Great Inflation Debate: When and How Big?

Mish

Jim Bianco at Bianco Research shares his views on inflation and when the Fed will hike.

When and Why Will the Fed Hike?

This is a guest post by Jim Bianco who explains his views on When Will the Fed Hike and Why.

Summary

The market is starting to see a Fed hike on the distant horizon. This is how a shift in thinking begins. The driving reason for this change seems to be a resurgence of inflation over booming real growth.

Over the summer the Fed started suggesting they would hold off on any rate hikes for years. In late July (brown line) the market was flirting with the idea of negative rates, as shown by the fed funds futures curve.

By late October (blue line) the forward curve was back to positive, but still not pricing in a rate hike for years. A rate hike is expected when the implied yield is above 0.125%.

The combination of the election and Pfizer’s vaccine news resulted in the fed funds curve jumping higher (cyan and red lines). This morning (orange line), the market is getting closer to pricing in a 2023 rate hike. 

This is how a shift in thinking begins. The market prices in a distant hike and then starts to move it closer and closer to the present as data warrants.

Why Is This Happening?

The surge in risk assets suggests the market is expecting booming real growth to be the catalyst for the shift toward a more hawkish Fed.  

The next chart shows the jobs lost from the pandemic (cyan) and the projection of non-farm payroll growth from a survey of about 70 economists conducted by Bloomberg (shaded area). To date, over 10 million jobs lost to the pandemic have yet to be recovered (green line). This shortfall is expected to be cut to 4.7 million jobs by the end of 2021 (cyan line). Given the Fed’s preference for jobs over inflation, this means there should be no talk of the Fed hiking rates. Yet the market is inching toward that reality.

Restoration of Jobs

Tracking the restoration of jobs

This same survey of economists expects economic growth to slow to pedestrian levels between now and the end of next year. No estimate, even after factoring in the election and vaccine news, expects real GDP growth to top 4% through the end of 2021. It is too early to consider 2022 forecasts.

With these levels of expected growth, real GDP is not expected to recover its previous peak (Q4 2019) until Q4 2021 (black line).

Measuring the Expected GDP Contraction

Measuring the Expected GDP Contraction

All of this is to say there is no reason for the market to start thinking about rate hikes, or even higher long rates. But that is what is happening. Why?

We believe the market is pricing in a higher likelihood of inflation. 

The next chart shows the 10-year inflation breakeven rate continues to move higher, suggesting more future inflation is being priced in.

US TIPS 10-year Inflation Breakeven Rate

US TIPS 10-year Inflation Breakeven

But it is important to define “high inflation.”

According to the Fed’s preferred measure of core PCE, a move above 2.5% on a year-over-year basis would essentially be a 27-year high in inflation. We would define this level as high.

Core PCE

Core PCE Bianco

The next chart shows core PCE on a rolling 5-month annualized basis. In the five months ending in April 2020, when the pandemic really began taking hold, prices declined the most in a generation. During the re-opening (five months ending in September 2020) prices rebounded at their fastest rate since the earlier 1990s.

5-Month Annualized Core PCE

5-Month Annualized Core PCE

We do not expect prices to continue to accelerate at this level, but we do expect prices to continue to advance enough to challenge 2.5% on a year-over-year basis next year.

Why Will Inflation Advance?

Above we showed that the economy is below potential and will not recover the lost GDP for years. This means less supply that should help reduce excess capacity in the economy, especially given population growth is not reversing so the demand for goods and services is not going to wane as much. 

In addition to reduced supply, the stimulation of demand has been unprecedented. As the next chart shows, the government’s total outlay (spending) was over 33% of 2020’s GDP. In the 200+ years show, the government only had a bigger footprint on the economy in the war years of 1943 to 1945 (note the government’s fiscal year ends September 30, so 2020 is the full year).

Total Government Outlays as a Percentage of GDP

Total Government Outlays as a percentage of GDP

This spending has led to massive government borrowing. This has blown out the deficit to $3.13 trillion (top panel), or more than 16% of GDP (bottom panel).

The U.S. Federal Deficit

The U.S. Federal Deficit

16% of GDP is rarefied air for the deficit. Only the year after WW1 (1919) and the WW2 years of 1943 to 1945 were larger.

