A Done Deal?
Can we guarantee that dominoes like MMT, debt monetization, a closed output gap, increasing money velocity and rising inflation expectations will all fall, resulting in a significant upward inflation path? We can't. And the baseline remains that inflation will be stuck in a low range for some time. But the addition of long-lasting MMT would markedly raise the likelihood of higher inflation several years in the future. Indeed, some of these dominoes likely will fall. Whether enough of them topple to generate real inflationary pressures remains to be seen, but we should probably assign a markedly higher probability to that outcome than the market appears to be pricing in.
Which Assets Should Benefit?
With growth likely to be challenged in the quarters ahead, along with a very large output gap and oil down by about a third since the start of the year, inflation is unlikely to be a problem for quite a while. Nonetheless, the prospects are greater that somewhere down the road, prices could run noticeably higher this upcoming cycle than what we witnessed during the past several expansions. This is not to say that we are expecting anything close to hyperinflation, or even inflation markedly higher than 3% or 4%, but rather that the trend toward ever-lower inflation will reverse.
Asset classes that could potentially benefit from, or helped offset, a moderately rising inflationary environment include value equities, Treasury Inflation Protected Securities (TIPS), limited maturity bonds, floating rates securities, commodities and hard assets such as real estate and gold. A rising inflationary environment could potentially disadvantage assets such as longer duration bonds, growth equities and bond proxies such as REITs, utilities and infrastructure.
On a closing note, if policy makers are successful in generating higher inflation, this could present a new set of risks. Central banks and fiscal balance sheets are currently socializing profit loss and solvency risk to sustain employment and household income in the hopes of protecting against the downside to growth and inflation. And full-fledged MMT would take this socialization to a new level. But capital markets offer two primary functions in society: capital allocation and price discovery. "Forcing" inflation higher would distort these functions, where the public policy cure could be worse than the disease. Investors should be prepared for more distorted markets, with or without inflation.
Erik Weisman is chief economist and fixed income portfolio manager at MFS.