3 Inflation Scenarios: How Bad Could It Get?

Art by Tilda Rose

How inflation fares going forward will be keenly watched on Wall Street. Pension plans and other asset allocators, whose returns will be affected (especially their bonds), can’t get a clear picture of whether the inflationary trend will persist and at what level. How escalating prices affect interest rates is a key question, with the Federal Reserve the main player in that drama.

“It could be that inflation rips and rates stay low,” said Mark Baumgartner, CIO of Carnegie Corporation of New York, which doesn’t have a lot of bonds in its portfolio. Or any number of other things could happen—he is eyeing wage hikes to gauge how the CPI might rise in the future.

Amid this swirl of unknowns, three inflation scenarios are getting attention: 1) stagflation erupts a la the 1970s, with a breathtaking price spiral that discourages economic growth; 2) the current surging CPI cools and settles down to an average 2% annually (this is the Fed’s expectation); and 3) inflation runs hotter than that but stays in the low single digits, say around 3% or so for some time.

The Fed, in its recent Beige Book assessing the overall economy, admits that inflation is buffeting US businesses, spurred by shortages, and that the higher prices likely will be passed onto consumers in many areas. And the Producer Price Index, which gauges how much companies pay for goods and services, has accelerated mightily, up a record 8.3% in August from 12 months before.

The “data on wholesale prices should be eye-opening for the Fed, as inflation pressures still don’t appear to be easing and will likely continue to be felt by the consumer in the coming months,” warned Charlie Ripley, senior investment strategist for Allianz Investment Management, in a client report.

There’s an ocean of new money flooding the economy that surely has helped fuel the inflation jump. Historically, the M2 money supply has shown a slow, steady expansion—until lately, when it went into overdrive. M2 has grown 30% to $20.5 trillion recently from $15.3 trillion at year-end 2019.

The newly engorged money supply’s sources are massive federal relief to combat the COVID-19 economic downturn and the Fed’s mandated near-zero short-term rates, along with its $120 billion monthly bond buying. Plus strong consumer spending from households that are emerging from last year’s lockdowns. Even more money is on the sidelines. Banks are bloated with reserves that could, in time, course into the economy via flow credit and loans.

Amid all this, the CPI’s path ahead is foggy. Let’s look at one key indication of inflation expectations, the breakeven rate—calculated from the difference between the yield of nominal bonds and Treasury inflation-protected securities (TIPS) of the same maturity, commonly five years. This metric has not shot up markedly. Since spring, the five-year rate has stabilized at about 2.5% annually.

But even that number may be artificially low. The Fed is purchasing enormous amounts of TIPS, noted Cliff Corso, president and CIO of Advisors Asset Management (AAM). “This could be distorting” the inflation outlook, he said.  

At the same time, gold, a prominent hedge against inflation, is down from its August 2020 high ($2,048) to $1,795, or 12%, suggesting that inflation expectations are hardly mounting.

And if inflation does get out of hand, will the Federal Reserve and other central banks have the willpower to choke it off with big interest rate increases, which is how the double-digit inflation of the 1970s and early 1980s ended? “No one wants to be Paul Volcker,” said Cameron Brandt, director of research at EPFR, referring to the Fed chair who led that epic tightening.

Indeed, in 2018, the Fed halted a series of quarter-point increases that had pumped the federal funds rate up to a 2.25% to 2.5% range, from near-zero during the Great Recession. As the bond market slumped and the Trump White House protested, the Fed reversed course.

Stagflation Peroration

Consider the scary arguments that foresee a stagflation-ridden future. New York University (NYU) professor Nouriel Roubini, who chairs Roubini Macro Associates and was one of the few economists to predict the 2008 housing bubble burst, admonishes that stagflation is coming. He is unconvinced that the troublesome supply bottlenecks will go away soon.

Factors that will push prices ever upward, he said in a recent article, are copious Washington spending, rising protectionism and re-shoring of manufacturing to the US from cheaper foreign locales, pushes against income inequality that produce higher worker pay, and a pandemic that keeps recurring. He wrote that “negative supply shocks are likely to persist over the medium and long term.” Forget the Fed acting to stop rocketing inflation, he declared. Because “when markets suffer a shock amid a slowing economy and high inflation,” he predicted, “… the Fed will wimp out and blink.”