Surplus or Deficit as a Percentage of GDP

Surplus Deficit as a Percentage of GDP

The chart above shows huge deficits relative to GDP in 1864, 1919, 1943 to 1945, and now. As the chart below shows, all these periods aligned with bouts of high inflation.

Huge deficits mean huge spending. Huge spending bids prices higher, otherwise known as inflation.

Year-Over-Year CPI Back to 1800

Year-Over-Year CPI Back to 1800

Why Does Inflation Matter?

Think of the Fed as a post and the bond market as a horse tied to that post. The horse will remain in place, tied to that post, unless spooked by inflation. The horse has the ability to rip that post from the ground and run wild. The post cannot stop a scared horse. 

We have argued the 0.33% low in 10-year yields on March 9 marked the end of the 39-year bull market. Rates should be moving higher, but they are being suppressed via massive QE. At some point we expect the “horse” to tear the post from the ground and start running with higher yields.

End Bianco Guest Post

According to Bianco, the Horse has not yet left the barn, but the Fed cannot keep the horse penned in forever.

That's quite the presentation and a very good case. 

If we factor in housing prices, inflation is already roaring. 

Case Shiller Composite Indexes

Case Shiller Composite Indexes 2020-11

I would be more convinced of an inflation surge had Democrats won the Senate and Progressives got the agenda they wanted. 

A longs as Republicans control the Senate the agenda will not go totally bonkers. 

Yet, it is hard to say what bonkers even means. No one even bats an eye at talk of $3.13 trillion deficits.

The Wall Street Journal notes Investors Bet Economic Recovery Won’t Spark Jump in Inflation

“The big picture view is that the disinflationary effects of the pandemic are outweighing the inflationary effects,” said Gero Jung, chief economist at Mirabaud Asset Management. “We think inflation will come down even further” in the short term.

Longer term, expectations haven’t changed significantly. The U.S. 10-year inflation break-even rate, a measure of how much inflation investors expect annually over the next decade, was largely flat at 1.72% on Wednesday, compared with 1.77% at the end of last year. At this year’s highest, it was about 1.8% in August.

We’ve been long inflation, with a positive view on the recovery story, particularly because of very loose monetary and fiscal stimulus working in tandem. Now we’re starting to question that,” says Adam Skerry, a rates and inflation fund manager at Aberdeen Standard Investments.

Two Inflationary Tail Risks For US Investors

Lacy Hunt at Hoisington Management is still a bond bull, but he has concerns about what the Fed might do.

Hunt sees Two Inflationary Tail Risks For US Investors

We identify two tail risks for long term Treasury investors: (1) a huge new debt financed fiscal package and (2) a major change in the Fed’s modus operandi. The first risk would change the short-run trajectory of the economy. This better growth, although short lived, could place transitory upward pressure on interest rates in a fashion that has been experienced many times. Over the longer run, disinflation would prevail and the downward trend in Treasury yields would resume.

The second risk would bring a rising inflationary dynamic into the picture, potentially becoming much more consequential. As this dissatisfaction intensifies, either de jure or de facto, the Federal Reserve’s liabilities could be made legal tender, or a medium of exchange. Already, the Fed has taken actions that appear to exceed the limits of the Federal Reserve Act under the exigent circumstances clause, but so far, they are still lending and not directly funding the expenditures of the government in any meaningful way. But some advocate making the Fed’s liabilities spendable and a few central banks have already moved in this direction. If the Fed's liabilities were made a medium of exchange, the inflation rate would rise and inflationary expectations would move ahead of actual inflation. In due course, Gresham’s law could be triggered as individuals move to hold commodities that can be consumed or traded for consumable items. This would result in a massive decline in productivity, thus real growth and the standard of living would fall as inflation escalates.

Questions

What will Congress do for those who don't have job? 

Those who kept their job and are working at home got a huge income boost. 

What about asset prices? The Fed targeted the stock market and that boosted home prices as well. 

A sustained plunge could be quite deflationary but I have given up attempting to figure out when bubbles will pop. I sit in gold instead.

Open Mind

My readers know that I have dissed most inflation claims for years, decades actually, (at least as the Fed and BLS calculate inflation).   

