Eight Reasons to Worry About Inflation

by | December 7, 2020

At first it was dismissed as fringe thinking. Then new voices, including the former president of the New York Federal Reserve sounded the alarm. And markets are beginning to take note.

Could inflation be the next big thing?

The answer is probably not yet. But it is worth taking a closer look. Inflation surprises are not far-fetched. And if inflation does shock to the upside, markets would be roiled.

To begin, it is useful to review what causes inflation. Broadly, two theories guide economists’ thinking about inflation. Monetarists believe inflation results from too much money chasing too few goods. Keynesians believe inflation is caused by excess demand relative to supply.

Those ways of thinking about inflation are not mutually exclusive. Too much money can spur demand above the economy’s ability to supply agents’ needs and wants.

Of course, the collapse of a country’s currency can also precipitate inflation, particularly in economies that have a high share of imports relative to domestic production. But currency crises are frequently just a special case of too much money printing.

For many, inflation still seems improbable. After all hasn’t inflation been wrongly forecasted for several decades?

Part of the problem is misdiagnosis. For instance, those who fretted excessively and incorrectly about surging inflation in the wake of the financial crisis missed an essential point. It is not the stock of money that matters, but rather its supply relative to both money demand and the amount of slack in the economy.

Simply put, inflation didn’t accelerate a decade ago despite massive money creation because the demand for liquidity soared as the financial system teetered on the brink of collapse, and because the ensuing great recession created considerable slack in labor and product markets that took years to absorb.

Also, while excess money growth and too much demand may be precursors to higher inflation, they, alone, are not sufficient. Consider the case of Japan, which in the decades preceding the pandemic witnessed both large-scale money printing and massive labor shortages – at the peak nearly 60% more job openings than applicants – and yet experienced only tepid price and wage inflation. Why? Because expectations are crucial. If businesses, consumers and workers don’t expect inflation, they will be less likely to jack up prices or ask for a raise. Low inflation, in other words, can become self-fulfilling.

Other factors are also at work. The internet, social media and online retailing have changed the psyche of inflation. Transparency allows consumers to shop for, and expect, the lowest prices. Searching for information and being connected are ‘free’ (in the sense that fees are not charged). The retail experience has been transformed by virtual shopping, with its pursuit of bargains, underpinned by the breathtaking logistical efficiency of its warehousing and delivery systems. When things are cheap or even free, it becomes more difficult to contemplate rising prices. In this light, Amazon can be considered a giant deflationary force on the economy.

Job insecurity also keeps wage demands at bay. Whether fears emanate from globalization or technological change, workers are cowed, willing to exchange a modicum of job security for stagnant wages.

In short, inflation is dictated by many factors, some of which have stymied its re-emergence in across industrial countries.

But that might now change. Here are a few reasons why:

First, monetary easing during the pandemic has not been accompanied by financial instability. Accordingly, money demand has probably not surged as it did during the financial crisis. The risk of ‘excess money’ creation is now higher.

Second, central banks are trying to boost inflation expectations. Low or zero policy rates and huge asset purchases are part of that effort, with the Fed recently going a step further by adding an explicit objective to overshoot its 2% inflation target.

Third, monetary easing has been accompanied by fiscal easing. True, the initial fiscal impulse has faded, and the political will to repeat it is smaller. But fears of voter backlash driven by the pandemic and falling living standards could prompt governments to loosen purse strings further.

Fourth, large-scale vaccinations in 2021 will allow broader economic activity to resume, potentially absorbing slack rapidly across labor and product markets.

Fifth, evidence suggests that bottlenecks are already apparent. The Fed’s latest Beige Book, for example, cited growing labor shortages, in part because the pandemic has severed support systems, such as schooling and daycare, that permitted women to work. While those shortages may be alleviated with widespread inoculation, the labor force might not fully recover if voluntary withdrawal from job-seeking is significant.

Sixth, the combination of the pandemic, and the risks it poses for long and vulnerable supply chains, as well as slowing rates of globalization, has diminished the flexibility of global production and distribution. Supply responses to stronger demand may be less flexible and slower than in the past, potentially leading to shortfalls and opportunistic price hikes.

Seventh, a weakening US dollar, already underway, could push many prices higher. US imports will become more expensive, while raw materials and energy prices also rise as the dollar falls.

Eighth and finally, by the second quarter of 2021, year-on-year comparisons will tend to lift reported rates of inflation. That’s because of how far many prices fell as the pandemic swept the world between April and June of 2020.

Any one of these eight factors, alone, might not be sufficient to change inflation expectations. But the coincidence of many, or most of them, could alter perceptions in financial markets and the broader economy.

Markets have taken note. The pricing on US Treasury Inflation Protected Securities (TIPS) suggests investors anticipate 1.9% yearly inflation over the next ten years. That might not sound like a lot, but that’s up a full percentage point in a half year and expected inflation is now higher than before the pandemic erupted. Cryptocurrencies (often viewed as an inflation hedge), such as Bitcoin, have also been on a tear in recent months.

