There’s a lot of talk, worry, concern, focus, and in some cases even anticipation of some massive wave of inflation that’s suppose to wash over the US economy. I don’t personally think most of those people know, or at least fully understand what they’re talking about. Granted there otherwise would be some validity to the idea of increasing inflationary expectations, with the measures we have just seen in response to the global recession, this time is different. Normally I would stop short of laughing at someone that would dear utter the phrase “this time is different”, but in this case there is indeed a fundamental difference.
In most previous recessions, correlation assumptions that are used in pricing everything from individual securities to entire portfolios held up for the most part. This time they didn’t. Prices on asset classes with the exception of Treasurys fell across the board. Central banks around the world (especially the Fed) had to rush interest rates to all-time lows and institute quantitative easing policies to provide lubrication to the gears of their respected economies as pricing mechanisms were grinding to a halt.
In the case of the US economy, medium-term historically about 70% of demand has been driven by private consumption, which in turn, medium-term historically has been supported by borrowing. This is the simplest way of explaining the US economic model for success. That’s why in my humble opinion, the government deficits that many people much smarter than myself are assuming would be able to get the economy growing again in ‘normal’ terms, are simply insufficient. I believe gone are the days when the government could even create stagflation from increased spending. Scaled for comparison to the 1970’s when the Vietnam War spending in the face of high unemployment resulted in stagflation, the US government would not be able to borrow at those levels in today’s capital markets simply because there is borrowing demands on a much larger scale from many more countries.
That takes care of the government, now to the Fed. They have been both greatly praised and criticized for the massive expansion of their balance sheet as a policy response. And the most argued point is the inflation that they are supposedly baking into the economic cake. I think it’s interesting to see where the new money that the Fed is creating is ending up. For the most part the final resting place of the money is the reserve or provisions section of the balance sheets of financial institutions, not chasing after goods and services in the real economy. Don’t get me wrong, eventually there is the possibility that some of those monies will be spent towards capital investments, but that would only occur when the cushion is no longer needed. At that point there would have undoubtedly been many quarters of consistent asset appreciation for these many institutions. If this scenario plays out without any significant increasing of credit availability, and the US consumer were to once again bring the economy back to sustainable growth, it would have to be done from savings.
Without the availability of much, much more credit the US job market is destined to remain soft for some considerable length of time. And with the job market in that condition there is only downward pressure on wages and benefits, which happen to be a big driver of increasing price levels.
Another strike against inflation expectations is the fact that both US households and major corporates are on a path of deleveraging. In the absence if the ability to borrow, deleveraging has almost the same effect as saving. Saving is basically postponing consumption of current income. Deleveraging accomplishes a similar end, because by using current income to pay down debt you are increasing you ability to borrow in the future. The point is, the postponing of consumption results in downward pressures on price levels, and in a economy like that of the US that relies so heavily on consumption to drive growth this spells sub-par levels of productivity and income for some time.
The government in their own perverse way is also, at least I think, through their borrowing producing downward pressures on future price levels by raising interest rates. Simply put, the more they borrow the higher the rates go, and the higher the [10 year Treasurys] rates go the higher mortgage rates go, which puts downward pressures on housing prices which happen to be another big driver of increasing price levels.
The last thing I can think of that would definitely put a damper on US inflation is a double dip (global) recession, as many well respected economists are forecasting. I think this is a very contingent scenario and even if it does occur would be relatively short lived. Basically, if there is a return to (global) contraction then the reserve currency perk would kick-in, resulting in a flight to safety which would appreciate to US dollar. When the dollar appreciates, foreign output becomes relatively cheaper to consume and so consumer prices would be restrained, as a consequence however, the trade deficit would widen as exports decreased because domestic output would be relatively more expensive for foreigners to consume. Like I said, this scenario is tentative, but if it were to occur my best guess is that its catalyst would be some emerging market debt contagion.
Keishaun Mark from Foresight Investment Fund is an exclusive contributor to Bonds Mutual.