Now I have an open mind as the bond market is flashing some warning signs and so is the Fed as observed by Lacy Hunt.

Lend vs Spend

It's important not to confuse the Fed's ability to lend with ability to spend.

Here is Lacy Hunt in a Bloomberg Interview in August 2020

Bloomberg: Lastly, I want to ask you about the rise of Modern Monetary Theory within economics, and some proposals to have the Fed give money directly to individuals.

LH: The great risk is that we become dissatisfied with the way things are, and either de jure or de facto, the Federal Reserve’s liabilities are made legal tender. The Federal Reserve as it’s constituted today can lend but it cannot spend. Now, they’ve done some things that are different from what the Federal Reserve Act said under the exigent circumstances clauses, but so far they’re lending. 

LH: There are folks who want to make the Fed’s liabilities legal tender. Now, if that happens, then the inflation rate would take off. However, in very short order, everyone would be totally miserable because no one would want to hold money. You would trigger Gresham’s Law — people would only want to hold commodities they can consume and commodities that can be traded for others. 

LH: But there is that risk that you could use the Fed’s liabilities to pay directly. The Bank of England has made a small move in that direction — they say it’s temporary. There are others that want to try that because they’re frustrated with the fact that issuing the debt is not getting the job done. So we could significantly alter the whole structure of the U.S. economy. But if you use the Fed’s liabilities for directly funding goods and services, the consequences could be very extreme and very quick.

For the full interview and a followup discussion, please see Bond Bull Lacy Hunt Warns of a Huge Monetary Risk

Is the Bond Bull Over?

Keep your eye on the treasury barn door. I would not at all be surprised if the 0.33% low in 10-year yields on March 9 marked the end of the 39-year bull market. 

What Value Remains? 

If you believe as I do, that the Fed will not take interest rates negative, what value in the 10-year treasury remained at 0.33%? 

Now at 0.85% perhaps one can find 50 basis points of "value" with a risk of 200 to 300 basis points of losses.

There is more value but also more risk in the 30-year long bond yielding 1.56%.

Why Not Negative?

The Fed can easily see negative rates hurt Japan and the ECB. Whereas the the ECB punished banks buy charging them interest on excess reserves, the Fed slowly recapitalized US banks over time by flooding the banks with excess reserves then paying them free money all the while.

The Fed might try other tactics such as making the Fed's liabilities legal tender, but that would have Hunt headed for the the door in a flash.

Hello Fed, Low Interest Rates Do Not Promote Growth

For further discussion of these ideas including negative rates and a recap of Lacy Hunt's position, please see Hello Fed, Low Interest Rates Do Not Promote Growth.

All bull markets come to an end. This end will have fireworks if the Fed does the wrong thing.

Mish

Comments (42)
No. 1-24
Eddie_T
Eddie_T

Nice piece.

My first thought is that maybe the markets are also pricing in MUCH more helicopter money. Helicopter money was always going to cause inflation, because it puts money into the hands of people who will actually spend it, rather than the .1% class of elites, who hoard wealth and don’t need to spend.

Eddie_T
Eddie_T

Another interesting conundrum is stagnant wages.....and how UBI might (or might not) be the fix to keep deflation at bay......rising wages have always been inflationary....but now "rising wages" seems to be a quaint, outdated concept.

You can make a case that UBI is a reasonable thing to do in a world faced with strong deflationary forces and low wages.

I know you don’t see deflation as a problem......and I expect that has to do with the fact that you carry “deflation insurance” in the form of bullion.

I don’t fear manageable deflation....but history seems to indicate that deflation can hit like a ton of bricks....and lead to periods of massive unemployment and lots of bankruptcies.

The problem with carrying “insurance” is that it isn’t cheap.....gold doesn’t pay any dividends...if it makes great gains against the fiat currency and you want to sell some, you pay high taxes. And whatever portion of your portfolio is held in gold can’t be invested in markets that might pay a better return. It is that last pert that costs the most in a market like we have now.

njbr
njbr

The pandemic has accelerated the increasing irrelevance of proximity to activity.

Work, shopping, heath-care, etc.

It has also pushed more companies and industries to consider the use of more robots and technology as opposed to those pesky humans and their ills.

