Published on Mar 18, 2021
What the Inflationistas May Be Missing
Investors are concerned that rising interest rates could choke off a nascent recovery. Many economists agree that long-term Treasury yields are rising because investors expect more growth and inflation. While these might be good things, you can have too much of a good thing. In particular, the pace of change matters: the roughly 75 basis point increase in the 10-year Treasury yield in the first ten weeks of this year is a rapid adjustment that creates the potential for disruption.
While we continue to monitor the situation, at this point our concerns have not reached the level where we find it necessary to safeguard our equity or fixed income portfolios from this risk beyond the natural diversification steps that we ordinarily take.
Presently, the potential for inflation is a source of angst in the investment community. But these inflationary fears come against a backdrop of decades of disappointingly low inflation, or disinflation. The drivers of disinflation have not gone away; indeed, some have intensified. Demographic pressures weigh on aggregate demand, as the proportion of U.S. residents past retirement age marches higher. Digital disruption pressures prices across the economy, with the pandemic accelerating this trend. On the other hand, globalization has stalled in recent years. While changes to trade policy may restore some global linkages, the post-pandemic priority of supply chain resilience over cost could reduce the disinflationary influence of this factor going forward.
Those who argue that we are on the cusp of outsize inflation typically focus on the nexus of fiscal stimulus, household savings, and pent-up consumer demand. However, this ignores the supply side of the economy, which will also grow with reopening. Supply growth may address shortages, relieving some pricing pressures. The nearly ten million unemployed U.S. workers is a lot of slack capacity in the labor market, which makes it difficult for pernicious inflation to sustain itself via a wage-price spiral.
Inflationistas further argue that price increases in commodities like crude oil, agricultural crops, copper, and lumber will be transmitted through the economy. But commodity prices similarly ran hot at the outset of the last economic recovery, while inflation did not follow. The U.S. economy is complex with many links in the chain that converts raw materials to finished goods. Higher corn prices on the farm are not sure to translate into higher cereal prices at the supermarket. Moreover, U.S. economic output under normal conditions is about 90% services and 10% goods. Goods inflation alone is therefore unlikely to have much of an impact on the overall economy.
There is also the unprecedented pace of asset purchases by the Federal Reserve, which has increased the money supply by about 25% from pre-pandemic levels. But the central bank purchased significant assets in the prior recovery without stoking inflation. One reason for not stirring up inflation was the payment of interest on excess reserves, a practice the Federal Reserve initiated in 2008, which creates an incentive for banks to deposit funds at the central bank, rather than lend them out. If the Federal Reserve were concerned about inflation today, it could raise the interest rate on excess reserves, which would slow the leakage of money supply growth into the real economy. This is a tool with little cost other than the political optics of paying out more to the banks. The Federal Reserve could go further if necessary, by tapering its asset purchases or raising its benchmark interest rate, but those steps would weigh on real economic activity.
Endorsing this view, Treasury Secretary Janet Yellen said last week that the Federal Reserve has learned how to manage inflation. Because of depressed comparisons in the year-ago period, inflation measures could accelerate in the coming months, generating headlines, but we expect those impacts to be transitory. Inflation expectations remain well anchored, as measured by Treasury Inflation Protected Securities, or TIPS, whose prices imply a slowdown in medium-term inflation after a near-term pickup, an inversion that is rare for this market.
Interest rates could move higher without inflation if investors anticipate a faster pace of real economic growth. If this shift were to happen slowly, with a modest accompanying rise in inflation expectations, it would be the Goldilocks scenario that the Federal Reserve wants to engineer. But if the adjustment came too rapidly, it would be self-defeating, weighing on the economy and capital markets.
Fortunately, the Federal Reserve also has tools to manage this scenario. The easiest is to shift the weighted average maturity of its asset purchases out farther along the yield curve, a maneuver that was known as Operation Twist when it was last employed in 2011. The Federal Reserve could go further if necessary, by initiating a yield curve control mechanism, as currently practiced by the Bank of Japan, by changing its forward guidance to forecast zero interest rate policy further into the future, or by increasing the overall pace of asset purchases, though these more extreme steps carry additional risks.
In analogous periods historically, rising interest rates early in economic recoveries left choppy equity markets in their wake without provoking bear market drawdowns. Bear markets typically follow the last interest rate increase by the Federal Reserve, rather than the first. In our view, there could be less equity market disruption from higher interest rates in this cycle, because the Federal Reserve is more transparent, offering substantial forward guidance, and holding press conferences after each committee meeting.
Recent easing actions by the Bank of Japan and the European Central Bank could reduce the near-term risk of dislocation because sovereign rates in these nations act as an anchor on U.S. Treasury yields. Moreover, after the rapid advance in Treasury yields over the last ten weeks, it seems reasonable there could be a pause for digestion. Lastly, in April, the Federal Reserve added a temporary exception to its supplementary leverage ratio rule for large banks, allowing the banks to own Treasury securities without holding capital against them. The exception is due to expire March 31, and large banks may be reducing their Treasury holdings in advance of this deadline, pushing yields higher. Though it has become politically fraught, we expect the Federal reserve to continue the exception for at least some Treasury holdings for some length of time, which may reduce this source of pressure on yields in the near term.