One year after the first deaths due to the Covid-19 pandemic in the United States, the markets are questioning the amount of monetary and budgetary expenditure likely to revive inflation. Will the Biden administration’s plan to inject an additional $ 1.9 trillion into the US economy and vaccination programs be enough to trigger both a cyclical recovery and the re-emergence of inflation?
In the past, inflation was predictable. Too much money for too few goods drove up prices as high employment rates and rising wages allowed companies to pass higher costs on to prices. Inflation has almost disappeared from advanced economies now. During the great financial crisis of 2007-2009, the rise in the unemployment rate did not lead to a fall in inflation. Then, when the job market improved and unemployment hit its 50-year low in the United States in 2019, inflation failed to rise.
On the surface, the classic ingredients of an overheating US economy and inflationary environment are looming on the horizon. US inflation is expected to rise above 2% in the second quarter of this year as the impact of lower prices in 2020 wears off. This statistical “base effect” reflects the post-pandemic recovery which translates into lower unemployment, higher oil prices and a reestablishment of supply chains following temporary disruptions.
While mild inflation may seem welcome in the persistent cycle of low yields and subdued growth of the past decade or more, an overheating US economy would quickly make corporate debt unsustainable and have a devastating impact on emerging economies. Most central banks have used interest rates to keep inflation around 2% per year, thus providing savings in predictable long-term borrowing costs.
Has the outlook for sustained inflation growth changed? The answer is no. We estimate that inflation will remain below 2% in the United States for most of 2021, despite possible temporary and economically sound increases, which are necessary for the recovery.
Improving employment figures still have a long way to go. During the pandemic, the US economy lost at least 4.5 million jobs and is expected to create more than 100,000 per month just to keep pace with population growth. In addition, as the effects of the pandemic subside, economies reopen, and global trade accelerates, supply chain issues are expected to ease, stabilizing price pressures.
The challenges of the job market
On February 10, Federal Reserve Chairman Jerome Powell said it may be “many years” before the damage from persistently high unemployment is behind us. With pandemic unemployment disproportionately affecting young people, ethnic minorities and women, the consequences could be long-lasting. Mr Powell suggested that the Fed consider the different impacts on each demographic group, in order to arrive at a broader estimate of the number of unemployed.
“Achieving and maintaining a maximum employment rate will require more than an accommodating monetary policy,” he said. In addition, Mr Powell noted that even before the pandemic, when unemployment was at its lowest level in five decades, at 3.5%, signs of inflation were rare. Following its meeting this month, the Fed left its monetary policy unchanged, while keeping its options open. If Treasury bill yields were to rise and the yield curve steeper, the central bank could buy more longer-dated securities, and less mortgage debt.
Inflation concerns mainly concern the United States. The euro zone’s interest rate has remained unchanged throughout the duration of the pandemic and inflation has been negative since August 2020. The minutes released last week by the European Central Bank suggest the latter’s determination to make a clear distinction between a short-lived jump in inflation and a more lasting increase. “A temporary increase in inflation should not be confused with a persistent increase,” said these minutes. Germany, which temporarily lowered its value-added tax last month, saw its consumer price index rise by 1% in January compared to the same period a year earlier, and by 0.8 % relative to December 2020.
The experience of central banks over the past decade has made them more cautious. The ECB raised interest rates in April and July 2011 in response to a surge in inflation, as the eurozone crisis intensified. In 2013, the Fed changed its outlook for key rates, triggering the famous “taper tantrum”. Markets have interpreted the slowdown in asset purchases as a sign that a rate hike is imminent. As stated in the report referred to above, there is a “risk of cliff-edge effect following an abrupt end to their support measures for theeconomy. “
We believe that once economic activity returns to pre-pandemic levels through more sustained production and employment, there will be little structural impetus for stronger inflationary pressures. Indeed, we remain in the same low inflation regime that has prevailed since the great financial crisis. Certainly, we expect inflationary surges, as in Germany in January, but the economies of the United States and the euro zone will continue to underperform their long-term potential. The same pre-pandemic structural factors of an aging population, sluggish productivity and globalized supply chains will remain in place.
The main risk would be the Fed overreacting to signs of inflation with a rapid increase in interest rates. However, from a practical point of view, even this scenario was ruled out by its new approach to targeting inflation over the medium term.
For bond investors, rising inflation is still a challenge and we are underweight the asset class, particularly the investment grade credit segment and sovereign debt. The US yield curve could straighten more than in past economic recoveries, because the Fed’s “forward guidance” will keep short-term rates close to zero. At the same time, targeting inflation over the medium term is likely to fuel inflation risk premia for longer term maturities.. However, if necessary, the Fed could prevent a surge in financing costs and a fall in the bond market by potentially increasing its asset purchases.
Equity markets remain supported by the current environment and equities provide a natural, albeit partial, refuge from inflation. This should hold true as long as price hikes don’t eat into corporate margins, which tends to be the case as long as inflation stays below 3%. Inevitably, a period of reflation will require careful selection of companies and sectors that are likely to outperform the market as a whole.
Where is the limit?
Ultimately, the U.S. economy is testing the stimulus limit issue. At the moment, no one knows where it stands and, while the Biden administration’s proposals are in the process of being approved, a political compromise will arguably lower the initial numbers.
However, we believe the current fiscal measures look more like an economic bailout than a traditional economic stimulus, designed to stimulate a particular sector or region in the event of a short-term downturn. This means that their impact is inevitably less inflationary and that monetary policy will take a much more cautious approach than in the aftermath of the great financial crisis.
In any case, given that the Fed has a lot of leeway to raise rates in response to any signal of persistent inflation, it seems premature to worry about its resurgence. At least for 2021.
In the near term, the US economy is expected to experience a temporary rise in inflation, as prices, including commodity prices, recover from last year.
The Fed seems unlikely to respond with a tightening of its monetary policy
Fears of damaging inflation appear premature in 2021. The inflation outlook will remain weak as long as excess capacity persists
The Fed should be able to steer bond market expectations while equities offer partial refuge from inflation.