The word "inflation" is on everyone's lips, with a sharp rise stirring reactions in the UK this week. But how fleeting are these price pressures, and how concerned should investors be? Wells Fargo's multi-asset head casts a longer view over expectations for the next 12 to 18 months.
After a sharp rise in the UK CPI this week to 3.2 per cent and the US consumer price index still edging up, questions are being raised about how soon central banks will start to taper. Matthias Scheiber, global head of multi-asset solutions at Wells Fargo Asset Management looks at the factors driving the inflationary environment over the next 12 to 18 months for investors wanting to "plot a prudent course." We welcome this analysis, where the usual editorial disclaimers apply. Email comments to email@example.com and firstname.lastname@example.org
The word “inflation” seems to be in the air these days. Prices for lumber, food, used cars, gas—you name it—are all up significantly over the past year. Companies are complaining about sky-high shipping rates, semiconductor shortages, and the difficulty of filling open positions at any wage. Perhaps the biggest question on the minds of investors now is whether these price pressures are fleeting in nature or more permanent.
Our analysis points to a reflationary upward swing in economic growth and inflation expectations following the pandemic, which is creating a transitory inflationary environment that will play out over the next 12 to 18 months.
Policy responses are a big part of what is driving price pressures. It is informative to look back at the last major policy responses following the global financial crisis (GFC) for precedent. We begin our analysis by highlighting some important differences with today’s environment. Another point of reference is the market’s view—how do our expectations differ?
Also, what are some of the factors that will inform the evolution of our views? We can summarize the main factors here: The market’s confidence in central banks’ ability to manage inflation expectations; corporations’ ability to manage bottlenecks and pass-through costs to their customers, the impact of debt dynamics and savings; and how productivity improvements may be able to absorb inflationary pressures.
This is by no means an exhaustive list. However, we think this is important groundwork to lay to inform investors how to plot a prudent course in asset allocation and to spot opportunities in various capital assets on a go-forward basis.
How did the policy response to the COVID-19 crisis
compare with the response to the GFC?
The monetary and fiscal impulse has been enormous during the past 18 months. The Federal Reserve’s massive asset purchases have ballooned its balance sheet and relief and stimulus programs have ballooned the federal government’s debt. The last time the Fed’s balance sheet and the federal debt grew at this pace or faster was in the wake of the GFC of 2008 to 2009. Back then, short-term government securities' yields dropped to 0 per cent and, in some cases such as in the eurozone and Japan, yields eventually dropped below 0 per cent.
The response to the COVID-19 crisis has differed in terms of the timing, scale, and focus of fiscal policy. Policymakers were very fast in responding to the COVID-19 crisis compared with how long it took to roll out fiscal support during the GFC. Figure 1 shows the difference in the scale of the stimulus—the COVID-19 crisis commanded a combined fiscal and monetary response of 20 per cent of gross domestic product (GDP) in the eurozone, 27 per cent in the US, and up to 54 per cent in Japan. For comparison, this dwarfed the fiscal support during the GFC, which ranged from a “mere” 1 per cent to 6 per cent of GDP across these regions.
The focus of stimulus has also been different. During the GFC, most of the fiscal support went to financial institutions. Arguably, the need to nurse financial institutions back to health made the recovery from the GFC weaker and enabled deflationary pressures. One school of thought is that monetary policy affects inflation via credit channels. The need to recapitalize financial institutions meant that monetary policy in the wake of the GFC was unlikely to be inflationary.
During the COVID-19 crisis, most of the stimulus has gone to households. The COVID-19 crisis was very different in that financial institutions were comparatively healthy at the start of the pandemic. Instead of needing to rebuild banks, monetary authorities could use banks to help channel credit to sectors that needed it most. The outsized nature of the monetary and fiscal impulse deployed during the COVID-19 crisis and the fact that this response was used in a health crisis and not a financial crisis - has summoned investors’ inflation fears.
These fears have been fed by how the US dollar has depreciated, by how real yields have fallen deeply negative, and by how the US current account and budget deficits were negative and have gotten worse.
What does the market think?
Markets process vast amounts of information, and it is generally a good idea to start with the collective wisdom of the markets in forming one’s own views. Then we can determine if there is something from the market narrative that is missing or distorted to determine whether we have an empirically based reason to have a difference of opinion.