Stimulus = Inflation?

The massive stimulus to the U.S. economy in the face of the COVID-19 crisis brings a persistent worry among investors that these policies will lead to inflation. Once the crisis is over, how will all the excess money be absorbed? There is a concern that inflation will erode the value of bonds.

Deflation is actually the more likely threat in the near term, and the risk of inflation in the next few years is limited. A lot will of course, depends on how quickly the economy rebounds from its steep decline. A rapid rebound in the economy could potentially lead to inflation.

The late economist Milton Friedman’s thesis that inflation is “always and everywhere a monetary phenomenon” drove the Federal Reserve to target money supply growth in the 1980s, bringing inflation down. Therefore, whenever the money supply rises rapidly it seems reasonable to assume that inflation must be around the corner. However, in order to produce inflation, the money must be loaned and/or spent and must drive up the demand relative to supply. If it sits on the balance sheets of banks or is saved by consumers, then it doesn’t necessarily drive up prices for goods and services.

Currently, demand for many goods and services has dropped sharply as consumers remain at home. Business inventories are rising as consumer spending falls amid soaring unemployment. In the first half of the year, it’s likely that gross domestic product growth (GDP) will decline. In response, the Fed and Congress are providing relief to fill the gap that has been created by the downturn. This “output gap” is the difference between the economy’s potential growth rate and its actual growth rate. In order to generate inflation, the gap would need to close and growth would need to exceed its potential for an extended period of time.

 

Mind the gap: GDP growth is falling far below its potential growth rate

Source: U.S. Bureau of Economic Analysis, Gross Domestic Product (GDP) and U.S. Congressional Budget Office. Nominal Potential Gross Domestic Product (NGDPPOT), Gross Domestic Product, and the Gross Domestic Product Forecast. Quarterly data as of Q1-2020 with forecast through Q4-2020, provided by U.S. Congressional Budget Office.

The longer the current downturn lasts, the more risk of a delayed bounce back. Why?  Because recessions tend to destroy productive capacity. Some businesses will not reopen. Some people may not get back into the workforce. And unused resources, such as structures and equipment, as well as skills, become outdated.

It is also tough to generate inflation if people don’t believe in it. After all, why would anyone “chase” goods if prices stay the same or fall? Delaying consumption could mean getting a discount later. There may be some price increases for certain goods that are in short supply due to supply chain issues, but widespread generalized price increases appear unlikely.

Consumer inflation expectations have fallen

Source: Bloomberg.  University of Michigan Consumer Expectations Index.  Monthly data as of April 2020.

 

Market expectations for inflation are also low

Notes: The 5-year 5-year forward rate is a measure of the average expected inflation over the five-year period that begins five years from the date data are reported. The rates are composed of Generic United States Breakeven forward rates: nominal forward 5 years minus US inflation-linked bonds forward 5 years.

Source: Blomberg 5-year 5-year Forward Inflation Expectation Rate (USGG5Y5Y Index). Daily data as of 5/11/2020.

Once the economy “re-opens,” surely all that money printing will result in inflation down the road, won’t it? It’s possible, but recent history doesn’t support the idea that it will necessarily happen. There were similar worries during the 2008-2009 financial crisis. However, despite the rapid and huge expansion of the Fed’s balance sheet at the time, inflation stayed muted. Asset prices went up, but that was the extent of the inflation.

Today, we’re looking at a different backdrop. Not only is there a wide output gap, suggesting excess supplies of goods and labour, but wages for many workers haven’t kept up with inflation for many years, partly as a result of globalization and outsourcing production to countries with lower wage costs. Perhaps that’s why there has been so little “chasing” of goods. On top of that, commodity prices have fallen and the dollar has been strong, holding down prices of imported goods.

 

Falling oil prices have pulled overall commodity prices lower

Note: Chart shows the Commodity Research Bureau (CRB) Spot Index, which is an index that measures the overall direction of commodity sectors. The CRB was designed to isolate and reveal the directional movement of prices in overall commodity trades. The Spot Market Price Index is a measure of price movements of 22 sensitive basic commodities whose markets are presumed to be among the first to be influenced by changes in economic conditions. As such, it serves as one early indication of impending changes in business activity. The commodities used are in most cases either raw materials or products close to the initial production stage which, as a result of daily trading in fairly large volume of standardization qualities, are particularly sensitive to factors affecting current and future economic forces and conditions. The composition of the groups are as follows:  Metals, Textiles and Fibers, Fats and Oils, Raw Industrials, Foodstuffs.

Source: Bloomberg. Commodity Research Bureau BLS/US Spot All Commodities (CRB CMDT Index). Daily data as of 5/11/2020.

Investor Warren Buffett summed up the situation very concisely at his annual meeting: “You can finance a deficit as long as your currency holds up.” It’s about debt sustainability. With 10-year Treasury yields at about 0.68% and 30-year yields at 1.30%, the U.S. can sustain high debt for a long time—unless investors lose confidence in U.S. policy.

The world’s financial system is more dependent on the dollar than ever. The vast majority of global transactions take place in U.S. dollars. Central banks around the world hold U.S. dollars—and therefore Treasuries—for these transactions. Over time, the debt issued in U.S. dollars has grown sharply—especially debt issued by emerging-market countries and corporations. All of these factors keep the demand for dollars firm.

Over the next one to two years, deflation is probably more of a risk than inflation. The recovery from the COVID-19 downturn is likely to be slow, keeping inflation and interest rates low. As the economy mends, the Fed will gradually unwind some of its emergency lending. As loans get repaid, the Fed will let some of its holdings roll off its balance sheet and start lifting interest rates—perhaps two or three years from now. The Fed will keep the federal funds rate pegged near zero for at least two years, and ten-year Treasury yields to remain under 1% in 2020 and under 2% in 2021. That’s the view of some U.S. analysts including Kathy Jones who examined the above topic.

 

What about Malaysia?

The temptation to “print” is there. But we are not the U.S. Our Ringgit is not the currency for trade. Thai or other foreign traders don’t want our Ringgit. So it is best to keep the feet off the paddle and resuscitate the economy measuredly.

We need stable exchange rates of RM3.80 to RM4.00 to the U.S. dollar. That will cushion any imported inflation and allow for businesses to consider expansion. Meanwhile, fiscal policy must remain targeted and expansionary to generate growth in the services and manufacturing sectors. And hopefully the Government responds to the private sector.

 

References:

1. Stimulus=Inflation? Why it may be different this time, Kathy Jones, (https://www.schwab.com)

2. Where is all the inflation? Tony Yiu (https://medium.com), 30 September 2020