We have received a number of queries about the expected trajectory for inflation given the dramatic shift in the global economic outlook as a result of COVID-19. As we have discussed often on this blog, realized inflation tends to have long and variable lags to the business cycle. For example, while the last recession official ended in June 2009, core inflation did not reach a bottom until October 2010.
Typically, the hard part of inflation forecasting is not understanding the lag but instead predicting the twists and turns in the business cycle. Today, we are aware that we are facing a major negative demand shock which will cause unemployment to rise and activity to fall. Even prior to when the coronavirus emerged in the US, we were highlighting that the impulse from core goods had already been softening[1] and the risks to shelter were primarily to the downside. Needless to say, there will be a meaningful deceleration in CPI as a result of the rise in the output gap and the immediate hit to service sectors like airfare, hotels and entertainment. The timing is more uncertain as we anticipate the BLS will struggle to collect data samples on prices where businesses are closed and employees are working from home. Although disinflation is common in recessions, deflation within the core series (prices excluding food and energy) is uncommon. In the last two recession core inflation bottomed at 1.1% and 0.6%, respectively.
So, how does this compare to market expectations? Well, the US inflation market, which is primarily traded using Treasury Inflation Protected Securities (TIPS) and zero-coupon inflation swaps, derives its value off of future headline inflation which includes food and energy. The tremendous depreciation in energy prices with Brent prices in the $20s will result in even weaker inflation in the coming months as it relates to headline prices.
However, the type of recession required in order for CPI to average what the TIPS market is pricing over the next five years is hard to envision. Headline inflation averaged ~120 bps over last financial crisis meanwhile 5yr inflation swaps currently stand at 60bps. These historical comparisons are difficult in that consumer price inflation is more stable now than it’s ever been; i.e. it’s less sensitive to the business cycle.
These historical comparisons are also difficult because of what monetary and fiscal policy makers are doing. Monetary policy makers at the Fed focused first on improving liquidity and market functionality through massive QE. The weekly pace of purchases of Treasuries was over USD 350bln last week: the largest on record and at least five times the fastest weekly pace of QE during the financial crisis. Fiscal policy makers scrambled to cushion plummeting demand with direct payments to consumers and grants to businesses. Government spending is also expected to reach records: the US deficit is likely to reach its highest peacetime level in history topping above 10% of GDP.
Investors have asked if the Treasury’s large deficit or the Fed’s aggressive balance sheet expansion should be considered in the inflation equation. To start, the Fed is likely to purchase over 2 trillion in Treasuries this year – which is enough to implicitly fund the entire CARES Act. In a lot of ways this smells like debt monetization or modern monetary theory (MMT) which we have discussed in prior blogs[2]. While the reserve status of the US dollar and the Federal Reserve’s credible inflation target may allow the US to successfully keep borrowing costs low is still too soon to tell. Other schools of thought however suggest too much debt actually prevents growth and inflation by crowding out private investment. Not only are governments expected to lever up but consumers, businesses, states and municipalities will also need to borrow to keep the lights on as consumer demand and revenues contracts. The risk is a cycle of debt disinflation where the magnitude of the debt and the cost to repay slows growth further resulting in unanticipated disinflationary outcomes.
So where does this leave us? Just as we expect the worst is yet to come in the employment and growth data, the worst is also yet to come in inflation data. Disinflation should be expected although the magnitude priced into inflation markets appears to be too pessimistic when taken at face value and suggests inflation breakevens may offer long-term value for investors, who are willing to ride out the volatility.