The Fed balance sheet is growing and the fiscal deficit is rising. But modest inflation will likely support risk assets.
The numbers are huge—and, in some ways, daunting. The policy responses from the Federal Reserve (Fed) and Congress are the most significant since World War II. The broad-based monetary easing could bring the Fed balance sheet anywhere between $7 trillion and $10 trillion in the coming quarters. The multiple phases of the fiscal response could push this year’s budget deficit to $3.7 trillion or higher, and total federal debt is set to breach 100% of GDP. Investors are reasonably concerned about how these policy experiments could go wrong. Could they mark a return to the rampant inflation of the 1970s? Is such a large government debt burden sustainable? What other risks might be lurking in the unprecedented policy response?
The risks are real, but shouldn’t be exaggerated. We believe that growing U.S. debt does not pose an imminent threat to the government’s ability to service its obligations at manageable interest rates. Nor do we expect that Fed programs or the government’s fiscal response will lead to materially higher inflation, especially in the near term, when we believe inflation risks are skewed toward falling rather than rising prices. To be blunt: The fear of hyperinflation is unfounded.
We’ll consider the interconnected issues—and explain why the risks are manageable—as we consider consumer prices, monetary policy, fiscal policy, currency and government debt.
Finally, we’ll examine the investment implications of our outlook. In a modest inflation regime (our base case scenario), bond yields are likely to remain at low levels, while equity prices and other risk assets should be supported. Still, inflation protection has a place in many portfolios, and in fact it is attractively priced in the current market environment.
Consumer prices amid COVID-19
In recent months we’ve seen growing concerns about the effects of rising inflation. But the April 2020 consumer price data tells us just how deflationary the near-term picture is: The 12-month change in the Consumer Price Index has fallen from 2.3% in February to just 0.3% in April, largely attributable to falling energy prices. Even excluding food and energy, so-called “core” prices exhibited the greatest monthly decline on record.
As lockdowns are lifted, economies will look very different than they did before the virus outbreak. Restaurants and airplanes will offer fewer available seats, music venues will sell fewer tickets, and global supply chains could easily be disrupted. Some sectors and companies may gain pricing power as a result of restricted supply, but we think the power will be limited and relatively short-lived.
The labor market and housing together account for roughly 55% of the U.S. Consumer Price Index;1 with healthcare at an additional roughly 10%. It’s hard to see much inflationary pressure coming from these main categories when the economy reopens. With surging unemployment, we don’t expect upward wage pressure, especially as wage growth was tame even pre-crisis when the unemployment rate was below 4%.
Major U.S. sectors unlikely to experience pricing pressure
The bar graph shows a breakdown of inflation (or the Consumer Price Index basket) into various components to demonstrate that a rise in prices in social distancing impacted industries due to supply constraints will unlikely induce high levels of overall inflation since the weight pales in comparison to the housing-driven and cyclical categories.
The monetary experiment: Increased liquidity, credit market support
Concerns about rising inflation are connected to the Fed’s forceful (and speedy) policy response. Some investors see the dramatic increases in the Fed’s balance sheet—up over $2 trillion in the past two months, to a current total of $6.7 trillion—and worry that the economy is vulnerable to hyperinflation or stagflation (weak growth, rising prices). In our view, both fears are unfounded.
The Fed is not directly “injecting money” into the real economy. Instead, the Fed is expanding its balance sheet to increase liquidity in financial markets. Its main goal is to ensure that the corporate sector and municipal governments can roll over existing debt at sustainable interest rates.
Remember, too, that the Fed still retains its inflation mandate. If inflation were to move well beyond the central bank’s 2% objective, the Fed would stand ready to cool the economy to keep inflation in check. That could be necessary if a medical solution to the virus were to arrive sooner than expected, allowing activity in the real economy to rebound strongly. Even then, a modest inflation overshoot would be a much better problem for the Fed to face compared with the deflationary impulse stemming from the virus itself.