I would guess that 10 years of change has been pushed into the last year.

All of those factors negatively impact employment and compensation.

But it increases profits.

So, falling cost means lower inflation.

Deflation as far as the eye can see--the toothpaste is out of the tube.

PreCambrian
PreCambrian

I am not sure why you were so worried about a Democratic controlled House and Senate. Democrats have been more fiscally responsible than Republicans at least since George HW Bush left office. Republicans reducing taxes without reducing spending is at least as bad as Democrats increasing spending while increasing taxes on the highest incomes or trying to make business income tax a little more equitable across industries.

However I am in the same boat as you trying to figure out if inflation or deflation is in the cards. I am basically hedging both ways which is not productive for the economy. I think that the government needs to make productive investments (both in infrastructure and human capital) and let the chips fall where they may especially with regards to the stock market and financialization which do not contribute much to employment or the financial lives of most of Americans.

numike
numike

remember Utah? Utah hospitals have begun informal rationing of care, doctors say, as they cope with surge of COVID-19 patients

stanleyh
stanleyh
  1. instead of just housing prices, what about housing payment? I bought a condo for 200k 20 years ago and my payment was 2k/mo, now people are paying 450k in the same building, but paying about 2.5k because of lower rates.
  2. not everyone who stays at home saves more money. many working couples I know are paying for someone to watch their kids/help them with schoolwork while kids do school online instead of being physically at school. this could easily be 1-2k/mo
Scooot
Scooot

“The surge in risk assets suggests the market is expecting booming real growth to be the catalyst for the shift toward a more hawkish Fed.”

I don’t agree with this. Currently the pricing of risk assets is completely divorced from the economy, it’s a bit rich to suddenly try and argue that a move in short dated rates and bond yields is suddenly due to a consequence of an improving economy when we’re in the midst of a global recession/depression. There is currently a perception of no/less risk in risk assets because the Fed will buy any sell off. If there is a market perception of inflation on the horizon it’s not because of an imminent economic boom it’s because of continued monetary debasement of the dollar.

If it were not for The Fed and QE, bond yields wouldn’t be so low. Given the trillions governments are spending and vast issuance of bonds on the horizon, coupled with the Government’s stated intention to create inflation, one might have expected yields to begin to rise before hand. They haven’t because of the Fed acting as buyer of last resort. The fact they are beginning to do so now indicates to me the market is beginning to wonder whether the Fed will still be there to soak up the supply. The election is over so there’s no need to support markets for political purposes. The government needs to borrow trillions and they can’t afford to repay it, they need inflation and they’re trying hard to achieve it. So I think there will be more meaningful inflation on the horizon but not because of an imminent booming economy but because of debasement of currencies.

frozeninthenorth
frozeninthenorth

Hold on Mish, the tax cut that was past three years ago was a massive boost to the economy, since the deficit, as you noted, rose dramatically. It may be that you don't like the Democrat's social programs (that's your right) and you are more interested in having the 1% even richer than it has ever been, but Trump and the Senate passed a massive Keneysian boost to the economy.

The likelihood is that with a GOP senate you will have massive cuts to the government (like in the Obama years).

JonSellers
JonSellers

Mish is still viewing the world from a 1970's lens. The world has changed. There can't be a sustained growth in inflation because there can't be a sustained growth in wages. There will be a few one and done fiscal stimuli, but that will end up just driving the stock market further north. Stock market growth is the new inflation, hopefully that's where you're investing. Oh, and China will happily make up for any lack of surplus.

TaxHaven
TaxHaven

What "booming real growth"???? This is entirely, 100% the result of "investors" being led astray by CHEAP CHEAP CHEAP MONEY

There's nothing "real" about it

Doug78
Doug78

Sign of our times. A famous film director who job is making illusion for entertainment criticises famous engineer for making real things that will change peoples lives. Best example of hubris I have seen in a while.

numike
numike

“Sometimes people don’t want to hear the truth because they don’t want their illusions destroyed.”
— Friedrich Nietzsche

jivefive99
jivefive99

Interest rates will NOT be allowed to rise in any meaningful way because the Federal government and every other level of government, and most countries' governments,
and the corporations, and the individuals CANNOT afford to pay the debt service, unless you REALLY want there to be a global economic nightmare, not a cocktail conversation. Rates aint going up. They cant.

humna909
humna909

I concur with others here. Things are looking quite deflationary. I wouldn't expect that to change except with massive fiscal policy into the hands of the 95%.

