All Asset All Access: Evaluating and Managing Long‑Term Inflation Risks

by Chris Brightman, Campbell Harvey of PIMCO, 8/27/21

n this edition, Chris Brightman, chief executive officer and chief investment officer of Research Affiliates, explains their outlook on long-term inflation and discusses how investors can prepare for this risk. Cam Harvey, partner and senior advisor of Research Affiliates, discusses whether bitcoin could be an inflation hedge. As always, their insights are in the context of the PIMCO All Asset and All Asset All Authority funds. Please note: The All Asset Funds and their underlying holdings in PIMCO Funds do not invest in cryptocurrencies generally or bitcoin specifically. All Asset All Access is published quarterly.

Q: What is Research Affiliates' outlook on inflation, and what informs this view?

Brightman: Wiring trillions of newly created U.S. dollars directly into peoples’ bank accounts tends to reduce the value of dollars relative to goods, services, and real assets. June and July’s year-over-year change in U.S. CPI (Consumer Price Index) was 5.4%. Housing prices jumped 18% in May from a year earlier, according to the Federal Housing Finance Agency. In Research Affiliates’ view, fiscal policy now being enacted in Washington creates a material risk of today’s soaring inflation continuing into the years ahead.

In stark contrast, the bond market is pricing forward inflation rates to remain stable at just above the Federal Reserve’s 2% target, according to the markets for U.S. Treasury Inflation-Protected Securities (TIPS). This benign market price for inflation implicitly assumes that recent extraordinary spending financed by Fed purchases of U.S. Treasury debt will prove transitory. We believe it also presents an opportunity to cheaply hedge inflation risk.

Before talking about how to hedge wealth from inflation, let’s take a quick look at the big picture of fiscal inflation risk in the U.S. As more baby boomers age, retire, and die, more millennials are beginning to govern. Policy appears to be shifting toward younger voters’ general preference for more generous social benefits and a secular increase in U.S. government expenditures toward European norms. From 1960 to 2020, total U.S. government spending (all levels) averaged 33% of GDP.Footnote1 In contrast, average government spending in the world’s 18 other advanced economies averaged 46% of GDP over that time frame. In France, Belgium, Sweden, and Denmark, average spending exceeded 50% of GDP. Only Switzerland spent less than the U.S.

Would a secular increase in U.S. government spending of approximately 10 percentage points of GDP cause inflation? The answer depends upon whether the increased spending is funded by taxes or money printing. Spending funded by tax receipts generally doesn’t create inflation. Worryingly, receiving checks from the government is widely popular, while very few voters will tolerate their taxes going up. Will U.S. politicians give people what they want by raising spending but not taxes?

To be sure, our government currently intends to raise income tax rates for corporations and the wealthiest 1%, and may even try to collect wealth taxes. Whatever the merits of this tax policy from a distributional perspective, it won’t raise the necessary revenue, in our view. Raising tax receipts to above 40% of GDP in a developed, democratic country without enacting a broad-based consumption tax has never been accomplished, according to our research. If the U.S. government funds a substantial secular increase in social spending through Fed purchases of Treasury debt or direct money creation as advocated by Modern Monetary Theory (MMT), then an inflation shock like the U.S. last experienced in the 1970s seems inevitable, in Research Affiliates’ view.