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Will Massive Stimulus Efforts Fuel High Inflation? Fiscal and Monetary Response Has Raised Inflation Fears

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Will Massive Stimulus Efforts Fuel High Inflation? Fiscal and Monetary Response Has Raised Inflation Fears T. ROWE PRICE INSIGHTS ON U.S. FIXED INCOME Will Massive Stimulus Efforts Fuel High Inflation? Fiscal and monetary response has raised inflation fears. June 2020 KEY INSIGHTS ■■ While the fiscal and monetary crisis response may have staved off deflation and prevented a deeper recession, it is by no means inflationary. Stephen Bartolini, CFA ■■ High inflation is unlikely to be a serious threat coming out of the current crisis due Co‑portfolio Manager, Inflation to multiple factors, such as below‑potential growth and subdued demand. Protected Bond Fund and Limited Duration Inflation‑Focused Bond Fund ■■ Though inflation is likely to remain subdued, investors should remember that an allocation to TIPS can provide a hedge against unexpected bursts of inflation. he U.S. fiscal response to the orderly market functioning. The balance Michael Sewell, CFA coronavirus pandemic has so far sheet expansion occurred at a much Co‑portfolio Manager, Inflation Ttotaled around USD 2.9 trillion faster pace than that seen during the Protected Bond Fund and Limited in combined government spending, 2008–2009 global financial crisis (GFC). Duration Inflation‑Focused Bond Fund tax relief, and credit support. This deficit spending has helped offset the Following the GFC, market participants deep decline in aggregate demand had similar concerns that the spike in caused by consumers staying at home the monetary base from quantitative and nonessential businesses closing. easing (QE) would result in runaway Although government aid provided a inflation. However, that scenario failed to lifeline to households and businesses transpire. Since September 2008, core while activity largely ground to a halt, consumer price index (CPI) inflation it has only made up for about half of has averaged around 1.8% on an the demand shortfall. While the fiscal annual basis and fell as low as 0.6% in response may have staved off deflation 2010, compelling the Fed to engage in and prevented an even deeper additional rounds of QE. recession, it is by no means inflationary, Several Factors Working as some observers fear. Against High Inflation On the monetary front, the Federal Similar to the GFC experience, we Reserve responded to the COVID‑19 believe that high inflation is unlikely to crisis by further expanding its balance be a serious threat coming out of the sheet by about USD 2.8 trillion, pushing current crisis due to multiple factors: total assets above USD 7 trillion, as it launched a multitude of facilities ■■ Inflation tends to follow economic intended to inject badly needed liquidity growth, and the current recession into fixed income markets and restore has resulted in a large output gap, 1 Economic Slack Should Mitigate Inflation (Fig. 1) Actual, estimated, and potential U.S. GDP (quarterly) 25,000 GDP CBO GDP Estimate Nominal Potential GDP1 20,000 15,000 USD Billions 10,000 5,000 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 As of May 31, 2020. Sources: Congressional Budget Office, U.S. Bureau of Economic Analysis, and Federal Reserve Bank of St. Louis (FRED). CBO estimated GDP covers second quarter of 2020 through fourth quarter of 2021. 1 Value of goods and services produced by the economy at full employment, not adjusted for inflation. Projections shown through the fourth quarter of 2021. with gross domestic product (GDP) automation is poised to increase at an forecast to run well below potential. even faster pace in response to the It will probably take several years for virus. As such, wage pressures are the economy to get back to operating likely to remain muted. at full capacity; while the recovery is It will probably take expected to be robust as the stalled ■■ Industries hit hard by the pandemic economy powers back up, it is also may have reduced pricing power for several years for expected to be flatter on the upside some time after social distancing than it was on the way down. measures are eased. For example, the economy to get airlines, lodging, and travel services back to operating at ■■ Demand is likely to remain subdued in could see continued muted demand the wake of the crisis as households as people remain skittish about leisure full capacity… increase savings and cut spending to and business travel. fortify their finances, while corporations look to conserve cash and reduce ■■ Oil prices have rebounded from their leverage to maintain credit ratings. April nadir but remain relatively low as supply continues to exceed demand. ■■ While the monetary base has While we could see a further rally in dramatically increased due to Fed prices as quarantines are lifted and asset purchases, the