Why Do We Worry About Inflation Right Now?
When people ask what I think about inflation now, I always have to start by presenting my bona fides because people expect that a company that focuses on inflation-linked products will have an "axe" to expect higher inflation.
Until the last year or so, however, I have been a disinflationist/deflationist for a long time despite being at firms and in roles that benefitted from more inflation instrument volume. The problem, as I have long written, has been that the amount of private debt was so overwhelming that inflation simply can't get started - no one has the power to raise margins. Historically speaking, every economy that has had heavy amounts of public debt ended up inflating (Weimar Germany, e.g.), but every economy that has had heavy amounts of private debt ended up in a deflationary bust. And no economy has ever had as much private debt per unit of GDP as the United States today. To my mind, that has always meant that inflation was never going to get going.
But all of that starts to change once that private debt (a) begins to default and (b) is transferred in huge amounts to the public side of the ledger.
With the amount of debt public assumed in the last year - not only via takeover (Fannie, Freddie) and guarantees but also through the expedient of running vast deficits to re-liquify corporate and personal balance sheets. Add to these deficits, which are projected far into the future, the unfunded and increasingly scary liabilities associated with Social Security and Medicare, and one thing is starting to become clear.
The math doesn't work unless you inflate.
The chart at right (Source: Bloomberg) is scary. Note that by taking out inflation, and adjusting it for population, I've represented the numbers in the quantity you care about - how much stuff you would have to surrender for each member of your family in order to pay off the national debt.
The real story is scarier still, because this chart stops in Q1, most of the stimulus money hasn't been spent yet (or, therefore, borrowed), and it excludes the companies whose debt the government has assumed, Social Security, Medicare, and state and local government debts. State and local government debt is around $2.3 trillion; the present value of the next 75 years of the Social Security system's shortfall is c. $5 trillion, and Medicare's next 75 years is approximately $35 trillion underfunded.¹ If I throw those numbers into the chart above, I figure roughly $160,000 per person in debt.
Now, no one is going to show up at your door and demand a half million dollars to pay off the national debt for your small family, and in fact there's no reason to think we ever need to pay it all off. But the question is one of sustainability. At $160,000 per person, if steady-state long-run yields are 5% or so (3% real growth plus 2% inflation) the annual interest alone is $8,000 per person...and growing rapidly.
Or, to put it another way, if the budget was balanced this very second then we would be paying about 20% of the nation's total output in interest without paying down any of the debt. If the government is going to pay that interest, and keeping in mind that a large number of Americans don't pay income tax, tax rates almost certainly have to rise unless the government is going to do nothing besides pay interest.
But if tax rates rise, then long-term growth will be lower and near-term growth isn't going to be so hot either.
On the other hand...
Inflation "solves" a lot of problems - not the problems we have as taxpayers or investors, mind you, but the problems that policymakers have. Want to bail out housing? Housing debt is in nominal terms; get housing prices higher with some solid inflation, and defaults will evaporate. Want to reduce that interest burden? Make those dollars worth less. (N.b. There's not much that inflation can do with Medicare, since those are promises in real space).
I don't think there can be anyone in government today who doesn't understand this at least viscerally. The interesting thing is that the Fed must either have a tremendous amount of credibility, or none at all, judging from the low level of inflation breakevens. Either the market believes that the FOMC will resist all of the pressure to be soft on inflation and will hike rates and pull back liquidity with the Unemployment Rate at 10% - which would represent truly remarkable credibility - or they don't think the Fed is capable of causing inflation, which would be a serious indictment since we have this technology called a printing press...
And Bernanke was right! If there is a printing press and a will to use it, the Fed can create inflation. It is, in fact, trivial to do so regardless of the output gap: add a "zero" to every bank account and inflation will rise. The trick is to get only 2% inflation. And here's where it's very tricky indeed. First, every policymaker secretly would be okay with 4-5% inflation, since that would gradually back us out of the debt crisis, as long as it was only 4-5%. But the lower level of private debt means that inflation will not be nearly as sticky on the way up as it has been over the last decade; moreover, once consumers understand that the Fed is letting prices rise, the genie will be out of the bottle and it will be hard to stuff it back in.
All of which argument seems to be at odds with the pricing of breakevens and of the stock market, which are both pricing a low, stable inflation regime for decades into the future. The S&P 500 as of June 30th sported a lusty P/E of 134.01.²
The weird thing about equities is that you can find investors who understand that the highest valuations for equities are in the periods of low, stable inflation, and you can also find investors - all too many of them - who think that equities are also a good inflation hedge. Now, there is no empirical support for this latter proposition; indeed, the 1970s by themselves would seem to provide a compelling refutation. But the more frustrating thing is that it simply cannot be the case that equities do well in both kinds of environments! There must be something that is bad for equities!
The current problems for equities are (a) equities are a rotten inflation hedge, and also don't do too well in deflation - and both of those outcomes are more likely than low, stable inflation going forward, and (b) the valuation of equities is so lofty that it is difficult to see how they can appreciate substantially further without another bubble inflating. In our view, inflation-indexed investments are likely to outperform equities in both scenarios, from today as a starting point.
But we may seem to be in the middle of a reawakening of optimism in equity-land. Investors feel they have no choice but to believe in stocks, because if they didn't they would be despondent - with 10 year rates at 3.6% and credit much tighter than it was, there is no mainstream investment that offers even a vain hope of the coveted 7% per annum return that makes their funding ratios look acceptable. So they have no choice but to believe...unfortunately, a belief of convenience is likely to prove unsteady when faith is required. I suspect that stocks are more vulnerable right now than they seem.
1 You often see larger numbers for Social Security and Medicare because far in the future the projected liability is convex upwards - so, taken to an infinite horizon, Social Security's shortfall is more than $15 trillion. I'm using the conservative numbers because the error bar around the 75+ year projections surely must be large enough to doubt that we have the shape exactly right.
2 What, you say that Bloomberg says it's 14? Well, that's because Bloomberg excludes negative earnings from its calculation, which is wrong. S&P calculates it as 134.01 here: http://www2.standardandpoors.com/portal/site/sp/en/us/page.topic/indices_500/2,3,2,2,0,0,0,0,0,1,11,0,0,0,0,0.html