History suggests that inflation is typically slow to emerge. But when it does, it manifests inertia, as rising prices reinforce expectations of more to come. That’s why the Fed’s overshooting objective is risky. Once inflation exceeds thresholds, bringing it down could be difficult.

Which brings us, finally, to the implications for asset prices. Rising inflation always undermines bond returns, with their fixed nominal coupons. But bond markets are much more vulnerable today, given significant over-valuation caused by central bank asset purchases and in the context of massive future supply due to unprecedented fiscal deficits. Bond markets will be in for a rude awakening if inflation accelerates.

Some argue that equities can withstand inflation because earnings and dividends rise with inflation. That’s simplistic and dangerous thinking.

As interest rates rise, so does the rate at which future earnings are discounted. Even more important, rising inflation increases economic risk. Central banks will eventually have to dampen spending to curb inflation. Accordingly, when inflation picks up investors require a higher risk premium to hold equities. Inflation de-rates valuations, which in some cases are already very high.

In sum, investors should care about rising inflation, which is now more probable than at any time in the past two decades. When it comes, it will be fast. Given that the consequences are huge for all investors, it is time to take notice.

About the Authors

Larry Hatheway

Larry Hatheway has over 25 years experience as an economist and multi-asset investment professional. He is co-founder, with Alexander Friedman, of Jackson Hole Economics, LLC, which offers commentary and analysis on the global economy, policy & politics, and their broad implications for capital markets. Prior to co-founding Jackson Hole Economics, LLC Larry worked at GAM Investments from 2015-2019 as Group Chief Economist and Global Head of Investment Solutions, where he was responsible for a team of 50 investment professionals managing over $10bn in assets. While at GAM, Larry authored numerous articles on the world economy, policy-making and multi-asset investment strategy. Larry was also the lead investment manager for various mandates, funds and an actively managed multi-asset index. Larry also served on the GAM Group Management Board, was Chairman of the GAM London Limited Board and served as member of the GAM Investment Management Limited Board. Larry was also Chairman of the GAM Diversity & Inclusion Committee. During his tenure at GAM, Larry was based in London, UK and Zurich, Switzerland. From 1992 until 2015 Larry worked at UBS Investment Bank as UBS Chief Economist (2005-2015), Head of Global Asset Allocation (2001-2012), Global Head of Fixed Income and Currency Strategy (1998-2001), Chief Economist, Asia (1995-1998) and Senior International Economist (1992-1995). During his tenure at UBS, Larry was also a standing member of the UBS Wealth Management Investment Committee. While at UBS, Larry worked in Zurich, Switzerland, London, UK (various occasions), Singapore and Stamford, CT. At both GAM Investments and UBS Investment Bank Larry was widely recognized for his appearances on Bloomberg TV, CNBC, the BBC, CNN and other media outlets. He frequently published articles and opinion pieces for Bloomberg, CNBC, Project Syndicate, and The Financial Times, among others. Before joining UBS in 1992, Larry held roles at the Federal Reserve (Board of Governors), Citibank and Manufacturers Hanover Trust. Larry Hatheway holds a PhD in Economics from the University of Texas, an MA in International Studies from the Johns Hopkins University, and a BA in History and German from Whitman College. Larry is married with four grown children and a loving Cairn Terrier, and resides in Wilson, WY.

Alex Friedman

Alex Friedman is the co-founder of Jackson Hole Economics, LLC, a private research organization which provides analysis on economics, politics, the environment and finance, and develops actionable ideas for how sustainable growth can be achieved. Friedman is a senior leader with two decades of experience growing and transforming organizations in the financial and non-profit industry. He was the CEO of GAM Investments in London and chairman of the firm’s executive board. Previously, he was the Global Chief Investment Officer of UBS Wealth Management in Zurich, chairman of the UBS global investment committee, and a member of the executive board of the private bank. Before moving to UBS, Alex Friedman served as the Chief Financial Officer of the Bill & Melinda Gates Foundation. He was a member of the foundation’s management committee, oversaw strategic planning, and managed a range of the day-to-day operating functions of the world’s largest philanthropic organization. Friedman also created the foundation’s program-related investments group, the largest impact investing philanthropic fund in the world. He started his career in corporate finance at Lazard. Friedman served as a White House Fellow in the Clinton administration and as an assistant to the U.S. Secretary of Defense. He is a member of the board of directors of Franklin Resources, Inc. (Franklin Templeton), a member of the Council on Foreign Relations, Chairman of the Advisory Board of Project Syndicate and a board member of the American Alpine Club. Friedman is a regular contributor to a range of newspapers and thought leadership groups and is also the author of Babu’s Bindi, and The Big Thing, both children’s books. He is an avid mountaineer and rock climber and led the first major climb to raise money for charity through an ascent of Mt. McKinley. Friedman holds a JD from Columbia Law School, where he was a Harlan Fiske Stone Scholar, an MBA from Columbia Business School, and a BA from Princeton University.

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