growth in the producers cut output, the longer‑term money supply will not necessarily crude outlook remains bearish due to flow into the economy. Similar to ongoing productivity gains and a shift the post‑GFC period, banks may be away from fossil fuels. hesitant to lend amid concerns about losses on consumer and real estate ■■ As the world’s reserve currency, loans, instead maintaining large demand for U.S. dollars remains reserve balances at the Fed. strong as global investors continue to view the dollar as a key store of value. ■■ The U.S. unemployment rate spiked This contrasts with other, less stable, to 14.7% in April, the highest level on economies that have seen inflation record. While the unemployment rate and hyperinflation when the money posted a surprising decrease in May, supply increases dramatically. we still think it is likely to only gradually trend lower. Job losses are likely to be permanent in some industries, and 2 Break‑Even Curve Should Flatten (Fig. 2) Break‑even spreads across maturities 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 Break-Even Spread (%) Spread Break-Even 0.0 2 Years 5 Years 10 Years 20 Years 30 Years Time to Maturity As of May 29, 2020. Source: Barclays Live. © 2020 Barclays. Core Inflation Set to require nominal Treasury rates to break Fall Over the Next Year out of their recent tight range and move Against this backdrop, our economics higher. For this to happen, economic team’s models are currently forecasting data will need to transition from no annual core CPI inflation in the U.S. longer getting worse to actually starting to fall from 2.2% in the first quarter to improve. Specifically, we expect of 2020 to around 1.2% in the four the shorter‑maturity segment of the quarters ending June 30, 2021, amid break‑even curve to move higher as the a faster rate of core goods deflation data begin to look less dire and very low and a sharp deceleration in non‑energy near‑term inflation expectations become services inflation. more aligned with moderately higher longer‑term inflation expectations. Breakevens Reflect Low Inflation Expectations Moreover, the break‑even spread curve is correlated2 with the Cboe Volatility Break‑even spreads, a market‑based Index (VIX), the closely watched measure measure of inflation expectations based of implied equity market volatility. The on yield differentials in same‑maturity break‑even curve has tended to steepen nominal (not inflation adjusted) at times when the VIX is elevated and Treasuries and Treasury inflation flatten when the VIX falls back to calmer protected securities (TIPS), are pricing levels. With volatility appearing to in low future inflation. Ten‑year TIPS moderate, we believe that shorter‑maturity breakevens fell as low as 50 basis breakevens can widen even in a scenario 1 points (bp) in mid‑March as equity where longer‑term inflation expectations and credit markets sold off. Despite remain muted and longer‑maturity a recovery in inflation expectations breakevens stay relatively steady. as risk appetite improved, as of early June, 10‑year TIPS were pricing in TIPS Can Provide a Useful Hedge inflation of only about 120 bp over the Against Unexpected Inflation next 10 years. At such depressed levels, Finally, although inflation is likely to there is scope for breakevens to expand remain subdued, investors should despite subdued inflation pressures. remember that an allocation to TIPS However, with real (inflation‑adjusted) can help preserve real value in rates on TIPS in negative territory, portfolios over longer time periods and upside for TIPS breakevens will likely provide a hedge against unexpected bursts of inflation. 1 A basis point is 0.01 percentage points. 2 Correlation measures how one asset class, style or individual group may be related to another. 3 WHAT WE’RE WATCHING NEXT In the nominal Treasury rates market, the shorter‑maturity segment of the curve is anchored near 0% due to the Fed’s zero interest rate policy, which is expected to remain in place for the foreseeable future. Meanwhile, movements in long‑term rates have driven the shape of the curve; the curve has flattened on days when risk aversion is higher and demand for safe havens increases, and steepened when risk appetite is stronger and long‑term Treasuries sell off. With this dynamic likely to remain in place, we see potential for the Treasury curve to steepen into the back half of 2020, driven by higher long‑term yields as the growth outlook improves. 4 T. Rowe Price focuses on delivering investment management excellence that investors can rely on—now and over the long term. To learn more, please visit troweprice.com. Important Information This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action. The views contained herein are those of the authors as of June 2020 and are subject to change without notice; these views may differ from those of other T.
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