ZZR600
ZZR600

So where to invest? Gold got hammered today

Doug78
Doug78

The new administration has to out-Tump Trump when it comes to economic performance . Austerity is out. I wonder if the ECB will take note and address the South part of their empire.

compsult
compsult

The inflation/deflation question haunts anyone who understands the fork in the road ahead. I agree with Lacy Hunt/Jeff Snider/Steve van Metre, that as long as the reserves stay inside the canyons of the Fed reserve bank, they are not dangerous.

Banks still must risk their own capital when lending against those reserves, and judging from C&I loans and the senior loan officer survey, they are lending less and tightening standards. But that could change, with Yellen as Sec of Treasury and increasing pressure on the Fed to "do something."

nzyank
nzyank

Hosehold wealth is at an all time high - and looking for a home - so we have high asset prices, stocks, home prices, bonds, gold, US$....due to emphasis on monetary policy over fiscal policy. Problem is this weath is held by a few, and most are struggling. Job losses will take a long time to recover on their own due to structural factors and inflation will not come back until the job situation is addressed. Asset price inflation and general price inflation of goods and services are very different.
Question is how best to unlock the weath held by a few, to get it more effectively working to grow the economy for everyone? My preference is a job guarantee program whereby Federal government initially prints money to fund guaranteed jobs for everyone that is out of work, or underemployed. The jobs would range from low skilled entry level & apprenticeships to highly skilled, and focus on areas of public benefit that are underserved by the private sector - public infrastructure, clean energy, environmental projects, social services, education, etc.
Inflation would be controlled by a robust MMT framework - when inflation indicators become present, taxes would be increased to soak up extra funds and demand - thus taxes would become part of monetary policy.

Realist
Realist

Many will tell you that inflation, by definition, is really the debasement of money, by increasing the money supply much faster than you increase the supply of what you can purchase. The average person on the street, however, thinks of inflation as rising prices, which are reflected in the official inflation rate. In addition, many will argue that the official inflation rate is severely understated. I am not here to argue any of these points. I’m here to talk about the future of inflation in terms of prices and the official inflation rate.

What have we learned from the past? Monetary stimulus from central banks by itself does not create price inflation or boost the official inflation rate. If it did, Japan would be awash in inflation.

Looking back at the inflation that occurred in the 1970s and 1980s, the situation was much different than what you have today. As Sechel correctly points out, back then, wages were able to increase nearly as much as the inflation rate. If the posted inflation rate was 6%, unions would demand 6% wage increases. A year later, with inflation running 8%, they demanded 8% wage increases. And so on. This increase in wages helped to keep the inflation game rolling along. It took Paul Volcker and 14% interest rates to stop the madness.

Today, wages are incapable of increasing because of a lack of unions, even more automation, and a global pool of workers all competing for jobs. As a result, there will be very little wage push inflation.

The monetary stimulus barely trickles down to the average person, so there will be very little demand push inflation.

Most of the monetary stimulus ends up in financial and housing markets, which are not reflected in the official inflation rate.

For the foreseeable future, there will be very little official inflation, even though prices of many things the average person actually purchases, will go up a little faster than the official inflation rate. Sadly, the average worker will likely not be able to keep up with those price increases because of an inability to get equivalent wage increases.

The slow decline in the standard of living in the US will continue for many years to come. All while the stats say that there is little to no inflation.

KidHorn
KidHorn

Even if the pubs win a senate seat in Georgia, don't assume they'll vote as a unified block. It will only take 1 or 2 to go against the party and with people like Romney and Collins, I wouldn't be shocked if the filibuster is voted out.

SarwarPedawi
SarwarPedawi

This is one of the most confusing times and no expert can tell whether to invest money in a particular avenue or keep it with them, whether to start out a business to stick to/find a job. We have been able to keep all our employees safe until now at Sarwar Pedawi Tech but I would be candid; it's been extremely difficult for me as a business owner.


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