Inflationary surge or deflationary slump? Five questions with Roger Early
June 6, 2011
Despite the fragile nature of the U.S. economic recovery, inflation appears to be ticking up, raising concerns about a drawn-out inflationary spiral. How realistic are these concerns? What are some of the factors putting pressure on prices today, not just in the U.S., but internationally?
Roger Early, head of fixed income investments and co-chief investment officer for total return fixed income strategies, considers these questions while discussing his team’s inflation expectations.
Click on each question to read its answer or scroll down the page.
Q: The Fed has massively pumped up its balance sheet in recent years. Why hasn't this expansion resulted in notable inflation?
A: In our view, it helps to look beyond balance sheet expansion at broad money supply statistics. The science behind these statistics can get complicated, but what we generally see is that expansion of the money supply has only happened in one place: at the point where the Fed actually prints money. Beyond that, the net effects on the nation's money supply have been relatively limited.
In the past, banks would use newly created cash reserves to write loans, gradually multiplying the amount of money circulating throughout the economy. Under today's conditions, however, this “multiplier effect” is broken. It's a crucial link — our economy depends on bank loans to stimulate commerce — and, in our opinion, inflation is not likely to take hold without it.
Data: The Federal Reserve, as of June 2011.
*Velocity rates in this chart are based on a measure of the money supply that economists refer to as M2. It includes (but is not limited to) the following forms of money: currency in circulation, commercial bank deposits, overnight repurchase agreements between commercial banks, savings accounts, and time deposits under $100,000.
Velocity measurements shown above are based on seasonally adjusted quarterly readings.
Data: Federal Reserve Bank of St. Louis, as of June 2011.
Q: For a long time, investors have believed that expansionary monetary policy aggravates the risks of inflation. Do you think this an outdated piece of conventional wisdom?
A: We do. We believe investors should not expect the connection to be as profound as it might have been at one time. Not to belabor the point, but we think investors should keep in mind that monetary easing on a grand scale has not yet been tested under today's conditions. Therefore, any expectation of historical cause-and-effect relationships might be somewhat naive.
Q: If the money supply isn't a dominating factor, what is?
A: The way we see it, this is a demand story much more than it is a money supply story. This is particularly true in developing economies where secular trends could put significant pressure on prices as tens of millions of people join the middle class.
In China, for instance, a profound shift in the labor market is under way as tighter job markets are allowing Chinese laborers to be more discriminating in the types of work they seek (and the wages they're willing to accept). It's hard to overstate the potential effects of such a dramatic change in the country's labor picture. One outcome is almost certain: more people with more income are going on more shopping trips.
Q: What about demand levels here in the U.S.?
A: Given the stubborn output gap that persists here at home, we expect continued softness in a key inflation driver: wages. Sure, similar levels of resource slack can be found in other economies (including some in Europe), but we expect wage pressure to have a muted effect on price levels here in the U.S. for quite some time.
Q: How is your outlook affecting your team's portfolio allocation decisions?
A: I'll go back to talking about emerging economies for a minute because they figure prominently in our outlook. We believe commodity-led inflation could take place largely in emerging markets because commodity prices are larger contributors to overall inflation in those fast-growing economies. This includes regions like Asia and South Africa, and specific nations like South Korea and Brazil.
Simply put, general price levels in these parts of the world tend to show significant correlation with commodities, given their relatively high rates of economic growth and steady demand for commodity-related materials. This is not to say that we're making a blanket bet across all types of commodities, because not all commodity prices follow the same trend. Further, current correlation does not necessarily mean continued correlation.
With the aforementioned in mind, we generally favor increased exposure to inflation-linked bonds issued by countries outside the U.S. When it comes to investing in inflation-linked securities, we're finding that bonds issued in certain regions overseas are compensating investors well, particularly when compared to inflation-protected bonds issued domestically.
Today's circumstances also affect how we view bonds with respect to maturity. Given that global inflation appears to be trekking upward in the near term, we believe it's prudent to emphasize bonds of intermediate maturities. We can't say with certainty what will happen to inflation in the distant future, so we're currently less compelled to move toward longer maturities.
Ways to alleviate the effects of inflation:
The views expressed were current as of June 6, 2011, and are subject to change at any time.
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