The case for eventual inflation

September 08, 2020 07:51
Photo: Reuters

At the annual Jackson Hole meeting, US Federal Reserve chairman Jerome Powell announced that the central bank will now allow its average inflation to rise beyond its long-held 2% target in account of the economy’s low inflation. The combination of massive unconventional monetary policy and the increasing willingness of policymakers to take advantage of historically low interest rates and embrace the aggressive use of fiscal policy could eventually set the stage for a medium-term shift in the inflation backdrop.

How do the GFC and COVID crises differ?

Despite an enormous monetary policy response to the global financial crisis (GFC), inflation remained historically very low. Why? In my view, there are two primary reasons: low money velocity and heavy deleveraging by banks, households and, eventually, governments. But that was then, and this is now. The conditions surrounding the GFC were quite different from those we face today.

We learned from the prior crisis that the supply of money alone won't kindle inflation and that demand plays a very important role. We’ve summarised why this time might be different:

1. The policy response has been immense and swift

The scope of the global policy response to the pandemic, both monetary and fiscal, far eclipses earlier episodes. Additionally, today's aid is more focused on getting the money into the broader system, concentrating on Main Street more than Wall Street and on households and businesses rather than financial institutions. Moreover, while the pandemic is far from over, the banking system has thus far not been forced to de-lever, unlike during the GFC.

2. Policymakers are unlikely to commit the same mistake again

Will fiscal policymakers repeat the error they made following the GFC, when they adopted austerity early in the expansion, beginning around 2011? Today, that premature belt-tightening is viewed as a mistake, especially in Europe, where a sovereign debt crisis subsequently engulfed the eurozone. Perhaps deteriorating debt profiles will force aggressive fiscal austerity again, but with yields pegged at (or below) zero, there should be additional scope to forestall fiscal normalization.

3. Politicians may be thinking the unthinkable

We’re starting to see some officeholders becoming increasingly comfortable adopting parts of Modern Monetary Theory (MMT) in practice. MMT asserts that a country can issue huge amounts of sovereign debt with little or no negative ramifications if it 1) can issue debt in its own currency, 2) has a very large negative output gap and 3) can finance deficits at close to zero cost.
While such an idea was until recently unthinkable, one consequence of the pandemic has been an opening of the Overton Window, which describes the range of policy ideas the public, and policymakers, are willing to entertain. The scope of the economic damage wrought by the pandemic appears to have forced the window wide open.

4. It looks like we're monetizing the debt

The extent of the Federal Reserve's monetization of US Treasury debt also feels different this time. While there are important semantic disagreements over what constitutes monetization, the combination of accelerating sovereign debt issuance with heightened central bank buying of that debt raises a red flag.
But not all prior episodes of heavy Fed government debt purchases have resulted in inflation. Fed buying of Treasuries during the two world wars coincided with inflation, while the GFC episode did not. The adoption of something resembling MMT on a sustained basis, coupled with debt monetization and a closed output gap, could upend the disinflationary dynamics of recent decades.

5. Inflation expectations could become unmoored

Inflationary expectations have been well anchored in recent decades, but that has not always been the case. Expectations plummeted during the Great Depression, and they vaulted higher in the 1970s. A change in psychology in response to new policies along the lines of MMT and debt monetization can't be ruled out. Alternatively, if we repeat the post-GFC mistake of imposing fiscal austerity too soon, we could potentially see inflation become unanchored to the downside. In either case, the Fed will need to be careful not to lose credibility.

6. Governments would welcome some inflation

How have countries historically reduced unsustainable debt burdens? We have seen this via default, austerity, currency depreciation or even financial repression. Though countries would prefer to have a higher growth rate of GDP than debt as a way out, it’s unlikely to happen given the low-growth environment and deteriorating demographics.
That said, the one method that we truly haven't tried is inflating our way out. Yes, central banks printed a lot of money during the last crisis, but deleveraging undermined the path toward higher inflation. However, if policymakers open the Overton Window wide enough and add MMT and debt monetization to their toolkits, that combination might sustainably lift inflation rates to levels we've not seen in more than a generation and could be enough to lighten the country's debt load over the coming years.

Which assets should benefit?

With growth likely to be challenged in the quarters ahead, along with a very large output gap and oil down by about a third since the start of the year, inflation is unlikely to be a problem for quite a while. We are not expecting anything close to hyperinflation but rather that the trend toward ever-lower inflation will reverse.

Asset classes that could potentially benefit from, or helped offset, a moderately rising inflationary environment include value equities, Treasury Inflation Protected Securities (TIPS), limited maturity bonds, floating rates securities, commodities and hard assets such as real estate and gold. A rising inflationary environment could potentially disadvantage assets like longer duration bonds, growth equities and bond proxies such as REITs, utilities and infrastructure.

If policy makers are successful in generating higher inflation, this could present a new set of risks. Central banks and fiscal balance sheets are currently socializing profit loss and solvency risk to sustain employment and household income in the hopes of protecting against the downside to growth and inflation. And full-fledged MMT would take this socialization to a new level. But capital markets offer two primary functions in society: capital allocation and price discovery. "Forcing" inflation higher would distort these functions, where the public policy cure could be worse than the disease. Investors should be prepared for more distorted markets, with or without inflation.

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Chief Economist, MFS Investment Management