The Narrative Changes

Posted on Jun 15, 2021 in Economics

The Narrative Changes

We’ve seen quite a sea change in the markets over the past few weeks. Rather abruptly, investors now appear to be discounting the threat of runaway inflation and embracing a more benign inflation outlook. These market developments stand in stark contrast to a recent survey which indicates that the public at large expects inflation to keep rising in the months and years ahead. On Monday of this week, the New York Fed reported results for its monthly survey of inflation expectations. Survey respondents now believe inflation will be 4.0% in one year compared to 3.4% in the April survey. Over the longer term, respondents now believe inflation will be 3.6% in three years compared to an expectation of 3.1% in April. This is the highest 3-year rate expectation since August, 2013. And though some economists might take solace in the fact that the medium-term inflation expectation (3.6%) is lower than the short-term inflation expectation (4.0%), both figures are well above the Fed’s longer-term inflation target of 2.0%.

As mentioned, the increases in inflation expectations are at odds with recent market developments. Consider the following:

  • Longer-term interest rates have pulled back significantly;
  • The 5- and 10-year inflation breakeven rates have also moderated significantly;
  • The dollar has bounced from its recent lows;
  • After a short period of mean reversion, growth stocks are back to outperforming value and cyclical stocks again;
  • Prices for most commodities, including gold, copper, steel and lumber, have undergone a sharp correction (oil is the exception);
  • Housing activity and housing sentiment (both consumers and homebuilders) have begun to moderate, despite continued low mortgage rates;

There are likely two possible explanations for the market changes we are witnessing. The first is that market participants are demonstrating their complete faith in the Fed’s ability to shepherd the economy from massive contraction last year to normalization. As part of its strategy, the Fed has been telegraphing for months that there will be a surge in inflation this year, after which we can expect inflation rates to normalize close to the longer-term target of about 2%. The “transitory” nature of the inflation surge, the Fed says, is due to the fact that the pressures are being caused by temporary factors: 1) base effects, which simply means we are now lapping the COVID-related disinflation/deflation in 2020; and 2) COVID-related supply disruptions. Investors and other market participants may simply be saying that the Fed’s rationale and execution have been sound and that it has the tools to deal with any major deviations from its plan.

The second possible explanation could be that the markets are sniffing out a significant deceleration in economic growth, or perhaps even a recession. True, a recession seems unlikely at this point given pent-up demand, high savings rates, high asset prices, and high levels of corporate cash and deferred investment. But a significant moderation in current rates of economic growth is almost inevitable, and a moderation in inflation would be expected if/when economic growth slows. Expectations for a quicker return to trend levels of economic growth (~2%) and lower inflation may simply reflect a political reality that further large-scale fiscal stimulus, including a large infrastructure bill, is looking less feasible at this point. Or they could reflect the continued drag of economic inequality that’s been an albatross around the neck of the economy for so long.

But could it be that the markets are expecting that the economy will grind to a halt specifically as a result of inflation? There is no doubt that the economy is booming right now, beyond the expectations of most any economist. But the markets are always forward-looking. Markets reflect conditions in 6-12 months, not what is currently happening. Will businesses and consumers stop spending and investing because prices are rising so fast? It seems to be (finally) happening in the housing market, so why not elsewhere? The last period of stagflation in the US was in the early 1970s, but the rapid expansion in the money supply in recent years would seem to increase the odds of another stint of weak economic growth combined with high inflation.

For now, the first explanation – that the Fed is, so far, doing an admirable job of orchestrating the transition to a post-COVID world – is still the more likely explanation for the sea change in the markets. And there is truth to the old saw that the cure for rising inflation is rising inflation. But a more rapid economic decline or even stagflation can’t be ruled out. There is no precedent for the amount of money creation we’ve seen over the past couple of years. The expansion in the money supply has, thus far, been offset by a sharp decline in the velocity of money (the number of times a dollar is spent in a year). That may not always be the case. If investment and lending picks up, money velocity may pick up as well. If that happens, inflation and interest rates are almost certain to spike without a massive response from the Fed.

Interest rates bounced a bit this afternoon following the release of the Fed statement and Chairman Powell’s press conference. The Chairman inched ever so gingerly toward a day when its unprecedented policy accommodation can begin to be lifted. The rearrangement of a few dots on the “dot plot” signified that a few more Fed members are getting nervous about the durability of the recent spike in inflation. The semantics and hair-splitting have become maddeningly irrelevant. The Fed doesn’t know where interest rates will be in 2-3 years any better than any of us do. Still, the Fed’s credibility is on the line, and a lot is at stake.

The evidence seems to suggest further gains for stocks, but that outcome is far from assured. Sticking to quality and keeping some dry powder still seems prudent.

 

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