In the classic Roadrunner skit, the Coyote buries one ACME box of dynamite beneath a pile of birdseed, strings the wires to a detonator hidden behind a rock, waits for our hero to arrive and start pecking, and then forcefully pushes down on the plunger. And, of course, nothing happens. He checks the wiring, jumps up and down on the detonator, and then jumps up and down on the dynamite pile as the roadrunner exits stage left with a cheerful “beep-beep.” Finally, as he stands there dejected, boom.

You can follow the evolution of his thought process. 

“It will go off.”
“It should go off.”
“Why won’t it go off?”
“It will never go off.” followed by
“Boom”

In the aftermath of the Great Financial Crisis, it seemed we had built ourselves an inflation bomb. A huge increase in government debt, monetized by the Federal Reserve, and triggered by an economic recovery should have caused inflation to surge. But as the years went by, and the mixture of fiscal largesse, monetary enabling and tightening labor markets proved entirely inert, most economists and policy makers appear to have concluded that the inflation bomb will never go off. That being said, the aftermath of the present deep but hopefully short-lived recession will give us another opportunity to ignite the inflation bomb. It may, of course, still not go off. However, investors would still be well advised to structure their portfolios with an eye to the possibility that it could.

Both the Federal Government and the Federal Reserve have gone to extremes in trying to defend the U.S. economy from the effects of the social distancing recession. Whatever the past missteps of both institutions in providing a healthy economy with excessive monetary and fiscal stimulus, it is hard to argue with the need for swift and bold action in reaction to this unprecedented crisis. However, it is important to consider how these actions will alter the investment landscape in the wake of the pandemic.

On the Federal Government side, last week Congress approved a further $484 billion package to supplement the CARES Act. All told, the federal government has now enacted four separate pieces of legislation to address the pandemic.  The Congressional Budget Office estimates that these will add $2.7 trillion to the federal debt over the next 18 months. It should also be noted that the small business grant program, enhancements to unemployment benefits and aid to state and local governments, appear designed to support the economy only until the middle of this summer. If, as seems likely, large parts of the U.S. economy remain shut until the distribution of a vaccine, hopefully by the second quarter of next year, then the federal government could easily approve a further $1 trillion in aid.

This, combined with interest costs and the automatic impact of a deep recession on both revenues and spending, could result in deficits of an astonishing $3.8 trillion this fiscal year and $2.9 trillion next fiscal year, boosting the debt from 79% of GDP at the end of the last fiscal year to 109% of GDP by the end of fiscal 2021, thus eclipsing the all-time record of 108% of GDP set in 1946 as the U.S. added up the extraordinary costs of fighting World War II.

Borrowing at this pace, particularly when other governments around the world are also running fast-rising deficits, might be expected to result in higher interest rates, even in a deep recession. However, this risk has been averted, for now, by an extremely aggressive Federal Reserve. 

Starting with a terse statement at the end of February, in which Jay Powell committed the Fed to use its “…tools and act as appropriate to support the economy,” the Fed has engaged in monetary stimulus unprecedented in both its scope and its magnitude. 

• First, in two quick steps in early March, the Fed cut the federal funds rate from a range of 1.50-1.75% to its effective lower bound of 0-0.25%.  They also eliminated reserve requirements and cut the discount rate by more than the federal funds rate to encourage banks to borrow from the discount window.

• Second, they established or re-opened multiple credit facilities to supply liquidity to markets for short-term credit instruments, corporate bonds, municipal bonds as well as to backstop loans to small and medium-sized businesses.

• Third, they ramped up and expanded dollar swap arrangements with other central banks with the twin goals of ensuring the availability of dollar funding overseas and alleviating upward pressure on the exchange rate.

• Finally, after proposing to boost its holdings of Treasuries by $500 billion and mortgage securities by $200 billion on March 15^th, the Fed then abandoned all limits on Quantitative Easing (QE) on March 23^rd.  As a result, since the end of February, the Fed’s holdings of U.S. Treasuries have increased by $1.4 trillion and the overall assets of the Fed, which also include additional mortgage securities, foreign central bank liquidity swaps and holdings in new and expanded credit facilities, have risen by $2.4 trillion.

On Wednesday of this week, at his post-FOMC press conference, Jay Powell will, no doubt, express the Fed’s determination to continue to support the economy at this uniquely stressful time. The principal avenue of that support will likely be further Treasury purchases, even as the economy begins to revive from this deep recession in 2021. However, it does beg the question of how far Washington can go in issuing and monetizing debt before everyone pays a price in terms of higher interest rates, higher taxes and higher inflation.

This is no easy question to answer. However, logically it should depend on the forces that suppressed inflation and interest rates in the last long economic expansion, the position of monetary and fiscal policy when the economy reaccelerates and the pace at which it reaccelerates.

On the first issue, it is worth noting that many worried about higher interest rates and inflation in the last expansion. These concerns were based on the simple monetarist argument that a big increase in bank reserves should lead to a big increase in the money supply and thereafter, a big increase in inflation.

In retrospect, this turned out to be wrong partly because, for regulatory and other reasons, bank lending and the money supply never increased nearly at the pace of bank reserves. In addition, caution among lenders to extend credit to riskier borrowers and steadily rising income inequality acted as a brake on the demand for goods and services and diverted income towards the purchase of financial assets. This lack of demand was amplified by fiscal austerity as the budget deficit, as a share of GDP, fell every year from 2010 to 2015. 

In addition, on the supply side, globalization, in an environment of weaker overseas demand and rising U.S. dollar, helped hold down import prices, information technology made the markets for more goods and services more competitive and a fragmented and de-unionized labor force held wages in check.

Based on this experience, there is some risk of higher inflation and interest rates in the aftermath of this recession. 

First, both the Federal Reserve and the Federal Government will likely be in a more expansionary mode. On the Fed side, the fact that this recession wasn’t preceded by a financial bubble will probably result in a more indulgent regulatory stance, encouraging more bank lending. In addition, the fiscal restraint during much of the Obama administration was due, in large part, to constraints placed on the administration by fiscally conservative congressional Republicans. However, the record of the last three years suggests that there are no fiscal conservatives left on either side of the aisle.

Second, the economy is likely set for a much more rapid rebound after the pandemic than was the case in the aftermath of the financial crisis. Put simply, once a vaccine is widely distributed, pent up demand among the American public for a very wide range of services and goods should be unleashed, and, while supply should be ramped up quickly also, the very pace of growth could prove inflationary.

Finally, it may be that, in the aftermath of the crisis, political steps are taken to address income inequality. This could, depending on the results of the November elections, include minimum wage increases, universal health care and reforms aimed at a more progressive tax system. Regardless of the social merits of such ideas, a redistribution of income from upper-income households, who tend to save more of their income, to lower and middle-income households, who have a higher propensity to spend, could also prove inflationary.

If inflation were to emerge, it would likely boost long-term interest rates and force the Fed to tighten monetary policy. It would also put additional pressure on the budget, given the huge amount of debt that would then need to be serviced, potentially forcing the government to raise taxes, likely on richer households. 

In the long run, this would hopefully lead to a more balanced approach to monetary and fiscal policy, with both the federal government and Federal Reserve adopting more rational counter cyclical policies when the economy is healthy. 

However, for investors today, with long-term bond yields at historic lows, it is a reminder that real assets, including stocks, real estate and precious metals can serve an important, although long-redundant role, in protecting a portfolio against the risk of inflation.

David Kelly is chief global strategist at JPMorgan Funds.