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.