Our first note of 2021 made the case that the events of 2020 heralded the return of inflation. We made two main observations. First, the Fed’s adoption of average inflation targeting, which would give the central bank cover to tolerate persistent inflation above the 2% to make up for the long periods of sub-2% inflation; and second, the co-ordinated effort by Fed and Treasury policymakers to support the Main Street economy. Unlike post-recession QE, we wrote, the policies implemented in response to the pandemic would create huge liquidity, and rather than remaining confined in the financial system, that liquidity would find its way to the consumer and to small and mid-sized corporates.
In the near term, we think that as the post-pandemic recovery unfolds, inflation will rise moderately. Readers who anticipate a more rapid and dramatic rise in inflation are likely to be disappointed. Our inflation target for year-end 2021 is 2–3% — with core inflation coming in towards the bottom of that range, and food and energy bringing it towards the top.
But it’s instructive to consider more than the immediate environment. The medium- to long-term implications of the policy changes that occurred last year are profound, and signify a fundamental shift in methods of economic, financial, and monetary management by governments and central banks.
It is not too dramatic to say that we are experiencing a transition, which will vary in intensity and speed among the developed economies, towards a covert command economy. In this new environment, political considerations will be paramount and have greater and greater influence over capital flows, credit, and the creation of money. It is no coincidence that the past year saw both the ascendency of ESG (environmental, social, and governance) considerations in the capital markets, and an unprecedented intervention by fiscal and monetary authorities that eclipses even the measures taken in the wake of the 2008 crisis. These phenomena are related and presage a future different from our immediate past.
If this shift endures it will be extremely consequential for investors, since it will ultimately create an investment landscape different from anything seen for many decades.
As with the situation faced at the end of the Second World War, the world’s developed economies are highly indebted. High indebtedness eventually hobbles economic growth and standard-of-living improvements. Catastrophic “solutions” to this problem include default and uncontrolled inflation. Both are obviously highly undesirable, and any reasonably well-managed economy, particularly of a country with a global reserve currency, can avoid them. The desirable solution is an extended period of controlled inflation which allows debt levels to be gradually reduced. (British financial analyst Russell Napier jokes that this process amount to “stealing from old people slowly,” since it is detrimental to savers.)
Covid spending and stimulus have pushed the developed world’s indebted economies to the highest debt levels since the end of the Second World War. Something must be done to create inflation — and yet in the decade-plus since the end of the 2008 financial crisis, central banks have been unable to do so. The mechanics of QE as implemented post-crisis did not effectively transmit easy policy to the “real” economy, and thus, while many financial assets appreciated, consumer price inflation remained muted.
Occasionally, “this time” is indeed different, and this is one of those times. What do we see that has changed?
The Rubicon: Commercial Bank Lending
In recent decades, short-term interest rates have been the primary policy tool of central banks. Since the 2008 crisis, QE has been an additional tool to bolster liquidity in the financial system and have some influence on long-term interest rates. However, neither of these tools affords policy leverage at the place where most money creation actually occurs: in the lending activity of commercial banks. Hence the constant lament of central bankers unable to spark demand for and supply of commercial loans — with all their available policy measures seeming to be “pushing on a string,” unable to increase the money supply and produce inflation.
What is different this time is that throughout the developed world, fiscal and monetary authorities acted in concert to backstop lending by commercial banks — stimulating both demand and supply and resulting in an extremely rapid expansion of the money supply. In short, this time, the authorities are spurring the creation of money in a wholly different place, one that is much closer to the “heart” of the real economy. Unlike the liquidity created by QE, this liquidity is much more likely to get into the pockets of consumers and small businesses, where it will be spent — and produce broad inflation.
Interest Rates and Yield Curve Control
The problem will occur as that inflation rises and long-term interest rates, in a free market, would rise in response. Since governments, corporates, and households that are highly indebted can’t handle a large or rapid rise in interest rates, this can’t be tolerated by policymakers. What they will have to do in response is simply called “financial repression.”
How will this manifest? Interest rates will be capped — so-called “yield curve control.” Institutions — perhaps large pension funds first of all — will be required to hold certain levels of government debt. (European governments did this in the postwar period — ratcheting up the levels of public debt that it required institutions to hold as governments’ funding needs increased. More recently, European countries asked European banks to hold the debt of debtor European nations; this was suasion rather than policy, but the direction is clear.)
Governments, rather than the market, will become the primary decision-makers in the allocation of credit. This will result in a likely irresistible temptation to use this power to direct credit towards favored sectors and industries. We are already beginning to see this trend in the treatment of politically favored industries, and in an environment of financial repression, it will surely get worse. Government choosing winners and losers is not a program for robust economic growth.
While hyperinflation is an unlikely outcome, it is likely that there will be periods of high inflation as politicians — who are not very effective managers of the economy — make mistakes and push their ideas too far. Many savers won’t be able to avoid these inflations — especially those who hold to an asset allocation strategy better suited to the past than this new environment.
Investment implications: Investors should be particularly alert for two things as we move forward tentatively into a “new world” of financial repression. First, watch for inflation to rise past the modest increases we’re likely to see this year. Second, watch policymakers in the developed world to see who is the first to implement caps on long-term rates or explicit yield-curve control. At that point, investors’ attention to alternatives, particularly precious metals and perhaps cryptocurrencies, should become much more focused. In the lead-up early stages of an inflation, however, stock markets can perform well and investors should not exit prematurely.
