Inflation risk revisited

Chas Craig, BridgeTower Media Newswires

Last June I wrote a column entitled “Inflation Risk.” I stated that “common sense dictates that government deficits and the resulting debt can’t be monetized via Fed purchases of Treasury obligations in increasing amounts without causing an inflationary impulse at some point.” The point was not so much that I had a high level of conviction that inflation would spike, but that the market seemed very certain that it wouldn’t. The difference between 30-year nominal and inflation protected Treasury bonds (the breakeven rate), a rough estimate of the market’s expectation for average inflation over the period, registered at roughly 1.5% at the time, a level well below the Fed’s goal of averaging 2%.

Back then inflation wasn’t high on investors’ worry list, but now it seems like the only thing people talk about. As a result, the 30-year breakeven rate has persistently risen, now registering at about 2.3%. In markets, the fact that something, inflation in this case, has become front of mind for most investors typically indicates that the ability to make outsized returns from the insight has largely or entirely passed. To this point, since my earlier column the Bloomberg Barclays U.S. Treasury Inflation-Linked Bond Index has returned 5.6% more than the Bloomberg Barclays U.S. Aggregate Bond Index (a measure of the broad U.S bond market), a wide margin for bonds.

Much like it was reasonable to consider how inflation might rise above the Fed’s 2% target when the market was pricing in a meaningfully lower level, it is likely a good use of time now to consider the possibility that the Fed could miss its inflation target to the downside now that the market for inflation-linked bonds has repriced to reflect an inflation expectation noticeably higher than the Fed’s target.

Despite my inflation concerns from the monetary/fiscal policy combo currently being pursued, we clearly have some deflationary undercurrents in our economy. If this were not so, the Fed would not have spent the past decade undershooting their inflation target despite mostly loose monetary policy, large fiscal deficits and, at least by the end of 2019, a tight labor market by traditional metrics such as the unemployment rate.
The three deflationary undercurrents that come to mind immediately are (1) an aging population, (2) automation and technology adoption and (3) globalization. Globalization is the only one I can plausibly envision partially reversing.

Beyond the more secular items discussed in the preceding paragraph, there is still likely a large amount of “slack” in the post-COVID economy, and after this last round of stimulus it seems as though the political will does not exist to send checks to people again outside of a very major virus resurgence. Therefore, while fiscal policy will likely be “loose” for the foreseeable future, soon, the rate of change of fiscal support will likely be negative. This will likely be true even if a large infrastructure bill gets through Congress (color me skeptical) because such spending would be spread out over many years and would very likely be partially paid for by higher taxes.

Bottom line, fiscal and monetary policymakers are both pursuing inflationary policies. However, Fed officials have a much better understanding of consumers’ and investors’ inflation expectations now than did their predecessors from the inflationary 1970s (e.g., Treasury Inflation Protected Securities did not exist until 1997). Therefore, Fed officials would be quickly alerted if inflation expectations became unanchored and, even if they are behind the curve now, they have ample room to tighten monetary policy to not allow inflation to move materially above their target if it comes to it.

—————

Chas Craig is president of Meliora Capital in Tulsa (www.melcapital.com).