It doesn’t take much to set reflation expectations on fire these days. With US interest rates near zero (or negative in some parts of the world), a mild uptick in yields inspires a new round of forecasts that a sustained run of higher inflation has finally started.
No wonder, then, that yesterday’s jump in the rate set hearts aflutter in the reflationista world. The benchmark yield rose to 0.78% (Oct. 5), based on daily data. That’s the highest since mid-June. Surely the inflation apocalypse must be near.
By the standard of recent history, the 8-basis-point rise is significant, although recent history is a low bar for spying changes in yield volatility. In an empty room, dropping a penny is noisy.
The reflation alarm is a bit stronger by way of the yield, which rose to 1.57%, which is also the yield’s 200-day moving average. The last time the two matched was March 2019, and so by this definition the upside bias seems to have a bit more oomph.
The immediate cause of the higher rates seems to be renewed prospects for a stimulus package passing muster with Republicans and Democrats in Washington. On Sunday, House Speaker Nancy Pelosi told CBS News that “we’re making progress” in talks with Republicans on passing a new stimulus package.
That was followed on Monday by an hour-long conversation between Pelosi and Treasury Secretary Steven Mnuchin, although nothing came of the chatter beyond an agreement to speak again today.
Meanwhile, Federal Reserve Bank of Chicago President Charles Evans yesterday reminded the market that the central bank has a relatively dovish posture these days. “I think we have to cross over, beyond 2% [inflation], with some momentum,” he explained. “I would be quite pleased if we could get core inflation up to 2.5% for a time.”
These are thin reeds for arguing that hotter inflation is near, but beggars can’t be choosy. Indeed, the annual pace of core inflation for consumer prices is currently 1.7% through August, although that’s above June’s 1.2% pace.
No matter since, by some accounts, the stars are aligning for stronger pricing pressure, thanks to a combination of 1) the likelihood that government fiscal policy will remain more active on the stimulus front and 2) extraordinary dovish monetary policy that’s desperately trying to drive up inflation will eventually be successful.
But as Lance Roberts at Real Investment Advice recently reminded, the Federal Reserve has trying (and failing) for more than a decade in trying to lift inflation.
“For the last 12-years, this belief has remained a constant in the market,” Roberts writes. “It stems from the idea that increasing the money supply is inflationary as it decreases the value of the dollar. There is indeed truth in that statement when considered in isolation. However, when the money supply is increasing, without an increase in economic activity, it becomes deflationary.”
The ongoing economic blowback from coronavirus certainly doesn’t change the calculus in favor of the reflationistas. Will a new stimulus bill at some point do what a decade of monetary policy hasn’t?
Maybe, but a slightly higher run of Treasury yields is hardly a smoking gun. But reflationistas also argue that eventually the surge in borrowing by governments will do what monetary policy has not. Economists at PGIM Fixed Income push back on this idea, arguing that recent history suggests the opposite:
“The data for the advanced economies suggest that heavier debt burdens have brought lower inflation and slower GDP growth,” advise Nathan Sheets and George Jiranek.
“The cost of high debt is not inflation but rather seems to be disinflation and weak economic performance, reflecting increased uncertainties for the private sector.”
What accounts for this new world order? Sheets and Jiranek cite “deep structural forces,” which include “aging demographics, the advance of innovation and automation, and increasingly entrenched inflation expectations.” These trends, they predict, will persist. “We expect the restraint from these factors, if anything, to become more pronounced in the years ahead.”
The future, of course, is full of surprises and so no one should assume that ongoing disinflation/deflation, higher inflation or something in between is off the table. Stuff happens. But years of weak growth, low inflation and relatively ineffective monetary policy to change the trajectory aren’t likely to reverse course overnight.
Reversals do happen, of course, and the warning from the proverbial canary in the coal mine will likely be a sustained rise in Treasury yields. The latest uptick is far from definitive proof, but perhaps it’s a start… or just more noise on the path to even lower realms.
The good news: At least we know where to look for early signs of regime change.