This article was written by Richard Horswill. All views and opinions expressed are strictly his own.
The current monetary supposition based upon the direction of long term bond yields in the US suggests inflation is on its way. This assumes that vaccines do their job and that reopening trade remains viable. Pent up demand is a buzz phrase, suggesting that cash on the sidelines is ready to pounce as consumers emerge from lockdowns ready to spend their savings from all of the free government handouts. It's important to state that the dollar-centric world in which we live means that what happens in the US is likely to bleed into the global economy. Inflation is a consequence of multiple factors and has been up to now highly elusive when considering the targeting measures central banks have at 2%+ annualised. Nevertheless, it is important to consider the factors that may or may not derail the inflationist overtures.
Inflation is the general rise in price levels in an economy over time which reflects a reduction in the purchasing power of the currency: a loss in "real value" in the medium of exchange.
Some consequences of the pandemic and the lockdowns over the last year have seen massive fiscal spending to help businesses and people keep the lights on (commonly known as stimulus). This has added to the already huge sovereign debt loads that future generations will be lumbered with. Historically, the preferred way to repay the debt has been to inflate and thus repay the nominal debt with devalued currency units. So far, central banks have not managed to create their desired outcomes however, and when all the market chatter and speculation is one of the emergence of the inflation genie, should we believe the rhetoric? Why should this time be different, particularly when millions more people are unemployed through shutdowns and bankruptcies that have happened or are likely to happen in an eventual new post pandemic world?However, if inflation is achievable at the prescribed rate, will this really be enough to create the conditions really to cut the debt, to provide for a "financial repression" that will be deemed acceptable, and to get the debt loads under control?
Many inflationists target liquidity, the money printing and cite the money supply as a reason for inflation. Quantitative easing has been the central bankers’ main tool to assist the mechanism of monetary creation in the financial system in order to provide the cash collateral for the banking system to provide lending leverage. The problem with this mechanism is that it requires banks to lend and consumers to borrow, which is probably not ideal in the middle of a pandemic. This has thus provided for dis-inflationary circumstances and even full on deflation in some sectors. Liquidity on its own does not solve the problem, and people need to be spending and creating velocity of money before real inflation can emerge. The other problem for QE is that it actually creates a liquidity trap. It locks money away on the balance sheet of the central bank and can only be reversed when the opposite occurs in the form of quantitative tightening, the resale of the purchased bonds. This is impossible to propose in current conditions, as the authorities need to control interest rates to the downside. The only useable central bank tool is QE to manage interest rates by making sure they do not rise too high and thus undermine debt servicing. Looking at the bond market, inflation expectations previously mentioned are showing themselves at the long end of the yield curve with 10 to 30 year rates being sold off, seeing yields moving higher and reflecting the risk of future inflation. The short end of the curve is currently relatively static primarily due to the current $80 billion per month treasury bond buying programme the Federal Reserve is undertaking. There are however other players who need to buy short term treasury debt and T bills. Another consequence that we need to consider in our inflation calculations are the fiscal authorities, the Treasury, who have been providing stimulus cheques to the people. This money is assisting personal saving rates, money not being spent into the economy and is also being used to pay off debt. These actions are not stimulative. The saved monies in cheque accounts have a consequence for banks. Banks require income and need to put the extra savings to work by buying short dated treasuries and T bills to secure some income. Also, under Basel 3 rules the “supplementary leverage ratio” (SLR) requires banks to manage the size of their balance sheets which means in the event of cash stimulus and an increase in deposits, banks will be forced to add further collateral in the form of short dated bonds. Thus, with further stimulus cheques around the corner from President Biden's $1.9 Trillion package, more short dated bond purchases are likely which could potentially take near term yields negative. This is clearly not the perceived current wisdom but when the new money arrives it could well signal a change of heart from the speculators at the long end of the curve, depending on how the cheques are put to use.
Which end of the bond market is currently telling the truth about inflation? Is the bond market so manipulated by the central bank that it has no bearing or meaning anymore? Is inflation a pipe dream particularly when the US CPI has been registering annualised growth at 1.4% well short of the 2% target; when velocity of money is tepid and when wage growth is non existent? Suggestions of minimum wage increases in a struggling economy will likely lead to more future lay offs if implemented. So many questions but no available answers just yet.
The question of significant increases in the CPI can only be answered when we get to the economic reopening. "Behavioural economics." How will people react? Will they return to normal behaviours, consumerism, travel, spending like drunken sailors or will the post pandemic world be wary and frugal. Japan may provide one possible model after the 90's bust which changed attitudes and created a 30 year deflationary economy and still running. Can the stock market melt up continue, and confidence in the system be maintained or will the asset of last resort pet rock central bank gold holdings be required to prop up over leveraged balance sheets with either a planned revaluation or the markets doing it for them in the possible event of highly negative real interest rates? These questions will only be answered in time but whilst we walk the tightrope between pandemic and post pandemic attitudes it is important to remember that if the genie were to escape from the bottle it may be impossible to get it back in and therefore central bankers really need to be careful of what they wish for. Paul Volker, the then head of the Federal Reserve at the time managed it in the 1980's but that took interest rates to nigh on 20% before confidence was restored. The luxury of being able to raise rates today clearly does not exist and therefore history in this case will almost certainly not repeat or rhyme! Expect the unexpected may be a more relevant saying.