Why the inflation outlook is a key question for 2021

Why the inflation outlook is a key question for 2021
  • One of the biggest question in the financial markets and economy in 2021 - what happens with inflation?
  • Inflation y/y is expected to rise in the spring given 2020 comparisons to the peak of the pandemic
  • But that inflation isn't expected to last, and so it wouldn't have much of a Fed monetary policy impact

Broadly speaking, investors and economists think inflation is going to rise next year. However, any bumps in prices are likely to be small, and still almost certain below (or near) the Fed's 2.0% inflation target.

A SIFMA survey of Wall Street economists showed expectations for headline PCE inflation to rise from 1.2% this year to 1.8% in 2021. Core PCE is only expected to rise 0.2pp to 1.7%. That is, inflation is expected to rise, but not by much.

In fact, a good portion of those economists said the US will face a period of disinflation over the next two years.

Low inflation is more than an academic problem. Low inflation or deflation gives businesses less incentive to make longer-term investments. Weak price growth could eventually weigh on the labor market - wages are sticky (you're not going to take a paycut anytime soon, right?), so lower price growth would increase the wage bill for a company relative to revenues, lowering margins and pushing employers to cut costs through chopping jobs.

On the other hand...

The weaker dollar trend is part of a higher inflation story for 2021. A Reuters survey showed expectations for a 6% decline for the dollar next year, which would both boost growth and raise commodity prices.

The stimulus package (if it ever gets passed...) would also help - or at the very least, it wouldn't hurt. Bank of America raised its 2021 GDP outlook based on the stimulus package that will soon be passed in Congress.

There's some give and take on both ends of the inflation argument. At the very least, there seems to be some baseline for disinflation. We might not see much inflation, but at least inflation shouldn't fall any further barring some big unforeseen event.

So why does this matter?

It all comes down to Jay Powell and the Fed.

The Fed's 2.0% inflation target is in danger of missing again next year despite the massive amount of liquidity pumped into the system.

This tells me two things.

This idea was straight out of the Milton Friedman textbook, but it hasn't been true in a very long time.

Chart: Bloomberg

See if you can spot where the central banks stepped in. Despite that, price growth (at least in the US) is expected to remain well below 2%.

Some of the most popular trades this year have been inflation plays. The December Bank of America Global Fund Manager Survey shows the second most overcrowded trade as short dollar. The third most overcrowded trade is long bitcoin.

Even the vaccine-driven rotation into value and cyclicals and small-caps is a reflation play.

I wrote earlier this week that the most popular (though I'd argue it's not the strongest) argument for Bitcoin is that money supply has grown like gangbusters. This year as money supply increased by $14T across the US, China, the eurozone, Japan, and eight other developed countries (Bloomberg). But that hasn't translated into higher prices, or even the threat of higher prices in most (all?) of those countries.

Despite this backdrop of central banks, a weaker dollar, and cash sloshing all over the place, the more probable risk in the US is that inflation doesn't materialize, which could come about in any number of ways:

  • The Fed (and/or other central banks) reduces asset purchases or tightens much earlier than expected.
  • The stimulus proves inadequate, and there's a slower labor market recovery than expected.
  • COVID-19 could stick around longer than expected, or issues around the vaccine supply chains or efficacy
  • Wage growth is likely to be muted given the huge pool of unemployed.
  • The CARES act suspended the 2% sequestration to Medicare payment rates, which ends at the end of the year.
  • Housing and rent price increases in some areas are pretty much directly offset by declines in other markets. Have you seen rent trends in New York and San Francisco?

To be fair, the Fund Manager Survey showed 79% of respondents expecting rising global CPI next year, with 56% saying they expect inflation to be "a lot stronger."

But that might be a matter of positioning - that is, why the economists and the fund managers have different opinions. Even a modest jump in inflation for a fund manager is going to hurt their PnL. When it comes to inflation, prepare for the worst, but in this case you can still assume a fairly high probability for the best (more low inflation).

And then there's the Fed...

Let's say we see inflation start to tick up in the spring when everyone is vaccinated and starts spending all that cash accumulated in 2020. That wouldn't be a surprise - but we also don't know how durable that bout of inflation would be.

Tim Duy wrote in Bloomberg Opinion that it's not hard to imagine that inflation will rise above the Fed's 2% target at some point next year given pent-up demand in travel and dining, widespread vaccinations sparking consumer spending, and the new $900B fiscal aid package also propelling the economy along. Those factors might even close the output gap, pushing aggregate demand above supply, completely reversing the 2020 dynamic. However,

...any estimates of the output or unemployment gaps are just that — estimates. They will raise some worries about reports showing higher rates of inflation yet still leave the Fed hesitant to change the expected path of rate increases. The Fed will believe the economy is operating closer to full capacity if wage growth accelerates meaningfully beyond the 3.5% seen in July 2019, the high of the last cycle. That would help the clear the way to higher interest rates.
My instinct is that getting all three of these pieces to come together makes inflation more of a 2022 story than a 2021 story. At this point, the 2021 story still looks less like real inflation and more like an inflation scare. And with its new policy strategy, the Fed won’t scare easily.

I am not going to make a prediction on where inflation lands in 2021 here. But I know enough that there's a lot more to inflation dynamics than just the amount of money being added to the Fed's balance sheet and any temporary vaccine-driven sugar highs.

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