by Brad Houle, CFA
Executive Vice President
The aggressive fiscal and monetary response to the COVID-19 crisis has been unprecedented in terms of speed and magnitude. A common topic we receive from clients is about the risk of inflation as a result of the response to the crisis. In our view, we believe deflation is a greater risk than inflation. This can seem counter intuitive when you consider the expansion of money supply and massive fiscal spending undertaken by the Federal Reserve and Congress.
Too much or too little inflation can be very damaging to an economy. Many people remember the elevated inflation experienced in the United States during the late 1970s or recall the ravages of hyperinflation in countries like Zimbabwe. Conversely, too little inflation or deflation can create different types of damaging economic conditions like what has been experienced by Japan in the past. Deflation creates a negative feedback loop whereby consumers delay purchases with the knowledge that prices are dropping causing economic growth to slow further. Inflation has a Goldilocks element to it: that is, too much is bad and too little is also bad. In the past, the Federal Reserve has been diligent about raising short-term interest rates to head-off elevated and anticipated inflation. Until recently, the Federal Reserve has had a 2 percent target on inflation, which has only been achieved briefly since the financial crisis. The Federal Reserve has recently changed its strategy to have an average target of inflation which means that the Federal Reserve is willing to let inflation run higher than 2 percent in order to average 2 percent over time. This is a change in policy that should result in low short-term interest rates for the foreseeable future.
The global economy is starting to heal, as evidenced by falling unemployment, a rise in manufacturing activity and an increase in consumer confidence; yet, the COVID crisis has created a demand shock in the global economy. This demand shock has left slack in the economy that is deflationary. Also, our growing national debt, while still affordable, is a drag on growth. As debt increases, a larger percentage of our GDP must go to pay the interest on the debt. This results in decreased spending on things such as infrastructure that stimulates economic growth. Additionally, as people age, they spend less money on most things other than healthcare, which also has a deflationary effect. A young population is engaged in new household formation which drives demand for things such as housing, durable goods and education. Aging demographics are a long-term trend that will impact the developed world for decades to come.
While subdued inflation is our base case, what could cause unscripted inflation to appear? Demand-pull inflation is inflation in prices that is caused by rising aggregate demand in an economy operating at full capacity with low unemployment. In other words, too much money is chasing too few goods and services. This scenario causes a rise in prices as firms reach full capacity and wages rise due to low unemployment. We believe this is very unlikely; globalization, which has been challenged recently, is still alive and well and adds production capacity and labor, which is an oversupplied global commodity.
Another potential cause of inflation is cost-push inflation which occurs when raw material prices rise unexpectedly, and businesses then pass on the cost to consumers. The oil shock in the 1970s, for example, was the leading cause of the elevated inflation in that era which ultimately morphed into stagflation, stagnate growth with high inflation.
For the week, the S&P 500 declined more than 2 percent. Leading the market lower were the bellwether stocks such as Amazon, Netflix and Microsoft. In addition, energy-related companies declined as the price of oil slumped nearly 7 percent due to concerns of mounting OPEC supply. Core inflation for the month of August rose at a 1.7 percent rate as measured by the Consumer Price Index. The inflation numbers were stronger than expected due mostly to a sharp increase in used car prices. The COVID-19-related manufacturing shutdowns have limited new car availability driving consumers to buy used cars. As manufacturing resumes, we view this vehicle shortage as a transitory increase in inflation.
Week in Review and Our Takeaways:
Deflation is a larger risk than inflation due to excess productive capacity, globalization and the aging demographics of the developed world
Inflation has not been a problem for the last 25 years and we do not believe it will be a problem for the foreseeable future