The moderate inflation we were experiencing prior to the COVID-19 outbreak has fallen off a cliff. Yesterday we received word that the Consumer Price Index (CPI) grew at just 0.1% year-over-year in May, down from a recent high of 2.5% in January of this year. If we adjust for the volatile categories of Food & Energy, the CPI was up just 1.2% year-over-year. The drop is unwelcome news for the Fed, which has been trying to stoke inflation for the better part of 11 years and is now contending with a collapse in demand associated with the COVID-19 epidemic. It may seem counterintuitive that the Fed is trying to increase inflation right now. Why would the Fed want to force consumers and businesses to pay higher prices in the midst of a severe economic downturn? Wouldn’t everyone be much better off if prices were falling? Well, there are two major reasons why the Fed is intently focused on fanning the flames of inflation, especially right now.
Why is Inflation a Policy Goal?
1. Higher inflation makes it easier for individuals, businesses or governments to manage their debt burdens, which in many cases are exorbitant following many years of artificially suppressed interest rates and the negative effects of COVID-19. The easiest way to explain this is to consider the case of a company that has borrowed aggressively in order to buy back stock and/or survive the effects of COVID-19. If inflation is +2% rather than 0%, the company will be able to charge higher prices for its products and services. Higher prices will lead to higher revenues, which can be used to pay interest on debt or to pay down principal balances.
You may have heard someone say that the Fed will try to “inflate our way out of debt.” Given the massive deficit spending in response to COVID-19 and the expected growth in entitlement spending, higher inflation may indeed be our best hope for restoring some semblance of fiscal responsibility. Incidentally, if you’re asking yourself why investors in US Treasuries would put up with such a scheme, then you get a star for today! The answer is that Treasury investors aren’t necessarily convinced that the Fed will be successful in generating enough inflation to offset the defensive characteristics associated with owning US government debt denominated in US dollars right now. Or they may just believe there will be plenty of time to exit positions before the inflation surge takes place. (Probably more of the latter).
2. The second reason that a little inflation is always better than no inflation is that steadily rising prices incentivize consumers and businesses to spend money now rather than waiting. Think about it. Would you buy a car today if you expected the price to drop 5% in six months? Probably not. By having a policy target of 2% inflation, the Fed is trying to stimulate economic activity in the here and now because, well, in the long run we’re all dead (elbow bump to Keynes). And nobody wants to end up like Japan, which has struggled with deflation and the associated economic weakness since the 1980s. You simply can’t get consumers and businesses in the mindset that it’s better to defer spending and investment. It’s crippling to growth. One final thought on this: Though the Fed is supposed to be independent of political influences, politicians seeking re-election can and usually do find ways, both subtle and not so subtle (tweeting), of influencing monetary policy. As such, the path of least resistance for price levels in normal times is higher rather than lower.
Inflatophobes
With that out of the way, we arrive at the real focus of this Market Commentary: What should we be more afraid of right now, inflation or deflation? It turns out it depends on who you ask, and the gap between the opposing opinions couldn’t be wider. Those in the inflation camp, who we’ll call Inflatophobes, are worried that trillions of dollars in fiscal and monetary stimulus designed to boost growth and combat the effects of COVID-19 will eventually (and inevitably) lead to surge in inflation. Inflatophobes are guided by Milton Friedman’s famous line that “inflation is everywhere and always a monetary phenomenon.” If we are constantly pumping vast amounts of liquidity into the global economy, it only stands to reason that demand will eventually spike higher and therefore prices will rise. The problem with this viewpoint is that the system has been flooded with liquidity since the Global Financial Crisis (GFC), and price levels have never reached the Fed’s target of 2% on a sustainable basis. Instead, and to the great frustration of some policymakers and central bankers, the stimulus was far more successful in goosing prices for financial assets. The investment gains have created massive wealth for those fortunate enough to have owned the assets. Inflatophobes believe those asset price increases will eventually contribute to more widespread inflationary pressures across the economy.