The fiscal experiment: Support more than stimulus
Along with fears about inflation risk, worries about the U.S fiscal deficit are on the rise. The government’s fiscal response (which so far totals $2.7 trillion, with likely more on the way) is commonly described as “stimulus.” We see it more as a “support” to cushion the economy while consumers are sheltering in place (by choice or government order). All told, social distancing could depress corporate and household income by some $4 trillion (or more if spillover effects are included).
Think of it this way: The increase in public sector spending (in loans to small businesses and expanded unemployment benefits, for example) is designed to essentially offset the decline in business and household income brought on by social distancing. In the short term, the government is merely recycling money: Households are slashing discretionary spending and hoarding cash, which puts downward pressure on interest rates and gives the public sector more flexibility to spend to support incomes. When the economy reopens, discretionary spending will undoubtedly rise. If it rises much faster than expected, the government can choose not to extend the policy support when it is due to expire.
The U.S. dollar: The benefit of reserve currency status
Currency is another subject of investor concern. The federal government is currently on track to run a budget deficit of around 18% of GDP, a post-World War II high. For most countries, that level of deficit would be reflected in a weaker currency and higher borrowing costs. But the U.S. dollar is a global reserve currency, and both the USD and U.S. Treasuries are widely viewed as safe haven assets. That helps explains why the dollar is up more than 5% on a trade-weighted basis this year and U.S. Treasury yields are lower.
Is reserve currency status at risk? Amid the virus outbreak, the Fed expanded its dollar funding program, in which central banks can borrow dollars from the Fed. This has likely further bolstered the USD’s status as a reserve currency. When the global economy reopens, the dollar’s recent rise may reverse, but that would likely be a healthy sign of renewed economic activity and by no means a threat to the dollar’s reserve currency status.2
Government debt burden: Approaching historical highs, but sustainable
For decades investors have mostly shrugged off rising government debt. By 2022, however, debt-to-GDP levels could surpass World War II highs of 106% of GDP. Not surprisingly, some investors are asking - How are we going to pay for this? Of course, the U.S. does not need to “pay off” its debt like a household pays off its mortgage. The U.S. government does need to service its debt at interest rates that are not so high that they crowd out private sector activity. Interest rates remain low and will allow the U.S. government to finance the bigger deficits at an average rate of just 0.4%. Looking ahead, the inflation rate, and the risks surrounding it (which we’ve already outlined), will largely determine whether deficit spending crowds out private sector activity.
If the government is determined to reduce the debt ratio, it could decline through a combination of increased taxation and nominal economic growth. Higher taxes are quite possible in coming years, and we are confident that growth will eventually resume in the years and decades ahead. In short, we do not foresee any imminent threat to the government’s ability to sustain its debt obligations.
As U.S. government borrowing soars, borrowing costs stay modest
The line chart shows that while the debt-to-GDP ratio is likely to climb to levels not seen since World War II, the interest expense is likely to stay below levels of the 1990s.
As we’ve discussed, we believe that the risks related to inflation, monetary policy, fiscal policy, currency and government debt are all quite manageable. Certainly, the rate of inflation does have broad implications for portfolios and asset class allocations. In the modest inflation regime that we anticipate, bond yields are likely to remain at low levels, while equity prices and other risks assets should be supported. Of course, inflation hasn’t vanished forever, and inflation protection does still have a place in many portfolios. Today that protection is quite inexpensive, historically speaking. Inflation protection can also serve as an effective counterweight in a portfolio with a high level of duration.
Markets predict lower inflation in the coming decade
The line chart shows how the market is pricing in a significant drop in inflation, making it relatively inexpensive to hedge inflation-vulnerable portfolios against potential future rises in inflation.
1Cyclically adjusted, see chart 1 footnote.
2A related observation: Inflation fears are sometimes connected to asset price moves. A rebounding stock market may be seen as a sign that policymakers are injecting liquidity too rapidly and thus raising the risk of higher inflation. We don’t deny that central bank liquidity is helping support asset prices, but asset prices carry almost no weight in the CPI, so a direct connection between asset price moves and inflation seems tenuous. Higher asset prices may exacerbate already wide wealth gaps in the economy, and that may have political ramifications, which ultimately may affect the inflation rate. But the timing here is difficult to predict, and the political responses could prove to be either inflationary or deflationary.