gone on an unlimited bond purchasing programme purchasing municipal bonds, even corporate bonds, and we’ve had the European Central Bank doing the same,” says Prof. Kitney, adding that the significant stimulus effort was mirrored in China and all over the world.

The Biden Administration also announced in March a sweeping US$2.25 trillion infrastructure plan in an eight-year programme that will create millions of jobs and shift its economy away from fossil fuels. This is on top of a US$1.9 trillion coronavirus relief package which passed Congress the same month, and another US$2.2 trillion approved by the Trump administration in 2020. This massive stimulus spend is driving up demand but with supply unable to catch up, the concern is that this would drive prices up.

“Normally in an economic recovery or expansion, we have firms increasing their production to keep up with demand. However, this time around because of the uncertainty created by COVID, some industries are not able to adjust their production,” Prof. Kitney says, pointing to examples in the airlines and catering industries.

Because of ongoing travel restrictions, airline companies are unable to reestablish passenger routes that were stopped at the height of the pandemic. The same goes for the restaurant industry, which is unable to reopen to full capacity because of the social distancing measures that are still enforced to keep the virus at bay.

Meanwhile, fiscal stimulus being implemented to keep economies afloat is causing large increases in aggregate demand, but this is happening without the offsetting increases in supply. What this means is that this generates an excess demand of goods and services in the economy which could well create some inflation, Prof. Kitney adds.

“This paradigm of deflation that we’ve seen for the past 20 years may be over at least temporarily, due to some of the disruption in production with this massive recovery that we are seeing,” he says, noting that the trend was demand driven and is driving inflationary pressures.

Effect on Asset Classes

Given these inflationary trends, bond yields are expected to rise as investors demand higher returns to compensate. Because bond prices fall when yields go up, the moving into reflationary mode will cause underperformance in bond prices.

The picture is more ambiguous for equities. Whereas traditionally it has been thought that equity markets moved in the opposite direction to bond yields. That is, when bond yields go down, equities tended to outperform and vice-versa. In reality, low levels of inflation are positive for performance in equity markets.

“When earnings growth increases by more than the increase in the cost of capital, equity markets can do okay,” Prof. Kitney says, noting however that current valuations on the S&P 500 were stretched (overvalued) at around 30 times price-to-earnings multiples. The key risk for equity market is sharply rising bond yields.

Meanwhile, negative inflation-adjusted returns on U.S. Treasuries have lowered the expected return on U.S. dollar assets, driving it down against other major currencies. This has also driven the current strong performance of proxies to fiat currencies such as gold and bitcoin in the weak dollar environment.

Going forward, Prof. Kitney adds that where inflation goes will, to a large extent, depend on the actions of the U.S. Federal Reserve. “The Fed is the most important actor for anyone looking at the financial markets in the world,” he says. “A lot of what will happen going forward will depend on whether the Fed continues to run the economy ‘hot’.”

If the Fed continues with its current expansionary monetary policy, then inflationary trends are likely to persist. On the other hand, it may decide at its regular policy meetings to reign in inflationary pressures, and subsequently raise policy interest rates or to taper its QE programmes.

“We’re in the midst of a very fragile economic recovery,” he adds. “So at the end of the day, it’s going to be a very delicate tight rope for the Fed to walk. Right now is good time as any for them to make a careful choice.”