Risk Commentary
Overview
Like drug addiction or the lyrics in the Hotel California, inflation is easy to enter, but difficult to leave:
“They gathered for the feast
They stab it with their steely knives,
But they just can't kill the beast …
You can check-out any time you like,
But you can never leave”
Lyrics from Hotel California by the Eagles
Perhaps a starting point for a discussion on inflation is a determination of the underlying causes. In simplistic terms, inflation is caused by a rise in the demand for goods and services in excess of the growth in supply. Fortunately, increased productivity and the rise of the global supply chain (providing the benefits of lower-cost labor) have tempered inflation over the past couple of decades. However, for the past 18 months both monetary and fiscal policy have been running red hot, in an attempt to offset the deflationary effects of the COVID crisis. Cynics will claim that this has been intentional; politicians and central bankers are incentivized to manage short-term results and thereby downplay longer-term impacts.
Current Situation
In case there is any doubt, inflation is running near 7.0% currently, while risk-free interest rates (measured by 10 year Treasuries) are running near 1.5%. We raise the issue of interest rates because the last time inflation was a major issue, FED Chair Paul Volcker orchestrated a massive increase in rates to “break” inflation.
Figure I - Consumer Price Index
Volcker’s (FED chair from 1979 to 1987) increase in interest rates slowed the economy thereby reducing demand for goods and services. (See Figure II below from 1979 to 1981.) Therefore, currently, the question is to what level might rates have to rise to quell demand. The short answer is that no one knows, but if history (i.e., from 1979 to 1981) is any guide, rates rose 600 bps. Another cause for concern is the fact that the spread between inflation and 10 year Treasuries now is near 540 bps compared to no more than 200 bps during the Volcker years.
Figure II
Regardless, times have changed dramatically since Mr. Volcker worked his magic. The major differences are the massive increase in central bank balance sheets and the rise in sovereign debt thereby begging the question of whether more might be needed. On this score, we believe that the rise in central bank balance sheets and sovereign debt is reflected in interest rates and therefore perhaps no additional effort would be needed, but then again, we have not been here before. Furthermore, it appears that central banks are at least discussing a tapering (sovereign debt is another matter). Regarding the levels, the expectation and hope is that inflation will ease as the economy catches up with demand and that a more realistic level might be in the area of 4.0 or 5.0%. Hopefully this is true although recent information gives little comfort. Assuming 5.5% is about the correct medium term inflation level, to break inflation, 10 year rates would need to rise to the 6.0% or 7.0% level, translating into a massive 450 to 550 bps rise.
While all this analysis might be completely accurate, what is missing is the political factor. Employing the adage that all in Washington either starts or ends politically, we doubt the current lineup of central bankers and their backers are willing to take the hard medicine to quell inflation. It is also doubtful that Progressives would tolerate any meaningful tightening. Providing support to those who are unconvinced, the forces and motivations which prompted the employment of the extraordinary measures remain operative, and unless there is a clear political motivation, those measures will remain.
Therefore, the inflation beast is likely to remain with us until after the 2024 election. Perhaps you do not like it, but per the lyrics “you can never leave”.
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