The recent passage of the $1.9 trillion American Rescue Plan – and the trillions of dollars in stimulus that came before it – have revived inflation fears. Many readers remember the period of double-digit inflation in the 1970s and early 1980s, which culminated in a major, global economic recession. With all the current spending, some fear history is bound to repeat itself.1
Early inflationary signs are appearing. One of the best places to look for future inflation is in the cost of risk-free debt, i.e., long-dated U.S. Treasury bonds. If the market expects higher future inflation, it will demand a higher yield on risk-free bonds today to compensate. That’s why in the late 1970s and early 1980s, investors could buy U.S. Treasury bonds yielding double-digit interest rates.
In 2021 to date, we have seen sustained upward pressure on the 10-year and 30-year U.S. Treasury bond yield, a signal that inflation expectations are rising. The 10-year started 2021 yielding 0.93%, and as I write, is now yielding 1.70%.2 That’s a significant move.
We’re also seeing price pressures in the real economy. The housing market is a good example. Lumber prices have never been higher, and crude oil – which is used in paint, drain pipes, roof shingles, and flooring – has rallied over the past several months. Copper prices have also jumped by nearly 40% since last fall, and brick, concrete, and insulation prices are all higher as well, with many hitting new records in 2021. Taken together, these higher prices for raw materials are putting upward pressure on the overall cost of homes in the US today.
I expect more inflationary pressures in the coming years, but I also believe the Federal Reserve has ample tools to keep it in check. Allow me to explain both positions.
To understand why additional government spending could impact inflation going forward, I think it’s useful to look back to the 2008-2009 Global Financial Crisis. Back then, the federal government also spent trillions to revive the economy, and many expected runaway inflation. It never happened.
If you go back to 2009, however, quantitative easing (QE) and other liquidity programs just served to recapitalize banks after the devastation of the financial crisis. Banks desperately needed capital reserves, and most of the stimulus just ended up parked on bank reserves. In order to trigger inflation, dollars need to move around the real economy – not sit on bank balance sheets.
Fast-forward to 2021. Banks are already well-capitalized, and a lion’s share of government stimulus payments have come in the form of direct transfers – stimulus payments to families, PPP and Main Street loans (which essentially become grants), expanded unemployment benefits, child tax credits, and more. Though many American families are saving their stimulus payments, a significant portion of stimulus payments are not sitting on bank balance sheets. The money is moving around the real economy.
The end result is that the M2 money supply is rising at an unprecedented 25% year-over-year rate, which is faster than during the inflationary period of the 1970s:
Source: Federal Reserve Bank of St. Louis3
In short, I think the case for future inflation is pretty strong. But I’m also not too worried about it today. The U.S. economy still has plenty of slack, and rising money supply is a good driver of growth. If inflationary pressures start in earnest, it will be a sign that the economy is returning to full health. Remember, some – but not too much – inflation is a good thing.
The Federal Reserve has made it clear they are comfortable seeing inflation run above their long-term target. So, seeing inflation in the 2% to 3% range would be acceptable, and would not put the economic expansion at risk. If inflation runs hotter than that, the Fed can easily step in and raise interest rates and sell bonds to tighten monetary policy. There are plenty of tools available to fight inflation, but I don’t think the Fed will have to use any of them in 2021.
Bottom Line for Investors
I agree inflation is a growing concern. I just disagree with framing it as an urgent concern today. The U.S. economy still has plenty of runway to return to pre-pandemic strength, and there is plenty of spare capacity and slack in the labor market to keep prices from moving too high too quickly, in my view. Inflation could very well become an economic issue down the road, but I just don’t think it will be a major concern in 2021.
At Zacks Investment Management, every decision we make on behalf of clients is data-driven and fueled by the power of independent proprietary research. If and when inflation becomes a significant concern, we will factor it into our decision-making process.