Letting the Air Out of Inflation Fears
Judging from our clients’ questions and news headlines, inflation anxiety goes beyond the typical concerns about Fed policymakers falling behind the curve as the economy recovers. The unprecedented government response to the deep recession has stoked fears of a fundamental shift away from the low and stable inflation environment that has prevailed since the early 1990s. Some fear that the United States could slip into a Japanese-style deflation, while others warn of a return to 1970s-style stagflation. The possibility of these scenarios has critical implications for investors.
Spare capacity is likely to cause disinflation in 2010
In traditional macroeconomic analysis, inflation (defined as a sustained, broad-based increase in prices) results from: (1) excess demand for goods or services relative to their supply (“demand pull”); (2) higher input prices (“cost push”); or (3) the expectation of future inflation which becomes embedded in pricing and wage negotiations.
The most important factor in the domestic inflation outlook is the amount of spare capacity in the U.S. economy. Spare capacity in an economic sector has had a statistically significant link to future inflation in that sector and is reflected in measures like the manufacturing capacity utilization, hotel occupancy, multi-family rental and office vacancy, and unemployment. Growth in the money supply is translated into inflation only to the extent that the money is spent on scarce goods and services. With spare capacity in the United States currently near record highs (see Table 1, below) in nearly every part of the economy, it is unlikely that demand will outstrip supply and result in inflation pressure.
With the possible exception of commodities, input costs do not look like a major inflation risk either. The biggest single cost for most businesses is labor. With unemployment at 10%, wage growth has slowed dramatically and typically continues to slow well after a recession ends. In the context of a recovering world economy and substantial monetary and fiscal stimulus, some increase in commodity prices is clearly possible. But commodity price spikes, if not accompanied by broad-based increases in incomes and spending, are inherently self-limiting. Other than in the mid-1980s, a year-over-year oil price increase of more than 50% has resulted in recession — except in the most recent economic expansion, where households managed to endure a five-year, more than three-fold increase in crude oil prices with the help of rapidly expanding credit and mortgage equity withdrawal.
Finally, current inflation expectations do not offer much reason for worry. From the household perspective, the latest Michigan survey of consumer sentiment reported median expectations of 2.8% over the next 5-10 years, just below the 2.9% average of the past decade. Meanwhile, investors’ expectations have been normalizing, with estimated inflation break-even rates for Treasury Inflation Protected Securities under 2%.
Analogies to historical high-inflation episodes are misleading
Debates about the inflation outlook with clients or in the media often lead to an assessment of historical parallels – why the current situation is, or is not, like past experiences. The most frequent analogy we hear is the “stagflation” of weak growth and high inflation in the US economy in the 1970s.
The recent economic environment in the United States has included volatile commodity prices, big federal deficits, and (in 2008) high headline inflation during a recession. These superficial similarities with the 1970s, combined with a weak growth outlook, suggest to some observers that we are in for a return of stagflation.
But with respect to factors related to inflation, the differences with the 1970s are far bigger than the similarities. The inflation of the 1970s was born in the “guns and butter” policies of the 1960s, with expanding military expenditures in Vietnam and domestic expenditures on “Great Society” initiatives. Growth accelerated and the unemployment rate touched a record low of 3.4% in late 1968. By that measure, spare capacity was at record lows in contrast with today’s near-record highs. Tight capacity, narrower profit margins, greater prevalence of collective bargaining in wage negotiations, and other factors such as greater unionization and indexation of wages fostered a broad-based wage-price spiral. Core inflation, wage growth, and inflation expectations accelerated from around 2% in the early 1960s to 6% in 1970.
When the Nixon price controls were lifted beginning in 1973, inflation surged, exacerbated by the sharp rise in oil prices. By this time, inflation had become embedded in household and business expectations. The problem of high inflation expectations was not resolved until the severe double-dip recession of 1980-82. Today, again in contrast with the 1970s, inflation expectations are near all-time lows.
Deflation is the bigger near-term risk...
Over the last 50 years, periods of disinflation invariably followed the end of a recession, so it would be natural for inflation to trend down over the next several years. If there were to be a big surprise in the next few years, the case for deflation looks stronger than for high inflation. Spare capacity could remain elevated well into the next decade if the U.S. and the other developed market economies experience a muted recovery, let alone a “double-dip” recession. This could eventually pull core inflation and inflation expectations into negative territory, reinforcing a downward spiral.
...but a deflationary spiral will be avoided.
The U.S. outlook has worrying similarities with Japan’s “lost decade” of stagnation and deflation, which also began with a bursting asset bubble and featured a full-blown banking crisis. However, the United States is dealing with a considerably smaller bubble (the Japanese stock market’s P/E ratio exceeded 50 at its peak versus a ratio under 20 in the U.S. market now) and has pursued a far more aggressive policy response. Rapid stabilization of the economy and financial system, combined with low and stable inflation expectations (thus far) should help the economy avoid a significant shift toward either inflation or deflation.
Our inflation expectations have important implications for asset allocation
Analysis of asset performance during episodes of inflation and deflation are limited to a few specific historical instances and are clouded by other factors. However, the differentiation between inflation scenarios is very clear. Bonds and cash outperform during deflation; equities or real assets hold value during periods of problem inflation. Due primarily to concern about paper currency, gold has outperformed on a relative basis in all of these undesirable inflation regimes, as it did in the most recent period leading up to the financial crisis.
While we are reluctant to make large tactical shifts in asset allocations, our portfolio recommendations reflect our expectations (described above) for economic and capital market performance. Responding to steep yield curves and credit spreads, our fixed income implementation uses bonds with longer duration and lower credit quality. The much higher yields on these bonds provide a cushion against rising interest rates and inflation. We believe that real estate and public equities, because of their higher growth potential and direct link to the sources of inflation, provide the most reliable protection against the long-term erosion of purchasing power. Finally, our commodity implementation, which includes an allocation to gold, protects against a commodity price spike while pursuing an opportunistic trading strategy which has paid handsomely in the oil and natural gas futures markets.
Jason Thomas, PhD, CFA
Chief Investment Officer