The real estate market, now overheated, is a perfect example of how price escalation can be embedded. In the 12 months through July, home prices vaulted 18% nationally, according to housing data provider CoreLogic. Reasons: chronic inventory undersupply (a hangover from the housing bust of a dozen years ago), a pandemic-driven zest for new homes outside of cities, low mortgage rates, and bountiful consumer cash stashes.

A lot of parallels exist between the 1970s and today, such as Fed reluctance to boost rates, large federal spending, and supply shocks—then the culprit was oil, thanks to the Saudi Arabia-led embargo, and now computer chips are scarce, leading to US factory shutdowns.

But the counterargument is that the situation today isn’t as dire as four to five decades ago. Pre-pandemic disinflationary forces haven’t disappeared. While talk abounds about re-shoring manufacturing, that would hardly happen quickly. “This will take a long time,” said Cindy Beaulieu, a managing director and portfolio manager at asset manager Conning. “Five or 10 years.”

Meanwhile in the domestic economy, automation continues its march, which makes commerce run cheaper. In addition, a major component of the 1970s inflation spurt, a vicious circle of wage escalation, is missing. Back then, unions were strong and insisted that their labor contracts keep abreast of inflation. Many had automatic cost-of-living adjustments (COLAs) built in. In 2021, unions are far weaker and COLAs are rare.

Although admitting that inflationary pressures are rife, AAM’s Corso thinks they aren’t sufficient to bring back the bad old days. “It’s not time to take out the platform shoes,” he said.

The 2% Goal

The Fed, along with other central banks, has long advocated an inflation rate of 2% as the ideal, giving a growing economy the sustenance needed to keep expanding, while also not eroding asset values and undermining the integrity of interest rates. Fed Chair Jerome Powell has amended that to be an average of 2% over time, to let the economy run faster and bring down virus-propelled unemployment. A 2% rate would be the closest to what we’ve seen in past years, albeit a little above.

In Powell’s view, the supply bottlenecks and other economic impediments are transitory, and things will return to normal, meaning low inflation in line with that 2% objective. “Inflation at these levels is, of course, a cause for concern,” he said at last month’s conclave in Jackson Hole, Wyoming. “But that concern is tempered by a number of factors that suggest that these elevated readings are likely to prove temporary.”

Inflation, he stated, is confined to a “narrow group of goods and services that have been directly affected by the pandemic and the reopening of the economy.” Certainly, some of that is simply a spring-back from artificially depressed pandemic levels, such as hotel room rates. Used auto prices also catapulted for a while, but now are falling back. Further, an aging population means fewer people working and thus a gradual lowering of demand.

Nevertheless, the staying power of inflationary currents has yet to be tested. “Getting to and staying at 2% will be tough,” as a result, said George Mokrzan, director of economics at Huntington Private Bank. Wage growth is likely to last for some time, and as pay is such a large part of the CPI, that will serve as an ongoing inflation pusher, he reasoned. Ditto for housing demand. “People want to buy, and high sales won’t go away quickly,” he added.

Above Target, But Not Overly So

To many strategists, the Three Bears porridge solution (not too hot, not too cold, etc.) seems like a reasonable condition for inflation in this decade. “Higher levels of inflation are here to stay, and it will be close to 3% for some time,” EPFR’s Brandt projected. And nearer term, “inflation will get pretty rough,” meaning somewhere north of that. Supply chain issues “won’t sort themselves out” as soon as Powell and other believe, he said.

Recessions typically undermine inflation, and that could well be the case when the next one rolls in—assuming, to be sure, that we rule out stagflation. Absent a downturn, high government spending and an accommodative Fed will keep the porridge simmering, as Brandt sees the matter.

During the 1990s and the aughts before the 2008-09 Great Recession, inflation was routinely at 3% or slightly higher, without any accompanying economic ferment. The federal funds rate, the Fed’s short-term benchmark, was around 5% in the 1990s, and in the aughts—between the dot-com crash and the housing debacle—stayed under 2% before creeping back to the 5% vicinity. As many economists have pointed out, the Fed increases were designed to keep inflation in check, and largely succeeded. Among the big questions: Will that playbook work now, and will the Fed even use it?

Invoking the supposedly ancient Chinese curse, Huntington’s Mokrzan said, “This is an interesting time.”

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