Last week’s economic data continues to confirm strong growth: The ISM Services Index is at a 24-year high and the Producer Price Index was up 1% in March, the fastest pace in nearly 10 years. There is no argument that an economic boom is here and will continue for the next few years.
In the meantime, the latest Federal Open Market Committee (FOMC) meeting minutes emphasize the 9.5 million jobs lost since the COVID-19 pandemic began and the human suffering among the most vulnerable in our society. The Federal Reserve (Fed) is in no hurry to taper. Last year, the Fed made some significant changes in its policy frameworks. First, instead of targeting 2% inflation every year, it will target the average inflation rate over the long run. This allows inflation to overshoot for several years to make up for the lower-than-targeted inflation during the past decade. Second, policymaking will be based on outcomes instead of outlooks. Both changes allow the Fed to stay accommodative much longer than it could have under the old framework.
On the fiscal side, years of worsening inequalities, as well as a lack of income growth and opportunities, have reached a tipping point during the COVID-19 pandemic. With most essential workers needing to go to work as usual, while many of the higher-paid get to work from home, inequalities have become more apparent. One result is that fiscal stimulus and generous government transfer payments have become much more acceptable among voters. The current political environment is ripe for fiscal stimulus along with higher taxes for the rich.
For many years, the equity market set the tone for financial markets, though this is slowly changing. With extremely accommodative fiscal and monetary policy, plus a booming economy, inflation is back on the minds of investors and bond vigilantes are awakening. For the last 10 years, deflation, or disinflation, was the worry of the market. In this environment, equity and bond prices are negatively correlated. With the risk of inflation growing and the risk of stagnation diminishing, the correlation has recently turned positive.
Currently, the biggest question facing investors is: Will inflation in the next year be transitory or longer-lasting? The five-year breakeven inflation rate is currently at 2.58%, while the five-year forward breakeven rate is at 2.16%. The market is indicating that we will see higher inflation in the next few years when the economy booms, but it will revert back to the long-term average when growth slows down. In more than a decade since the financial crisis, we have seen how technology, high financial leverage and demographics exert powerful disinflationary power on the economy.
However, in my opinion, this cycle will play out differently. More persistent and higher inflation is coming in the next several years. It is not easy to call for higher inflation when we look at the composition of personal consumption expenditure (PCE) and core PCE price index. A recent research paper from Goldman Sachs offers more details about this topic. In short, about 40% of the components are cyclical and volatile. The non-cyclical components have an annual growth rate of 1% over the long term and the cyclical components have the highest growth rate of about 4% over the last few decades. Even if this part of the core PCE price index grows at a 5% annual rate, the overall index will be only slightly higher than 2.5%. This bottom-up analysis makes it very hard to forecast higher inflation.
However, from the top-down, there is reason to worry about inflation. First, policymakers learned the lesson of being too timid and worrying too much about moral hazard in 2008. The limited monetary and fiscal response post-2008 contributed to an extremely slow recovery. This time around, we see trillions of dollars in fiscal support, with more likely to come in the next few months. We also see that the Fed is committed to zero rates and quantitative easing (QE) for a long period of time while the economy is booming. The practice of sending out stimulus checks has proven to be extremely popular among voters. I would not be surprised to see both parties embrace this in the coming years. We will have a recession a few years down the road and that may mean more stimulus checks. Inflation won’t go down as much as in previous recessions. Already, I am hearing stories that restaurants cannot reopen because they don’t have job applicants. This is how generous transfer payments eventually lead to higher wages. The pandemic has truly changed a lot of social and political norms. Universal income was considered a crazy idea two years ago and now Andrew Yang, an advocate for this policy, is the leading candidate in New York’s mayoral race.
Secondly, the rise of ESG (environmental, social and governance) investing is adding more considerations for corporate CEOs. If we think of running a corporation as an optimization problem, the more constraints we add to it, the less optimal the result will be. Historically, corporations have paid no price for contributing to climate change. Now, we are putting a price tag on them, and rightly so. This eventually should lead to higher costs and inflation.
Lastly, there is competition with China. The U.S. has rarely faced such a strong competitor on the world stage before, even though I think it is a little silly to dwell on who is No. 1 globally as long as a country’s citizens are happy and safe. I guess each country has its pride. The Chinese government allocates a lot of resources to areas such as 5G, renewable energy, electric vehicles (EV), semiconductors, etc. It is difficult for a single U.S. company to compete with the resources of a country such as China; therefore, the U.S. government will need to play a bigger role. Also, a new global supply chain with less Chinese involvement will be another driver for higher inflation.
Even though a bottom-up analysis shows that a sustainable inflation regime isn’t likely to come to fruition, a top-down analysis shows powerful inflation forces in the coming years. I believe inflation will eventually show up in unexpected components of the core PCE price index. In the coming months, I will focus on the new fiscal package from the Biden administration, as well as monitor how fast wages grow and the number of people coming back to the workforce after the reopening.
There is a heated debate about how transitory inflation will be over the next 12 months. I think the risk is higher inflation, even though it will play out very slowly. Fixed-income investors should pay attention to how much interest-rate risk they are taking and have a plan to hedge that risk when opportunities present themselves.
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