Why do you write about inflation so much?
Because it’s the most important long-term issue facing investors.
What about COVID and elections and fires and killer hornets? Do you not know what year it is?
All of those (except maybe hornets) are more important to our lives right now, but not to our portfolios. As long as inflation is low, monetary and fiscal authorities can respond to these shocks with stimulus measures, leading to recoveries in asset prices. If inflation were to rise, authorities would be unable to respond in the same way. They may even tighten policy.
Are you forecasting higher inflation in the short run?
This is AQR, we don’t make economic forecasts. And you were saying I didn’t know what year it was!
That’s good because the inflation forecasters have been consistently wrong. Why is inflation so unpredictable?
It’s actually been very predictable. It’s barely moved! Forecasters keep thinking it will rise because of tight labor markets and low rates, but it hasn’t. It’s sort of like being a meteorologist in San Diego, you’ll probably be the most accurate by just saying it will be sunny every day. Any additional information can muddle the forecast.
So why has it stayed so low?
There are more theories than interruptions at a Presidential debate. Some attribute it to globalization, others to demographics. 1 1 Close “Has Globalization Changed Inflation?” NBER, June 2007. Many economists argue that central banks have gotten more credible about inflation fighting, and this has kept inflation expectations anchored. 2 2 Close “The Ups and Downs of Inflation and the Role of Fed Credibility,” Federal Reserve Bank of St. Louis, April 1, 2014. One thing we’ve learned about inflation is that it is stubborn. When it’s low, it tends to stay low.
If everyone’s been wrong, why are so many people still forecasting it to rise?
People can be stubborn too! The main reason is that there has been so much monetary stimulus. Past QE measures did not result in higher inflation, but this round is different in two ways. First, it is on a broader set of assets which provides an element of credit easing. Second, it is coordinated with fiscal stimulus. In theory, this combination should be inflationary.
Isn’t this what Central Banks want? Aren’t they trying to get inflation higher?
They are. They want higher inflation so they can move rates away from the zero lower bound, but they don’t want it to get too high. That is the problem with inflation: once it gets too high, it can be quite painful to bring down.
What is too high?
2% is fine. Even 3-4% is probably ok if it’s temporary. High single digits would be a problem.
What will they do if inflation does get too high?
The last time that happened en masse in the developed world, they ended up hiking aggressively and causing severe recessions. 3 3 Close “The Economy Is Bad, but 1982 Was Worse,” The New York Times, January 20, 2009.
That doesn’t sound good. Is that why higher inflation is bad for portfolios?
Partly. Inflation is bad for portfolios because it erodes the value of future cash flows and creates economic uncertainty. Even good nominal returns can become negative real returns. The monetary reaction doesn’t help either.
What can investors do to hedge against inflation?
There are plenty of choices. Commodities tend to do well when inflation goes up. There are bonds with coupons directly tied to inflation levels as measured by the CPI. Some tactical strategies can do well.
Among commodities which are the most direct hedges?
Gold and other precious metals. Energy, base metal and agricultural commodities should also do well in times of high inflation, but there is some noise because of the specific supply and demand characteristics of those markets.
If inflation is such a big risk, should investors drop everything and just invest in those assets?
No!! There is a cost to everything. Assets that do well in inflation don’t always do well in other environments. Like deflation for one. It’s easy to get caught up on one outcome at the expense of diversification. There is no free lunch in switching to a portfolio completely based on hedging against one economic outcome.
How do stocks do in an inflationary environment?
The data is mixed, but to generalize, real returns tend to be lower.
What about bonds?
Not so good. They tend to do well in deflationary environments.
Even if rates are already low?
Even if rates are already low.
How will we know if inflation is going up?
At first it won’t be clear. There is plenty of room for inflation to rise without raising alarms. It will have to be sustained at high levels. Unfortunately, that means we have to wait.
Is there anything different about inflation now than in the past? Is there anything new we’ve learned?
Everyone was aware of two things. First, high inflation is difficult to bring down. Second, deflation is hard to fight in times or recession or depression. Now we’ve learned that in times of moderate growth, low inflation can be just as persistent. This will change the way we look at the problem.
Is a little disinflation all that bad?
Probably not. Any economist from the 1970s would be very pleased with what we’re seeing now. People like being dissatisfied.
What We Are Watching
U.S. Fiscal Negotiations
Stimulus measures passed in the early days of the pandemic have played an important role in supporting U.S. household and business incomes in recent months. However, key provisions of March’s CARES act have now expired, including notably the expanded unemployment benefits of up to $600 per week, which lapsed at the end of July. While the Trump administration, Republican leadership in the Senate, and Democratic leadership in the House all agree that a new support package is needed, they have been unable to reach agreement on the appropriate size and composition of a new bill. With the election approaching, and with the Senate focused on a potentially-rapid Supreme Court confirmation process, the window for passage of a new bill may be narrowing. Nonetheless, positive comments from Treasury Secretary Mnuchin and House Speaker Pelosi this week may have rekindled investor hopes for near-term stimulus legislation. 4 4 Close CNBC: “Pelosi and Mnuchin take a last-ditch shot at a coronavirus stimulus deal,” 10/1/2020. If talks appear to be progressing, and particularly if there are signs of support from Senate Republicans, it could provide a boost to equity market sentiment and could put upward pressure on bond yields.
U.S. Election Polls
With the U.S. election only one month away, market participants have been increasingly focused on the potential impacts of different electoral outcomes. Based on current polling, Vice President Biden appears to be a favorite to defeat President Trump. 5 5 Close As of 10/1/2020, the RealClearPolitics polling average showed a Biden lead of +6.6%, while the FiveThirtyEight polling average stood at +7.9%. If the actual vote is in line with current polling, the result could be the most lopsided since President Obama’s 7.3% margin in 2008 or even President Clinton’s 8.5% in 1996. However, it would only take a modest shift in key swing states to revive the prospects for reelection for President Trump. Following the first presidential debate, polls over the next several days will be closely watched for any signs of such a shift. The market implications of the election will also likely be sensitive to developments in the Senate, where Republicans are currently in control but Democrats have a reasonably good chance to win back a majority. A Biden victory accompanied by Democratic control of the Senate might open the door to meaningful legislative changes, including increases in corporate tax rates and potentially a large increase in infrastructure spending.
Reserve Bank of Australia (Monday)
Expectations for additional easing from the RBA have been on the rise in recent weeks, particularly after deputy Governor Guy Debelle’s speech at the Australian Industry Group. 6 6 Close As of 10/1/2020, the RealClearPolitics polling average showed a Biden lead of +6.6%, while the FiveThirtyEight polling average stood at +7.9%. If the actual vote is in line with current polling, the result could be the most lopsided since President Obama’s 7.3% margin in 2008 or even President Clinton’s 8.5% in 1996. The speech discussed the RBA’s additional easing options given that the outlook for inflation and employment is not consistent with the central bank’s objectives. These options included government bond purchases beyond the 3-year point, foreign exchange intervention (although this was downplayed in the same speech), lowering interest rates without going into negative territory (the option on which markets seem to be focusing), and introducing negative rates for which Debelle provided mixed arguments. Next week’s is expected to be a “live” meeting for the RBA. An interest rate cut would weaken the Australian dollar and support the local equity market.