Three Conditions For A Lasting Inflation Acceleration

[Bearish Bonds, Stocks, USD / Bullish TIPS & Gold]

A spike in inflation is likely when the US economy normalizes. Beyond that, continued inflation acceleration could require: the Fed to be constrained to remain behind the curve; stronger competition policies; stronger workers market power. These would leave the Fed facing a difficult choice between inflation and financial markets stability.

Inflation: One Off or Regime Change?

The spike in money growth since the COVID crisis suggests higher inflation when the economy normalizes (Chart 1). Since the 1990s great moderation, inflation has become less connected from money growth. Nevertheless, the recent increase in M2 (basically bank deposits) has been so large that it is bound to translate into a burst of inflation once consumer and business behaviour normalizes.

The Fed would likely not stand in the way of a recovery in inflation due to past inflation underperformance, concerns over tightening too early, and high corporate leverage. Rather, the Fed would likely view the inflation spike as a one off, caused by the unprecedented level of government support that would be unwound once COVID-19 no longer impedes the economy.

By contrast, a lasting increase in inflation would require structural changes, specifically that 3 conditions be met.

Condition #1: Fed Constrained to Remain Behind the Curve

The Fed review of its policy and procedures could see a move to a make-up strategy for past inflation underperformance, for instance average inflation targeting. If so, the move is unlikely to usher in a new inflation regime, since it would aim to keep average inflation at 2% and would likely only allow limited temporary deviations from the target.

A move to a new inflation regime would require a deeper change in the Fed reaction function that would compel it to remain behind the curve. Such a change could come, for instance, from fiscal dominance: the Treasury exceptionally large deficit could force the Fed to keep buying bonds out of concerns that not doing so could see yields spike and financial conditions tighten. Another scenario where Fed policy could become constrained is if it builds a large exposure to the nonfinancial sector. In this context, higher interest rates could compromise the solvency of Fed borrowers and undermine its balance sheet.

Condition #2: Stronger Competition Policies

Economic inequality has been in the news for a number of years but has only recently come into focus as a major cause of weak growth. Income distribution matters for growth because higher income households have a higher propensity to save. Therefore, when incremental income accrues mainly to higher income households, it tends to fuel the demand for financial assets more than the demand for goods and services – creating what academics have called ‘the savings glut of the rich’. This savings glut makes for sluggish demand, growth and CPI inflation as well as high asset price inflation.

The increased share of profits in GDP since the 1990s has been one of the main drivers of rising inequality since profits tend to accrue mainly to the top-earning households. In recent years, there has been a bi-partisan revival of the anti-trust movement. The revival reflects in part the emergence of large tech platforms such as Amazon, Facebook or Google that are being challenged by conservatives and progressives. Irrespective of the results of the November elections, antitrust enforcement against big tech, and possibly other sectors, seems likely over the next couple of years, which could lead to a decreased share of profit in GDP, less inequality and an acceleration in growth and inflation.

Condition #3: Stronger Worker Bargaining Power

As stressed by Governor Kuroda, an inflation acceleration requires the emergence of a wage price spiral. In turn, the emergence of a wage price spiral in the US would require stronger workers bargaining power, which would also lower income inequality by reducing the share of profits in GDP.

Worker bargaining power has been declining since the great moderation of the 1990s, as shown by a declining share of employee compensation in gross domestic income as well as by a flattening Phillips curve. The causes are well known: globalization, technological change, and labour market policies unfavourable to workers. These are likely to improve irrespective of who wins the November elections, but likely by more under a Biden than a Trump administration.

Market Implications

On balance, the three conditions seem more likely than not to be met over the next couple of years, which could see inflation accelerate beyond a possible spike to 3-4% upon post-COVID-19 economic normalization. This could leave the Fed with an unpleasant dilemma: continue to let inflation accelerate and lose credibility, which could see investors move away from dollar assets and eventually inflation accelerate further; or tighten policies and generate market volatility, including risking a selloff in US Treasuries that could make the funding of a large government deficit difficult.