Commentary on Political Economy

Thursday, 4 February 2021


Rising Inflation Will Force the Fed's Hand

The Fed has created the biggest financial bubble in history, but rising prices will require a fundamental rethink of monetary policy.

Ready to burst?
Ready to burst? Photographer: JOHANNES EISELE/AFP

The problems faced by new U.S. President Joe Biden would be formidable for anyone. There’s the political schism that won’t be cured by optimistic calls for unity. Then there’s the herculean challenge of stopping Covid from killing too many more people. High up on his list, and sooner rather than later, will be dealing with the consequences of the biggest financial bubble in U.S. history. Why the biggest? Because it encompasses not just stocks but pretty much every other financial asset too. And for that, you may thank the Federal Reserve.

The fallout from a Fed that has encouraged investors into buying horribly overpriced assets will be every bit as difficult as coming off the gold standard in the early 1970s or tackling runaway inflation in the early 1980s. It will require an act of political will and a complete rethink of monetary policy. Having Janet Yellen, a former Fed chair, as Treasury Secretary is unlikely to help. She was among a long line of Fed bosses, from Alan Greenspan on, who reacted to each crisis by slashing interest rates and, over the last decade or so, massively expanding the Fed’s balance sheet.

By coming to the rescue every time in the manner it did, the Federal Reserve created the conditions for the current bubble — and the next crisis.

That game is now over. Little noticed last week amid the copious commentary on the GameStop Corp. jollity was a data release showing the Fed’s preferred measure of consumer inflation is going up. Over the past 12 months core personal consumption expenditure rose 1.5%, higher than the 1.3% expected. Admittedly this is still low, but it’s likely to go up a lot further. The Fed is monetizing much of the government deficit; the monster amount of money that it created is finding its way out of the banking system; there are severe supply constraints in both manufacturing and services; and Asia is on fire.

The charts below are revealing. Sean Wolpert, a former colleague of mine at Rubicon Fund Management, has compared the price pressures in the two ISM surveys (manufacturing and non-manufacturing) with subsequent CPI. Even without a sharp recovery in demand, inflation is already rising and these two surveys are a very good predictor of where it will go next.

Price Pressures

ISM surveys are a good predictor of inflation

Source: Sean Wolpert

Rapidly rising inflation will eventually force the Fed to rein in its lax monetary policy. But it will move, by its own admission, very slowly; on my interpretation much too slowly. It’s a racing certainty that markets will be spooked much earlier than the central bank.

Central bankers the world over seem to be the only people who don’t see signs of wild excess wherever they look. Most investments are almost certainly going to lose money over the next few years. On the measures that matter —  you know, the ones that actually predict returns — the U.S. stock market is as expensive as it was in 1929, 2001 and the lead up to the Global Financial Crisis.

All stock-market bubbles go hand in hand with rapid credit growth and this latest one is no exception. Non-financial corporate debt has been on a tear these few years past, relative to gross domestic product. Part of the reason last year, of course, was the rapid fall in GDP, although the Fed also played its part by buying billions of dollars of corporate debt.

At least when stock markets went south in those earlier periods, investors could plonk their money in government debt because they offered yields. In the early 1990s, lest we forget, Japanese 10-year yields briefly touched 8%. They don’t have quaint things like interest rates in Europe or Japan any more, thanks to their respective central banks. The 1.1% available on 10-year U.S. Treasuries looks breathtakingly meager, too.

It’s probably an even worse idea for investors to buy corporate debt, especially lower-rated issuance. Spreads on company debt over government bonds are also desperately low, meaning corporate debt yields are at record lows. Yields on borrowers rated CCC or less — the lowest ranks of junk before default — have never been lower. 

If investors are about to face a crisis, so too is the White House and the Fed. It wouldn’t take much movement from the Fed to upset the markets, hence its desire to move carefully. On the other hand, doing nothing is also problematic from a political perspective. Inflation is regressive: It hurts poor people far more than rich ones. That doesn’t look like a model of social justice.

Reasonable people can disagree, but I think we’ll find out how much of a hole the Fed has dug for itself, markets and the U.S. in the next three months.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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