Awakening From a Deep Slumber: A Potential Jump in Inflation
I often tell my son when we’re driving home from school that before he can play games on his iPad he needs to finish his homework. This is a common behavior among parents and we do this to set expectations to try to reduce the chances for an argument. If I wait until my son and I walk in the door before telling him he must do his homework first, he’s far more likely to argue. What does this have to do with inflation? Everything.
Venezuela ended 2017 with an inflation rate that had climbed above 4,000% giving it the unfortunate title of the country with the world’s highest inflation. The regime of President Nicolás Maduro is printing money at an increasingly rapid rate since it cannot otherwise fund government operations. Inflation has been climbing for years and had risen to hyperinflation levels by the end of last year. People also see their diminishing buying power and adjust their behaviors accordingly by buying today knowing that tomorrow they will be able to buy fewer goods. And since goods, even necessities, are scarce, they buy whatever is available rather than what they want. In extreme cases inflation becomes hyperbolic. One of the best examples of this is Zimbabwe which eventually produced the largest bill ever printed –a whopping 100 trillion dollars.
Inflation expectations often drive the future behavior of those experiencing inflation and this is also true in the U.S.
When Paul Volcker became Chairman of the Federal Reserve in August of 1979, annual inflation had reached 10 percent. He determined that the best course of action was to massively increase interest rates. The Volcker led Fed doubled interest rates from about 10 to 20 percent from August 1979 to March of 1980. Yet inflation continued to increase, rising from 12% to over 14% during the same period. Why did this happen? It took time for the higher interest rates to have their desired effect. People expected inflation to be higher simply because it had already been moving up. Eventually those sky high rates squashed growth, which reduced spending, breaking the inflation cycle. But by accomplishing this goal Chairman Volcker also pushed the economy into recession. And it took a couple of decades under the leadership of Volcker and Greenspan to squeeze inflation down to moderate levels.
Today the US is experiencing inflation at a very different level than 1980. Inflation has been running between 0 and 2 percent since the end of the Great Recession and expectations and behavior reflects an environment where there is little in the way of inflation. Companies have kept salary increases at modest levels and haven’t needed to move them much higher. Employees have also been experiencing those modest increases and based on those experiences for the past 10 years have not demanded larger increases. Expectations have been set for a long time that it is normal to have very modest compensation increases. Over time, however, pressures build. Just as it took a long time in the 1960s and 1970s to increase inflation and inflation expectations and it took a long time to reduce inflation expectations, it is taking plenty of time to change behavior today.
Events are now aligning that are inflationary in the U.S. Widely known is the passage of major tax reform and a growth oriented budget deal, both of which will further increase inflationary pressures. But far less known is that in the months of March and April 2018 another event will occur–we will have lapped the one year mark of cellular service pricing declines. In April of 2017, the price of wireless-telephone services dropped by almost 13 percent from a year earlier. This was caused by intense competitive pressures among wireless companies as unlimited data plans were introduced at cheaper rates. The drop was large enough that it was estimated to have caused nearly half of the decline in core CPI. However, we are now coming up on a year since the large drop, and the one-time depressing effects on inflation will no longer be in the year-over-year data. This could easily cause a spike in inflation in March and April of 2018 by another 0.3 – 0.4 percent.
Markets are not fully prepared for this change. Investors, my son, and all of us, change behaviors significantly based on expectations. And the market does not seem likely to be anticipating this potential spike. This could easily lead to another bout of volatility in equity and bond markets. Bonds seem especially vulnerable. Tax and budget reform point to higher federal deficits that need to be funded. This spending gap is being financed by increased Treasury issuance which will create a spike in supply in 2018 and 2019. In 2017, about $1 trillion of Treasuries were issued. This will increase to around $1.5 T in 2018 and $2.3 T in 2019. At the same time, the Federal Reserve will be reducing the size of its balance sheet, which will also add to the market supply of Treasury debt. As Treasury supply increases while demand remains stable, yields should move higher and bond prices would thus move commensurately lower. Other bonds trade off of risk-free Treasury spreads and their prices should follow.
The impact of rising Treasury yields on equities is less clear. Equity valuations have declined due to the recent market correction, but more importantly, due to ongoing significant earnings increases both from tax reform and growth. It would not be surprising, however, to see another pullback if the inflation data shows a spike. For this reason, we are cautious for the next couple of months, particularly in advance of inflation data released in early April. None of this is to suggest that we’re about to embark on runaway inflation to levels seen today in Venezuela or in the U.S. in 1980. But higher inflation and an increasing federal deficit are likely to push the Fed to increase rates faster, and this increases the likelihood of a hard landing and recession. This is easily one of the top risks the U.S. economy faces over the next 24 months. This is still somewhat early. Inflation is still low. But the next 6 months may be telling regarding the scope and pace at which interest rates need to rise.
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