The return of inflation is now the market’s most feared Halloween horror story. But how petrified should investors be about the threat from rising prices?
It depends whom you ask. Central bankers remain remarkably unruffled. The bond market, too, doesn’t seem all that fussed. Many economists also insist that an inflationary spurt is just a passing phase in the post-lockdown recovery.
But there are notable exceptions. Take Alan Ruskin, a macro strategist at Deutsche Bank, who this week published a report entitled A Hangover Like No Other.
“We now look to be in for a bout of inflation scarring,” he wrote. His view is that inflation will not peak before the middle of next year and could persist much longer if central banks don’t get off their haunches.
If so, and policy makers have to suddenly hike interest rates to keep a lid on rising prices, the howls of pain will echo down Bay Street and Wall Street. Ever since the 1990s, investors have trusted in the “central bank put” – the belief that central banks will always rush to the aid of the stock market in times of crisis. (The comparison is to a put option, which provides a floor to an individual stock price.)
If soaring inflation were to force policy makers to abruptly raise interest rates, regardless of the bone-crunching impact on stock prices, their crackdown would shatter belief in the central bank put. Chaos could ensue. “It is not clear that investors are at all prepared for these outcomes,” noted analysts at Man Group, the London-based money manager.
This is scary stuff, to be sure. But before loading up on inflation hedges, investors may want to put the danger in perspective. Here are four things to remember:
This is not your daddy’s inflation
The Bank of Canada and the U.S. Federal Reserve acknowledge that what they initially described as a “transitory” bump in postpandemic inflation has lasted longer than expected. This doesn’t mean, though, that we’re headed back to the 1970s.
Back then, annual inflation soared above 12 per cent in Canada and the United States. By comparison, today’s inflation is running below half that level – 4.4 per cent in Canada and 5.4 per cent in the U.S.
Most forecasters expect price increases to subside in coming months. Capital Economics, for instance, sees the consumer price index (CPI) in the U.S. advancing at around 3 per cent in both 2022 and 2023. That would be higher than the 2-per-cent level that most central banks aim for in normal times, but tame compared with what we endured half a century ago.
The world has changed
There are many excellent reasons to fear a return of the 1970s but they mostly have to do with wide bell-bottoms and disco. When it comes to financial conditions, investors should avoid easy analogies between then and now.
At least three big shocks were required to send inflation soaring in the 1970s, noted Daniel Alpert, managing partner of investment bank Westwood Capital, in an essay last week. The shocks included Richard Nixon’s decision to take the U.S. off the gold standard in 1971, oil crises in 1973 and 1979, and the unprecedented surge of baby boomers into the work force throughout the decade, which fed a surge in consumer demand.
None of those conditions apply now. Yes, oil prices have rocketed in recent months, but their gains relative to prepandemic levels hardly register compared with the tenfold increase in the 1970s. Meanwhile, there is no monetary shock comparable to the end of the gold standard and work forces are aging and retiring, not suddenly expanding.
The bond market is just fine, thanks
The bond market offers a good guide to what the smart money expects from inflation over coming years. It is signalling concern but not distress.
Look, for instance, at breakeven rates. These are calculated by comparing how much inflation-protected government bonds pay in real, or after-inflation, terms versus how much regular government bonds pay in nominal, or before-inflation, terms. The gap between these two yields reflects market expectations of what inflation will be over the years ahead.
Right now, breakeven rates on 10-year U.S. Treasuries sit at 2.54 per cent. That is higher than prepandemic levels, but not wildly out of line with central banks’ 2-per-cent targets, especially since many of those institutions – the Federal Reserve, in particular – have indicated their willingness to tolerate slightly higher than normal inflation during economic recoveries.
Humility is good
“The biggest error in analyzing the economic impact of the pandemic is to try and treat the past 18 months as a normal cycle,” says Paul Donovan, chief economist at UBS Global Wealth Management. He has a point. Policy makers face an extraordinarily tough task in interpreting what today’s readings mean.
Some inflation drivers – such as wage gains and home-price increases – could linger. Others, such as microchip shortages and the bottlenecks at ports caused by enormous jumps in demand for goods, are likely to ease. But we have never before tried to restart an advanced global economy after a major pandemic, so nobody knows.
What should investors take away from all this? One conclusion is to be wary of anyone who claims to know what inflation will do next. A new study by the Federal Reserve Bank of Cleveland shows that consumers and experts have both been lousy inflation forecasters, especially over the past decade. For now, there is good reason to be cautious, but not enough reason to radically restructure your portfolio on the basis of a horror story that may not come to pass.
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