In an effort to stabilize financial markets and mitigate the economic fallout from the coronavirus lockdowns, the Federal Reserve has drawn on various monetary stimulus tools. The target range for the Federal Funds rate was lowered to 0.00%-0.25%, quantitative easing was restarted, and multiple funding and corporate credit facilities were rolled out to provide access to credit for struggling businesses and inject liquidity into fixed income markets. In eleven weeks, the Fed has increased its balance sheet by $2.9 trillion, more than it increased over the five-year period after the Global Financial Crisis. Traditionally, expansionary monetary policy measures are inflationary, as more money is chasing the same amount of goods. The scale of the current measures being put in place has investors keenly focused on the potential for a spike in inflation over the medium to long term. In our eyes, higher than expected inflation would be detrimental to most market participants and would be a very destabilizing force in general.
The Case for Inflation
Economic theory explains why increasing the money supply can lead to an increase in inflation. By increasing the amount of money circulating through the economy and putting that money into the hands of consumers, the Federal Reserve is attempting to spur economic activity. However, when that increase in the money supply isn’t accompanied by an increase in real economic output, inflation tends to be the result as more money chases the same amount of goods. Additionally, some of the effects of the COVID-19 crisis are likely to put upward pressure on inflation. Supply chains are currently in disarray as producers and suppliers are either permanently offline, still temporarily offline, or coming back online at varying paces. The combination of shuttered businesses and a collapse in business investment due to a highly uncertain economic outlook, could create a supply shock in multiple industries. Deglobalization rhetoric has also picked up due to the COVID-19 crisis’ impact on international supply chains. Many companies will have to balance the risk of international supply chain exposure with covering higher costs of producing domestically. In the end, it’s likely that more production will be brought back from overseas, which will likely push inflation higher as labor costs increase. Finally, expectations for future inflation play a key role in how inflation manifests. If expectations are for inflation to be higher in the future, consumers will typically demand higher wages to cover those higher expected costs. This can lead companies to raise prices to cover the higher labor costs and thus, inflation expectations can act as somewhat of a self-fulfilling prophecy.
Case Against Inflation
While the idea that more money results in higher inflation is sound in theory, it does not always occur in practice. A growing money supply is an important contributor to rising inflation, but the rate at which that money is spent is just as important. The rate at which money is spent is called the velocity of money and it has been falling steadily since the early days of the financial crisis. This could be occurring because of changing demographics (money in the hands of older and wealthier individuals), changing behaviors because of the Financial Crisis (increased capital requirements and higher savings rates) or some combination of both.
As COVID-19 continues to grip the world and economies remain partially shut down, we do not expect the velocity of money to speed up in the near term. Although we have witnessed a massive amount of stimulus over the past few months, we have also witnessed an equal, if not larger, loss in productivity. As of last month, the unemployment rate stood at 13.3%, the highest level since the Great Depression excluding the prior month’s reading of 14.7%.
Due to such widespread job loss and a change in consumer behavior, savings rates have spiked to 33.0%, while year over year Personal Consumption Expenditures (PCE) have fallen close to 17.0%.
The current stimulus has helped keep households and businesses afloat through this turbulent time, but it is unknown whether it will be enough long-term. The virus seems to be better under control than earlier in the year, however, we expect specific industries (restaurant, travel, retail) to remain under pressure as the virus lurks in the background. The case against short term inflation is sound as there will be permanent loss from the ongoing pandemic. Likewise, the recovery will be slow until a vaccine is created, or herd immunity is reached.
We expect to see disinflation1 or potentially deflation in the near term as aggregate demand remains under pressure. Due to the length and scale at which the global economy was shutdown, there will be permanent losses in productivity. With that said, inflationary pressures will begin to pick up as levels of travel, interaction, and spending return on the other side of the crisis. Due to COVID-19, we also expect behaviors to change dramatically down the road. Fewer tables at restaurants, less seats on a plane, and lower capacities at amusement parks will cause prices to increase in order for firms to maintain profitability. Companies may also implement measures to safeguard profits in the event of future supply disruption, which could also drive up operating costs. Lastly, we expect continued bankruptcies throughout various industries which will consolidate market share for specific companies, leading to more pricing power.
Investors are smart to be thinking about the impacts of inflation, however, we don’t expect much in the near term.
1A decrease in inflation
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