With the US Federal Reserve (Fed) shifting policy to allow for greater flexibility on inflation, we believe that the central bank revealed its real concern: a ruinous debt-deflationary spiral.
- Now that the Fed made official what it has implicitly stated since spring, inflation alarmists believe that higher prices are an inevitability.
- We believe the Fed’s actions were superfluous as it is well aware that the greater risk to the US economy is the vicious combination of high debt levels and falling prices.
- The Fed has proven it can support financial markets but has yet to crack the code on how to translate that to growth in the real economy.
Very few were surprised by Fed Chairman Jerome Powell’s comments at Jackson Hole on Thursday 27 August that the central bank was willing to let inflation drift higher than its 2% target as long as it averaged roughly 2% over a longer horizon. We are surprised, however, by the number of market participants who believe that higher inflation is now an inevitability.
As evidenced by his deft handling of the financial system during the height of the COVID-19-induced recession, Chairman Powell has proven he is the right man for the job. Given this shrewdness, he would not have backed himself into a corner that could force the Fed to change course should inflation run hot. Rather, he likely recognises that the greater threat to the economy is not inflation but a debt-deflationary spiral – a scenario that has likely increased in the wake of the government’s massive fiscal response to the pandemic.
Textbooks versus reality
Over the past month, the level of inflation that Treasury Inflation Protected Securities (TIPS) expect the US to average between 2025 and 2030 has risen from roughly 1.50% in July to 1.85% in late August1. While a notable spike, that only brings it back to January’s level, well before the Fed increased the size of its balance sheet to US$7 trillion2. One would think that the combination of large-scale quantitative easing (QE) and the Fed’s more liberal stance on inflation would have resulted in an even higher spike in TIPS-implied inflation.
Economic theory may indicate that a dovish Fed and wall of money are key ingredients for higher prices, but the experience of the past decade tells a different story. Despite three rounds of QE and US policy rates at the zero bound, core inflation as measured by the Fed’s favoured gauge averaged only 1.6% over this 10-year stretch3. Even more compelling evidence is found in Japan – the petri dish of extraordinary, but ultimately ineffective, monetary policy.
Milton Friedman, the economist, stated that “inflation is always and everywhere a monetary phenomenon.” A corollary to his maxim should be that someone has to spend the money. Part of the last decade’s lack of inflation is likely explained by the steady downtrend in monetary velocity, or the pace at which it cycles through the economy. That measure plummeted even further in the wake of the spring’s economic shutdown. While some spending will certainly bounce back on pent-up demand, other disinflationary forces evident over the past decade – ageing demographics, disintermediation of business and technological innovation – are not going away anytime soon.
Consequently, we believe that the Fed will have to maintain its hyper-accommodative stance far longer than the market expects. The purpose of this “whatever it takes” mentality is to stave off a potentially ruinous debt-deflationary spiral. In such a scenario, lower prices beget lower prices as weak revenue growth stresses highly levered entities, leading to insolvency, idled capacity and layoffs, thus reinforcing the broader economic pall. State and local governments are not immune to this threat as lower tax revenues will likely lead to job reductions and fewer services.
A Potemkin market?
While the Fed has moved the goalposts on its inflation mandate, it has scored in what many call its unspoken mandate of keeping financial markets buoyant. The rationale for keeping asset prices high and interest rates low is to create an environment conducive for growth-enhancing investment. Just as with the post-Global Financial Crisis era, the objective of easing financial conditions is to form a bridge between an economic shock and a period where sustained growth takes hold. The Fed has proven deft at supporting equity and bond prices but has yet to crack the code on having monetary policy deliver sustainable economic growth.
High asset prices may give the veneer of a promising future, but without the follow through on productivity-enhancing capital investment and job creation, the weak foundations of this construct will soon be revealed. The result could very well be the “zombification” of financial markets where capital flowing to underserving borrowers keeps asset prices frothy but does nothing for the real economy.
These risks are magnified by the spectre of deflation as it would raise the cost of capital for corporate borrowers and thus discouraging capital investment. With such powerful forces lining up on the side economic weakness, we doubt Chairman Powell will face the possibility of having to watch inflation run above 2%.
1Source: Bloomberg, US 5 year 5 year forward breakeven, 2 January 2020 to 28 August 2020
2Source: Refinitiv Datastream, US Federal Reserve, total assets at 24 August 2020.
3Source: Refinitiv Datastream, Bureau of Economic Analysis, US price index, personal consumption expenditure (PCE) less food and energy, seasonally adjusted, 31 July 2010 to 31 July 2020.
Potemkin. Grigori Potemkin was a Russian statesman reputed to have erected artificial villages along the Crimea to convince Empress Catherine II that the Crimea was more wealthy than it really was.