One of the debates that has surfaced as a result of the recent fiscal and monetary policy initiatives is whether or not the initiatives will cause inflation. While we have no way of perfectly predicting the future, we can outline how inflation is measured, the conditions that led to prior increases in inflation measures, what those conditions look like today, and some assumptions about the near-term path.
For the purposes of this outline, we are going to use the Consumer Price Index (CPI) for All Urban Consumers data as the measure of inflation. Data on this measure of inflation can be found at the U.S. Bureau of Labor Statistic website. The simplistic definition of CPI is that it measures a basket of goods that the average consumer buys, weighted by percentage of total expenditures. The weights and components of the basket are updated periodically on a lag of a few years. As of February 2020, the largest categories were shelter (33%) and food (14%). Shelter is a combination of owned and rented housing and food is a combination of groceries and restaurants.
Next, we need to define what we mean by inflation. There are two basic explanations, both are illustrations of what cause prices to increase. One is based on a mismatch between the supply and demand of goods. This can be caused by either a decrease in the availability of a good or service, or an increase in the demand beyond the current supply capacity. Another cause of inflation is a decline in currency value, which leads to an increase in the cost of imported goods and services.
With this framework in place, we can look at some examples of prior increases in CPI and the underlying conditions. The first example is the mid-1970s when CPI rose to 12% year-over-year (y/y) by Q4 of 1974.
This was primarily caused by an increase in the cost of oil, driven by a decline in the supply of available foreign crude.
The next increase in CPI took place in the late 1970s and early 1980s when CPI rose to 14.5% in Q2 1980.
One of the major contributing factors was the decline in the U.S. Dollar exchange rate.
This caused the price of imported goods and services to increase, including foreign crude and items manufactured in Japan.
CPI increased again in early 1990s with CPI reaching 6.25% in Q4 1990.
This was driven in part by higher oil prices as a result of the first Gulf War.
The final example came at the end of the last economic cycle as CPI peaked at 5.25% in Q3 2008.
This increase was driven by a combination of a decline in the U.S. Dollar exchange rate, especially to the Euro, an increase in oil prices driven by an increase in demand from China, and an increase in home prices.
Since then, the highest CPI growth has been was 3.7% in Q3 2011 and has rarely been above 2.2%.
The big takeaway from these examples is that the price of oil and the U.S. Dollar exchange rate have been the largest determinants of inflation.
From a policy standpoint, the impact on inflation from fiscal and monetary actions is typically realized in a change in the exchange rate (too much U.S. Dollar available and a decreased desire to own it) or an increase in the availability of credit, leading to a mismatch in the supply and demand of goods (over production or spike in demand).
On the monetary policy side, the most common measurements of potential inflationary impacts are the supply of money (M2) and the movement of money (velocity). The Federal Reserve can influence the supply of money by purchasing securities and converting those holdings into reserves, which banks can then lend. The velocity of money, the rate at which reserves/deposits get converted into loans, depends on the banks willingness to lend and the markets willingness/need to borrow. The type of borrowing matters also plays a part as it has different impacts on the economy. Looking at some of the prior examples, we can see various relationships between M2 and velocity of money.
There was a delayed impact in early 1970s, but eventually velocity increased after the increase of M2 and inflation began to accelerate.
The late 1970s/early 1980s was more of a fiscal situation as M2 growth and velocity were unchanged.
In the early 1990s, M2 growth and velocity were increasing prior to the oil shock, and velocity picked back up when the economic expansion restarted.
In the mid-2000s, velocity was increasing which helped fuel credit growth for housing.
One of the reasons inflation growth has been so low since 2010, despite an increase in M2, is due to the decline of velocity and the demand for new lending has declined.
Consumer and mortgage lending growth has declined in this cycle and more corporate lending has moved to the capital markets.
The fiscal policy impact is usually measured through the budget deficit and has an impact on the supply of the U.S. Dollar, which can impact the value of the exchange rate. The budget deficit in 1974 was under 0.5% and had been decreasing for a few years.
In 1980 the deficit was 2.5%, up from 1.5% in 1979.
