The Last Reliable Buoy
War and pandemic have disrupted recent patterns of prices and yields, but long-term inflation expectations remain in line—for now.
I was exploring an unfamiliar stretch of New Hampshire’s Lake Winnipesaukee matching the dots on my chart with the buoys in the water, when a chill ran down my spine as a red marker appeared on the wrong side of the boat. Of course, it was the boat that was on the wrong side of the marker, and I can still hear the grinding sound of my propeller against the submerged rock.
That same chill strikes investors when the data appear outside trend lines they thought they could trust marking the decline in interest rates over four decades. Now they must decide if the current hot inflation readings still mostly reflect temporary disruptions of pandemic and war, or whether they have triggered a brand new paradigm. Will central banks regain control over inflation in a year or so? Or will this be a multi-year struggle that makes a deeper recession inevitable?
As price and yield readings continue appearing in unfamiliar places on the data charts, the most important buoy to watch is the one that marks long-term consumer expectations. For now, it confirms the market view that central banks will prevail, but if it becomes unmoored we’ll all be navigating in strange and treacherous waters.
10-Year Treasury Note Yield
Source: Haver as of April 7, 2022.
University of Michigan: Expected Inflation Rate, Next 5 Years (%)
Source: University of Michigan as of April 7, 2022.
Some negative bond yields notwithstanding, we knew before the pandemic that rates could not fall indefinitely without the global economy being absorbed into a black hole. But there was a comfortable predictability to this global imbalance of savings and investment that kept rates and inflation drifting inexorably lower.
Globalization of supply chains expanded the world’s labor pool and undercut wage pressures. Technological innovation and automation drove down operational costs. Aging demographics of the world's richest countries led households to save more for retirement and spend less.
COVID disruptions triggered questions about just how long supply chains should be when a link breaks. But the logic of international trade with lower costs and more specialized suppliers remains unassailable. Indeed, we may even be on the cusp of a rapid expansion of trade in digital services.
Yet some of the elements that helped entrench the trends we came to describe as “secular stagnation” have clearly changed.
First, watch for a fresh wave of government spending as the list of “top priorities” grows ever longer. In addition to spending on infrastructure, climate change, and redressing inequality, the Russian invasion has sparked a new wave of defense spending—Germany has pledged a massive increase to 2% of GDP while the Biden administration is proposing a 4% increase in its 2023 budget. Meanwhile, the spike in food and energy prices will likely force many governments, especially in emerging markets, to budget for consumer subsidies.
Second, the world’s largest banks are emerging from the pandemic with strong balance sheets and plenty of room to start lending. Even as interest rates begin to normalize, we should expect credit growth that will encourage more spending. At the same time, companies are expanding their capital expenditures to address supply chain constraints, update technology, and meet stronger consumer demand.
Third, both the Federal Reserve and the European Central Bank are now working off far more flexible frameworks that have them aiming for “symmetric” or “average” inflation levels. While their current rhetoric has turned decidedly hawkish, central banks are clearly inclined to allow their economies to run hotter for longer. This carries the added benefit of shrinking large sovereign debt levels in real terms as price levels rise.
These are changes in the global economy that may in fact drive more investment and less saving, fueling new price pressures even after pandemic-battered supply chains return to normal. Disruptions from Russian sanctions in energy, mineral, and food markets will make it all last a little longer.
The key will be in those expectations. Surveys show that U.S. consumers know prices are heading higher over the next year, but they believe inflation will fall back to its historical range soon enough. A recent Fed study found that consumers are actually less likely than before the pandemic to adjust three-year price expectations based on a one-year outlook.
But Larry Summers, the former Treasury secretary and current inflation Cassandra, warns that if expectations are still in line they are still rising. “If the experience of the 1970s has taught us anything,” he writes, “it is that by the time high inflation expectations are entrenched, it is too late to bring down inflation without a major recession.”
We don’t want to wind up on the wrong side of that buoy.