Is Inflation Rising Persistently, or Is It a Short-Term Blip?

by Mark Lindbloom of Western Asset Management, 3/23/21

Most market watchers believe this is going to be a year of robust growth, and they cite many reasons: the reopening of worldwide economies as Covid vaccinations progress, pent-up consumer demand and continued global monetary and fiscal support of monumental proportions. Asset inflation is surging in many areas. Equities have generally been performing well. Bonds, on the other hand, may be challenged, although investors favor fixed-income securities for their diversification benefits.

In this uncertain landscape, Western Asset holds an out-of-consensus view about the potential path of inflation.

We are keeping an open mind, but our bottom line is that we are not convinced there will be a persistent, year-over-year increase in inflation, nor significant rate increases.

We heard 10 years ago that rates and inflation were going up. Five years ago, inflation was supposedly going up again. It was not true then, and while we do think it’s more likely now, we still don’t see a sustained rise in inflation over the short term. Our view here is based on several factors, including substantial slack in the labor market, low nominal GDP growth and the current state of bank lending.

We agree that, in the short run, inflation will likely go higher, mostly because of the so-called base effects. A year ago, as we were dealing with the onset of the global pandemic, we saw very weak inflation prints. The worry then was deflation, not inflation. So just the year-over-year comparison from these very low levels will show inflation rising.

Now we believe short-term inflation could be well in excess of the U.S. Federal Reserve’s annual target of 2%. Yet in his recent appearance before the Senate Banking Committee, Fed Chair Jerome H. Powell suggested the economy has a long way to go before reaching 2% inflation.

“The economic recovery remains uneven and far from complete, and the path ahead is highly uncertain,” Mr. Powell said in his prepared remarks. “Although there has been much progress in the labor market since the spring, millions of Americans remain out of work.”

We agree, but with Covid diminishing – we hope – strong services demand should return later in the year. The Fed has promised not to take the punchbowl away, and with Democratic control of Congress and the Presidency, fiscal policies are ramping up far beyond expectations prior to the Georgia Senate run-off elections.

Could all the fiscal spending lead to higher inflation? That is an open question. Witness Japan. Witness Europe. This is a global conversation. We must be mindful of how fiscal stimulus will be spent and if it will lead to borrowing more growth from the future and making the existing huge debt overhang even greater.

We cannot forget the impacts on demographics globally, such as the aging of populations, the benefits of technology and global trade, which should keep long-term inflation muted. And it appears that some areas of the bond markets have been moving for reasons that are not perhaps fundamental, nor related to economic growth or inflation.

While we’ve seen a rise in rates recently, particularly in the long part of the yield curve, we are not at all convinced that we are entering a bear market in terms of interest rates based upon higher inflation. Nor are we convinced (as many market participants are) that there will be persistently higher inflation – emphasis on persistent, not just the cyclical short-term impacts.

Last March, when we were all sitting around in the deep fog brought on by the onset of the pandemic, no one – no one – predicted the conflicting realities we witnessed in 2020 as a humanitarian disaster unfolded while the stock market saw explosive growth.

Yet that is exactly what happened to equities, fixed income, pretty much everything. Valuations in some markets are high and seemingly untethered to reality. In this climate, risk mitigation and active management are extremely important.

Is Inflation Rising Persistently, or Is It a Short-Term Blip?

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