You can relax. The Fed has no intention to fight inflation (yet).
You can relax. The Fed has no intention to fight inflation (yet).
Fri 13 Aug 2021
You can relax. The Fed is (probably) not serious about fighting inflation.
When the French revolutionary Maximilien Robespierre embarked on an all-out war against the monarchy in 18th century France, he probably feared that his end would come at the hands of the Royal Executioner. But the French king was beheaded first. Then he feared that the Aristocrats would take revenge. But their heads also fell before his. Still, he saw enemies everywhere. As a result, nearly 300,000 were arrested and at least 30,000 lost their lives during his ‘Reign of Terror’.
In the end, what brought Robespierre before Charles-Henry Sanson, the High Executioner of the First French Republic (ironically previously the Royal Executioner), was the one enemy that could not be intimidated: inflation.
As the monarchy collapsed under the weight of failed economic policies, the new French government printed money called the ‘Assignat’. The greater the needs of the new bureaucracy trying to control a country in anarchy, the more money was printed. Between 1789 and 1794, the new currency had collapsed to 1% of its original value. The prices of goods and services soared, resulting in large-scale hoarding. People that were hungry under Louis XVI, grew even hungrier during the revolution. The government attempted to curb wage inflation. On 23 July 1794 the Commune limited the wages of employees, in some cases by half, provoking sharp protests and strikes across all of Paris. Five days later Robespierre was arrested and his own head promptly rolled in the Place de la Revolution, less than a thousand days after those of King Louis XVI and Marie Antoinette.
Inflation is a primary enemy of stability. Even at its most benign, it can become a very visible proof of policy failures. At its worst, it can equally topple the most brutal despots or the most stable democratic governments. It is no coincidence that the number one mandate of all central banks across the globe is price stability.
The current inflation
Except for the 2011-2012 Euro crisis, the Fed, the world’s de facto central bank, has not seen persistently high inflation in the past twenty years, a gift of China and globalisation. However, prices in western economies have been rising dramatically in the past few months, a confluence of pent-up demand, broad inefficiencies across a global supply chain gasping to re-stock and wage pressures from a workforce in disarray. US inflation tops 5% for the last three months. In the UK it is about half that, but it is still above the BoE’s threshold, and it could go higher.
In normal times, investors would have been modestly worried about such an inflationary event. Equities tend to underperform versus average when inflation hits and bonds lose value in terms of real (post-inflation) returns. This time around, the threat is much bigger. What is at stake is the way we have been investing for a decade.
Since 2008 asset returns have been consistently underpinned by the willingness of central banks to suppress risk by buying assets. Four attempts to stop ‘Quantitative Easing’ have resulted in market and economic stagnation. One strategy to reduce central bank balance sheets collapsed five months before Covid-19 became an issue. The cornerstone of the so-called ‘only game in town’, central bank accommodation, was low inflation. As long as prices remained in check, money printed by central banks was ‘real wealth’, circulated in the financial economy and inflating only the prices of stocks and bonds, not those of food and iPhones. Prices on the shelves remained relatively steady, but assets in pension investment accounts nearly doubled in the past decade. Hardly a cause for revolution.
The more inflation rises, the more the current monetary-driven regime is in danger. “Can the Fed continue to print money”, portfolio managers wonder, “when prices on the shelves rise at the current pace?”
Unconfusing the inflation debate
A big problem is that the inflation debate is confused. Interest rate hikes are often seen as a panacea for all price problems. However, this is simply not the case.
Inflation can be caused by high demand for goods, or limited supply, or both. Interest rate hikes and the cessation of Quantitative Easing are tools primarily designed to curb demand-side inflation. The central bank would raise interest rates to curb excess lending, which leads to higher demand and ultimately would cause a rise in the prices of products and services.
Is there evidence of demand-side inflation? Yes, but it is limited. Post-lockdown pent-up demand is petering out. In the US, the ‘labour participation rate of the economy’ (the proportion of the working-age population who are either employed or looking for a job) fell from 63.5% to 61.2% during the pandemic. The situation is similar across the world. This fall was enough for labour shortages to occur and push prices up. Prominent economists like Larry Summers are worried that these pressures will persist. However, central banks consider this drop transitory and expect labour supply to increase once Covid-19 childcare issues can be addressed.
Conversely, more convincing evidence points toward supply-side inflation. Energy costs are up 23% for the year. Dry cargo prices are at cycle highs and container rates are at all-time highs. Factory delivery times have not been as long in more than a decade. The Delta variant is making things worse for supply than demand. Western consumers are mostly vaccinated and have less fear of generalised lockdowns. Thus, demand is on its way to be streamlined. Vaccination rates for the developing world are still meagre. Only 20% have received both doses of a vaccine required to stave off Covid-related hospitalisation. The developing markets are home to 6bn people and the starting point of many supply chains.
The Fed has little incentive to hike rates
With inflation pressures coming mostly from the supply side, there is little the Fed can do to curb it. Interest rates are tools best used to cool down the economy during a mature, credit-driven economic boom. They are not designed for a recovering economy and much less for one still under the threat of a pandemic. Interest rate hikes could curb some excess demand, but they risk dampening consumers’ newfound optimism with very little to show for it. They would not fix supply issues, closed borders, lockdowns in emerging markets, delays in production, energy and transportation costs etc.
We believe the Fed knows this. We also believe that if it was serious about fighting inflation, the FOMC, the Fed’s rate-setting body, would not be forecasting minimal rate hikes in eighteen months, or some moderate tapering of quantitative easing by the end of 2021. To fight inflation, historically, one needs interest rates higher than the CPI. For a 5% CPI, the Fed would need at least 6% rates, now, not 0.75% in two years. Thus, they are willing to treat the present inflation factors as transitory, and they are willing to wait.
Even if this inflation bout lasts longer than expected, the Fed might welcome a modicum of inflation anyway to reduce the global debt burden, currently at an unsustainable 356% of annual global GDP. On the other hand, raising rates could risk indebted entities, many of which are national governments and consumer wellbeing.
A salient point for investors is that, whereas the Fed probably has no intention to fight inflation, it might take advantage of high inflation to ‘talk’ future rates up. By extending the short-term supply of money and ‘threatening’ rate hikes in the future, it can try to manipulate the long end of the yield curve higher, which helps the bond market stay alive and provides an incentive for banks to continue lending. It is also covering its bases in case it does need to push through fast rate hikes if demand-inflation occurs as a result of Mr. Biden’s fiscal stimulus package.
What this means for investors and our portfolios
For one, we would follow the decree of ‘looking at what the Fed does, not what it says’. Market consensus is also pursuing this strategy which is why bonds and equities have barely reacted to recent hawkish comments from the FOMC. We may even consider any surprise rate hike as a possible ‘policy error’.
It also means that we are less fearful of a rate-driven bond rerating in our portfolios. Markets may well decide by themselves that bonds are too expensive, especially in light of persisting inflation, and thrust long rate rises. But we don’t expect policymakers to go anywhere near this particular bubble. We have already been underweight bonds in our portfolios and are actively looking into ways we can further decrease risk, especially for the more conservative portfolios.