It seems economists all grew up watching Sesame Street, as they said the economic recovery in 2020 was brought to you by the letters “L,””V” and “K”. If so, then 2021 will surely be brought to you by the letters R and I, which stand for Reflation and Inflation.
Interest rates move up and down with changes in expected nominal gross domestic product, which is the combination of real economic growth and inflation. Nominal growth can come from either reflation or inflation, a difference that matters greatly to the economy and markets.
If interest rates are rising on the heels of reflation and real growth, that is positive for risk assets. In the last few decades, when interest rates have risen, it has been due to real growth. The markets have shown they are willing to tolerate the Federal Reserve’s suppression of interest rates in such a scenario.
But if interest rates are rising because of faster inflation, then that is not good for risk assets. All else being equal, inflation depresses real economic growth and earnings as purchasing power dwindles. During the inflationary period from 1966 to 1982, stocks lost 65% of their real (after-inflation) value as inflation raged. These real losses were not recouped until the mid-1990s. Inflation has not been a problem since the 1990s.
And if inflation is pushing nominal growth higher, any attempt by the Fed to suppress interest rates will be rejected by the bond market. Nothing scares bond investors away faster than a central bank forcing negative real yields on them in the face of faster inflation. The analogy here is the Fed as a post and the market as a horse tethered to the post. The horse remains calm and in place so long as nothing spooks it. Inflation has the potential to spook the proverbial horse, in which case the post might not hold. The horse could rip the post out of the ground and run wild.
So, is nominal growth coming from reflation or inflation? This is difficult to ascertain thus far based on the reaction of markets. In the early stages of nominal growth, the markets react similarly to reflation-led growth and inflation-led growth. Investments that benefit from rising nominal growth do well, which is to that commodity prices typically rise, the dollar weakens, and cyclical and value-oriented stocks outperform.
The consensus seems to favor the idea of reflation, but there are worrisome signs that inflation may be an issue.
First, personal income has been booming, thanks to government transfer payments. In 2020, a record 20% of all the income Americans received was mailed to them by the government. This took the form of stimulus checks, additional unemployment insurance, social security, disability, and the like. With $900 billion more in stimulus just approved and President-elect Joe Biden pushing for trillions of dollars more, the idea of faster inflation tied to increased demand stemming from booming personal income does not seem too far-fetched.
Second, the economy is smaller than it was a year ago. The country is producing fewer goods and services to purchase. The concern is that, whenever vaccines take hold, the mix of more money chasing fewer goods could prove problematic.
Finally, how much inflation is too much inflation? Note that the core personal consumption expenditure index, one of the Fed’s favorite inflation measures, was at 1.38% on a year-over-year basis for its most recent reading for November and 2.34% on annualized basis since the economy re-opened in May, a rounding error away from a 13-year high. Should it exceed 2.5%, something Federal Reserve Bank of Chicago President Charles Evans forecast for last week, it would be a 28-year high! So, although inflation might not look like what it was during the 1970s, it will be the market that will decide when and if we have too much inflation, not the Fed.
It seems market participants at this moment are not making the distinction between R and I, but such a distinction matters. It is likely that all the talk about R will shift to I later this year, which will matter for markets.
Jim Bianco is the president and founder of Bianco Research, a provider of data-driven insights into the global economy and financial markets. He may have a stake in the areas he writes about.