In 1990, the deficit went from 2.75% to over 4.5%.
In the mid-2000s, the deficit went from 3.25% to 1% in 2007, before increasing again in 2008-2009.
The decline in the U.S. Dollar exchange rate in the mid-2000s was due to the increase in the trade deficit, which grew from 2% to 4.5% of GDP.
CPI was growing at a rate of 1.5% y/y as of March 2020, M2 was growing at an 8% y/y rate (which has since increased to 15% in April), and velocity has declined to 1.45.
The budget deficit is likely to increase to a record level in the near-term while the trade deficit will likely continue to shrink as a result of less overall activity and a shift to more domestic supply sources.
In the near-term, the significant decrease in economic activity is likely going to cause a large decrease in CPI due to the lack of demand for goods and services. For monetary policy to cause inflation to increase in the longer term, the velocity of money would need to increase significantly. This requires an increase in demand for credit (which is tied to an increase in economic activity) and a willingness to lend by banks (adequate credit worthiness and a belief that a sufficient return can be made by lending). The current record level of unemployment claims means that consumers are unlikely to be in a position to borrow. Corporate debt levels were already high, and many companies will likely need to restructure their balance sheets. There will be a near-term increase in corporate lending but that is mostly through credit lines needed for liquidity purposes, not capacity expansion.
For fiscal policy to cause inflation to increase, the budget deficit would need to lead to a decline the U.S. Dollar exchange rate. This seems unlikely in the near-term as many other countries are also planning to increase fiscal spending and the need for the U.S. Dollar is still high based on the amount of borrowing that takes place in other countries (the U.S. exchange rate is currently near multi-year highs based on various measures and against multiple currency pairs).
The new dynamic in this period is the direct supply of fiscal stimulus to U.S. citizens. If this were to continue for an extended period, there is a chance that demand could exceed supply as citizens have more capital to spend than the economy has capacity to meet. This could be exacerbated by a shift to more domestic supply sources, delaying the return of new supply. Rising oil prices were a major cause of higher inflation in prior examples. Given the current low oil prices driven by excess supply and the low expected prices in the futures market, this is not likely going to cause higher inflation in the near-term.
There are a few ways to measure expectations for inflation that should help determine which way the inflation debate is leaning. One way is by looking at the Treasury Inflation Protected Securities (TIPS) breakeven curve. The TIPS breakeven curve is a projection of what the rate of inflation needs to average over different time periods for the return of a regular Treasury and TIP to be equal. Currently, the breakeven inflation rate ranges from 0.70% for five years out to 1.4% for 30 years. Those are very low levels compared to history.
There are forward markets for inflation that act as securities that trade based on the expectation that investors have for rates of inflation over different time periods. The most common is the 5-year, 5-year, which measures 5-year inflation expectations five years from now (what will the average 5-year inflation rate be from 2025-2020). At the end of April, the forward inflation rate was 1.44%. That was the lowest rate since January 2009.
There are also survey-based measures that gauge corporate and consumer outlooks on inflation. The University of Michigan consumer survey for March showed inflation expectations for the next twelve months of 2.2%. That is tied for the lowest level since March 2009.
Duke University conducts a survey of Chief Financial Officers (CFOs) and their expectation for inflation was 2.2% as of December 31, 2019. This will likely decline when the March survey is released.
In summary, it is likely that in the near-term, the decrease in demand exceeds supply, causing inflation to decline. From there, it will depend on the path of monetary policy (interest rates and money supply), the response of the market (whether credit demand increases or decreases), the path of fiscal policy (budget and trade deficit), the response of the market (where does the money go), the path of the economic recovery (when does unemployment improve, when does global trade increase), and what happens to the U.S. Dollar exchange rate. All of this will influence the supply and demand of goods and services, including oil, which will determine the growth rate in the CPI basket.
Rank Dawson, CFA
Vice President, Investment Strategy
Boyd Watterson Asset Management, LLC
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance. The information, opinions, and views contained herein are current only as of the date hereof and are subject to change at any time without prior notice.