Deflatophobes
Folks who are more worried about deflation, who we’ll call Deflatophobes, believe that there is an oversupply of just about everything in the global economy. Deflatophobes believe that the problem of oversupply is largely the result of globalization and technological innovation, but that the Fed’s artificial suppression of interest rates over a 10+ year period has only made the problem worse. Access to ultra-low cost capital, they believe, has been keeping otherwise economically unviable companies afloat, and therefore the culling of the herd associated with normal business cycles has simply not been allowed to take place. Moreover, the ongoing focus of fiscal and monetary policies on the supply side has not worked in boosting demand and accelerating economic growth, and it is unlikely to work now. But that’s not keeping the powers that be from doubling down on their bets. Faced with a collapse in demand related to COVID-19, the Fed and federal government are extending lifelines to a huge number of companies through grants, loan guarantees and tax cuts. Absent a big rebound in demand, these actions could eventually exacerbate the problem of oversupply. The most obvious supporting evidence for the Deflatophobe point of view is the energy sector, which experienced a supply shock (and price collapse) in the form of a US production surge fueled by low-cost capital and new technologies (hydraulic fracturing).
Which school of thought is right? The answer to this question may largely be determined by several factors:
1. Is the COVID-19 epidemic having a greater negative impact on demand or supply? It is easy to understand that a collapse in demand can have deflationary consequences. But it is also true that work stoppages and supply-chain disruptions can lead to severe shortages, which would normally cause prices to rise. Walmart CEO Doug McMillon said the following in a recent presentation: “Our supply chain is amongst the most capable in the world. But in this environment, we’ve stretched it. Not only had products in categories like hand sanitizer, disinfecting wipes and sprays, toilet paper, beef and pork been hard to find, but items such as laptops, office chairs and fabric have been cleared out in some of our stores and online. We’re working to recover our in stock position as we begin the second quarter.” The impact on price levels at a macro level will be determined by the relative contractions in supply and demand for countless goods and services across the global economy.
2. While the downward shift in demand related to COVID-19 could eventually fully reverse, recent supply-chain disruptions may linger. The trade war with China had been disrupting supply chains, raising production costs, and putting some upward pressure on prices well in advance of the virus’ arrival. It is hard to predict the ultimate fate of US/China trade relations, but it sure seems like both presidential candidates are intent on painting the Chinese as adversaries for a variety of reasons (including COVID-19). Many economists and political analysts believe we are at the beginning stages of a long-term trend toward deglobalization (for the record, I’m not convinced). If so, that would clearly be supportive of higher price levels.
3. Will the unprecedented flood of monetary and fiscal policy finally prime the pump for sustained increases in consumption, bank lending and corporate investment, or will the massive liquidity injections simply further inflate asset prices? Throughout much of the economic recovery from the GFC, central bankers became frustrated that ultra-low interest rates and massive bond purchases were not having their intended effect on the pace of economic growth. The problem was that lingering fears and tighter regulation were inhibiting bank lending. Instead of using the Fed-supplied liquidity to make loans, banks simply deposited the money with the Fed, and the primary beneficiaries of the liquidity injections were financial assets (stocks, bonds, real estate). As a result, we were not able to break out of the relatively low 2% economic growth. Looking forward, we will have to see the new liquidity injections be put to better use if we are to expect a more rapid economic recovery. If not, it’s hard to see inflation getting out of control any time soon.
4. Finally, I would be remiss if I did not mention the impact of economic inequality on economic growth (and therefore inflation). Prior to the COVID-19 outbreak, moderate-income folks did start to see a little better income growth following a couple decades of stagnancy. Those improvements were largely the result of very low unemployment, which has now spiked as a result of COVID-19. Fortunately, Congress acted quickly to replace lost jobs and income through expanded unemployment benefits, stimulus checks and loans to businesses in exchange for maintaining payroll. However, many of those benefits will expire in relatively short order, and the impact of the virus will ultimately be most painful for those in the bottom half of the income scale. If the economy does not quickly rebound and restore some relief for those most affected, it’s hard to see how price levels, especially for discretionary good and services, can spiral out of control.
Measuring Inflation
Complicating the inflation question is the problem of the accurate measurement of price levels. In my opinion, there are a couple of glaring concerns with using the CPI, and similar metric like the PCE price index, to gauge price levels, particularly at this time. First, the business shutdowns and self-quarantines associated with COVID-19 have dramatically changed the spending patterns for nearly all US consumers. For instance, some categories of spending, like food away from home and air travel, have dramatically decreased while others, like food at home, have increased sharply. But the weightings used in the calculation of the CPI have not changed to reflect the shifts in spending. Therefore, the CPI is currently overstating the impact of price changes for more discretionary expenditures while understating the inflationary impact of less discretionary expenditures (necessities).
