Think like the Fed

17 September 2020

We have noticed an increasing amount of commentary about the outlook for inflation and that over the next couple of years we might actually see some increases. Central Banks have spent the last ten years trying to get some acceleration in this, but with little success. The Fed, in its recent policy change (see Dermot O’Leary’s recent Economic Monitor for more details), has added further strength to this by saying that it will not raise rates until inflation has gone above target, the so-called averaging process. As Dermot outlined this will have economic and financial market repercussions. But there is one other underlying message in it. The Fed does not believe its models can predict the inflation rate. It will not react until it sees it. 

If the Fed cannot predict inflation should we be trying? 

For us in Wealth Management it is not predicting the actual rate of inflation that is the important thing. It is getting the trend right and making sure our clients’ portfolios benefit if we are right but do not suffer unduly otherwise. So, it becomes an issue of assessing the probability of the different outcomes:

a higher or an unchanged rate of inflation. To judge that, and it will be judgement, one must assess the case for each outcome. 

Case for the prosecution: inflation will be higher

It is true that central banks have been allowing the ‘printing presses run at high throttle’ over the last five to ten years and this has had no impact on inflation. The problem was that much of the money created went back to the central banks as commercial banks rebuilt their decimated balance sheets and had to comply with new regulations for higher levels of reserve capital. Now we are seeing central banks moving towards ‘full throttle’ (the Fed is already there with unlimited QE) and much of it will be used to finance budget deficits which will get spent in the real economy raising the velocity of money and with it inflation. This is the central plank of the case for higher inflation but there are other developments.

Since China joined the WTO in 2001 there have been strong deflationary pressures as supply chains were adjusted to take advantage of the lower cost base there. Since the election of President Trump this process has come under pressure. No matter who wins the US elections in November this is likely to continue and going forward we are likely to see de-globalisation and with it rising price pressures.

There will also be the psychological impact of the Fed’s change in policy. If it is not going to do anything until inflation moves above target, then everybody’s inflation expectations increase and become a self-fulfilling prophecy.

Case for the defence: no change

The disbelievers base their case on the three D’s. Disruption (read: technological innovation), debt and demographics. They argue that the drivers of the inflation rate are structural forces rather than cyclical forces. In the recent past we have seen the impact of the information revolution across numerous industries leading to price disruption. Layers of middle men get removed as producers of goods and services move closer to their end customer base and consumers are enabled to ‘shop around‘ with greater breadth and freedom to find the best price. One result of the current pandemic (and we will be exploring these in more detail in upcoming Thematic pieces) is to accelerate these trends. Thus, you can expect greater deflationary pressure from these forces.

Debt levels in the private sector are elevated and this makes companies less inclined to increase prices and consumers to pay higher prices. With ultra-low interest rates this is not going to change. Along with this the population is aging and a population consumes less as it gets older. This process is going to continue.

The cyclical forces are not certain either as there appears little prospect of cost-push inflation. There is an abundance of cheap energy and commodities, debt capital is cheap and labour markets are far from robust. So even if governments do raise aggregate demand there is plenty of capacity to meet it without increasing prices. With respect to deglobalisation, leaps in factory automation and developments in the ‘internet of things’ leaves this development somewhat redundant and certainly of much lowered influence.

So, where do we stand?

To come to a judgement, we must consider whether the drivers of inflation have changed and if so to what extent. Many of the structural forces have been with it for some time but we must concede that they seem to have a got a recent boost and hence could be somewhat stronger. The stalling/reversal of globalisation may not be inflationary, but it does look like a deflationary force that is gone. The arrival of more active fiscal policy is something new but we must also be conscious that a major part of the reason for it being there is the slack that has appeared in economies so it may not be all that inflationary.

And what have we done about it?

Overall, we feel that there is likely to be greater inflationary pressure over the next couple of years primarily due to the combination of extremely loose monetary and fiscal policy. However, we do acknowledge the structural forces which have been impossible to forecast. Hence we would have ‘soft positions’ in portfolios to reflect some inflation risk. At the asset selection level, we are over-weight property and equities, the inflation hedges, and underweight fixed income. Within fixed income we have exposure to the high yield sector and relatively low exposure to government debt. But we still have some - the case for higher inflation is not strong enough to abandon the anchor of government bonds. Within equities we would not have a strong inflation bias but there are other influences at work there. We are still looking for quality growth rather than cyclical growth with low exposure to the inflation sensitive commodity sectors as the case for higher inflation is not yet strong enough to change this.

When we discuss inflation internally, we feel a bit like the Fed. We can see the theoretical case for why inflation should move up from here. But the forecasts of inflation have been very poor and we need to see some evidence before taking extreme action. If it’s good enough for the Fed it’s good enough for us.

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