The second problem with CPI is a more systemic one. Do the weightings used for the spending categories in the CPI accurately reflect a cross section of Americans? In other words, is it realistic that most regular Americans are only spending 14% of their money on food and 7% on medical care services, for example? If not, is it right to base policy on metrics like CPI? Again, our concern is that CPI places undue emphasis on discretionary expenditures and not enough emphasis on non-discretionary expenses (necessities). A quick look at the table below will show that the prices for the latter category (in yellow) continue to grow at a much faster pace than the former.
Conclusions
What are our conclusions? I can think of several.
- First, it appears that over the near term COVID-19 is having a greater impact on aggregate demand than aggregate supply. However, if we experience a rapid recovery in demand as economies in the US and across the world begin to reopen, that imbalance could be quick to resolve. It stands to reason, then, that if we are indeed past the worse stages with regard to COVID-19 (I’m not yet convinced), then the short-term disinflationary pressures we are seeing may start to subside in relatively short order.
- Second, the impact of technological innovation and globalization have clearly had huge disinflationary implications for the global economy. But while we may be at the initial stages of a reversal in globalization (I’m still not convinced of that either), the effects of technological innovation will continue to be disinflationary, and possibly at an accelerating pace. There is simply no way to hold back the flood of technological advancement and creative destruction. We see evidence of it every day. One point for the Deflatophobes.
- There is a more-than-trivial risk that, at some point, the massive amount of liquidity being used to defend against COVID-19 will cause an inflationary spike that will be hard to control without substantial pain for all. However, this scenario would require 1) no meaningful follow-on outbreaks of COVID-19; 2) a dramatic improvement in consumer and business confidence, which we might refer to as “animal spirits”; 3) the successful transmission of liquidity injections into the real economy rather than just toward further asset price inflation; and 4) a broadening in the benefits of the economic recovery to include a larger portion of the middle class, which had been largely left behind up until the final stages of the last expansion.
- The Fed has been making policy decisions using bad data. The central bank continues to largely ignore 1) the inflation in asset prices, which dramatically increases the cost of saving for retirement; and 2) the fact that inflation has been running much higher for non-discretionary goods and services than it has for discretionary goods and services. The effect of using bad data has been that the Fed has consistently underestimated the amount of inflation in the economy, and therefore their dovish policy decisions have exacerbated economic inequality and could eventually lead to a situation whereby inflation gets out of control.
- Two factors have been incredibly supportive of economic growth and wealth creation in the US over the past 3-4 decades: 1) low inflation; and 2) the dollar’s status as reserve currency to the world. These factors have enabled the Fed and federal government to repeatedly inject expansionary monetary and fiscal stimulus to support hiccups in growth (and with very few repercussions). Our fear going forward, then, is that too much of a good thing could backfire. The massive growth in the Fed’s balance sheet, coupled with a surge in US government debt, could finally kill the golden goose. And a decline in the dollar, whether due to a surge in inflation or loss of confidence, would likely be a big hit to investors in US assets, who have operated under the assumption of US dominance for decades. Let’s hope it doesn’t come to that, but it can’t be ruled out.
The ultimate outcome of the inflation debate could have a profound impact on investment returns in the years to come. The economy had already become heavily dependent on low interest rates, and the effects of COVID-19 will intensify that dependency. Therefore, the Fed will be forced to walk a fine line. It must both avoid a Japanese-style deflationary spiral while also preventing the kinds of inflation that can destroy savings and cripple those living off fixed incomes. Oh, and they also need to ensure against asset bubbles, which played a major role in the past two recessions. What’s the best investment strategy for a backdrop such as this? First, investors need to lower their return expectations and avoid swinging for the fences. Second, bond and equity investors need to ensure that their investments are high-quality, meaning that the issuers of those securities should have relatively low debt and the financial strength to withstand whatever may come. Third, investors should target issuers that do not have a heavy dependence on the capital markets to fund operations. And finally, there is no substitute for a seasoned management team that has been through crises before. These are the types of investment attributions we at Farr, Miller & Washington favor for client portfolios, and we think they make most sense in the present uncertain environment.
Farr, Miller & Washington 