Tuesday, July 20, 2021 / 06:47 AM / Content/Image By Comercio Partners
The Overheating Debate - playing with fire might get you burnt
How much spending is too much? Is the global economy over-heating? Is the world about to relive the 1970s-runaway-type-inflation?. These are some of the questions that have dominated the global economic scene, as the world grapples with the varying probability of occurrence of a lasting inflation in the U.S. Whether by historical nostalgia, data-driven expectations, or politically oriented perspectives, concerns around inflation have understandably materialized, forcing experts to debate whether the price increase will be transitory and short-lived, or if it will cascade into a broad-based and long-lasting type. This divergence in inflationary expectations form the central thrust of the overheating debate.
What led us here?
Desperate times warrant an even more desperate response, and the Covid-19 pandemic was no different. The pandemic had a devastating impact on the world, causing economic activities to grind to a halt; hence, forcing major economies like the U.S. to deploy desperate economic survival measures, in the form of dovish policies from both fiscal and monetary authorities. The shuttering impact of the pandemic on the U.S. economy was met with unprecedented measures to cushion the impact and stimulate growth. The monetary authorities resumed quantitative easing through a $120 billion monthly asset purchase program and reduced its benchmark interest rate twice by a total of 1% to 1.5%, putting the range at 0% to 0.25%. Likewise, there was also massive spending on the fiscal side, the most recent of which was the $2.3 trillion stimulus bill.
Decades of economic theorizing has identified inflation as the necessary consequence of employment and output growth, and this recovery year is rooted in this relationship. During the pandemic, restrictions put in place halted spending on things like traveling and dining out, consequently forcing prices of goods and services in these categories to decline. Fast-forward to the post-pandemic recovery; normalization is starting to creep into the U.S. economy on the back of increased vaccinations; there are deep pockets of demand for things that people were unable to access during the pandemic; supply disruptions that characterized 2020 continue to linger, leaving producers with the available option of passing this cost down to the consumer; and energy prices are elevated, blame the efforts of OPEC and its allies at restricting supply. All these inflationary drivers exist against a backdrop of an accommodative fiscal and monetary policy stance, as policy makers are convinced that a policy reversal will derail the ongoing recovery. Accordingly, the economy is growing, and prices are rising, but several possible outcomes can succeed the price increase. The problem here is with the possibility of the worst likely outcome materializing.
The Overheating Debate - how much is too much?
The Economy is clearly heating up, and everyone can agree to this. However, the disagreement stems from the extent to which the U.S. economy can tolerate the rate of price increase. Sure, there is inflation, but would this price increase be transitory or are we going to witness a run-away inflation that possibly forces the Federal Reserve to stifle the growth that is so desperately pursued, all in a bid to nip inflation in the bud. Both sides of the isle agree as to what a bad inflationary outcome would look like but differ in expectations regarding the likelihood of this outcome. Hence, we will dive into the narratives purported by the dominant participants of this global economic discourse.
The unfazed - the concerns are exaggerated: This group finds the nature of the current inflation to be non-problematic. The rise in prices is considered as the momentary effect of reopening an economy that was completely grounded to a halt, and this price increase is expected to fade off as economic activities normalize. With regards to the comparisons with the 1970s stagflation, experts on this side of the debate see no clear parallels, sighting inflationary drivers that characterized the mid-1960s to 1970s as unique and non-dominant in the current context.
Some of these drivers include the ultra-loose interest rate regime maintained for an extended period during the Vietnam war, the 1970s oil embargo, and the policy inaction of the monetary authorities to curb inflation early enough. Currently, the U.S. has risen to become one of the largest crude producers globally and has also shored up its reserves to the point where a 1970s-type energy crisis is unlikely. Also, the monetary authorities have become more proactive in deploying policy levers to control the economy.
The worriers - the economy is flying too close to the sun: Overheating worriers opine that the trend of low inflation has been upended, and that the more pessimistic scenarios are highly probable. This group believes that the current inflation should be taken more seriously, and the reiterated view by the authorities that inflation is simply transitory, is destructive, in the sense that the failure to recognize the threat posed by inflation early enough would result to either an inflation-tapering recession or a vicious cycle of ever-higher prices. Another viewpoint of the overheating worriers describes the inflationary fears as a self-fulfilling prophecy. There is a growing demand that is well in excess of supply as the economy reopens; hence, causing prices to go up as consumers excessively bid, leading to business expansions that then pushes wages up, eventually creating a demand push inflationary cycle.
The authorities - exercising caution: The policymakers also share the viewpoint that the current inflation will be short-lived, while demonstrating a willingness to readapt their position on the issue as new facts unravel. The Federal Reserve appears intentional in calibrating its messaging in a manner that would not spook the market and throw it into a frenzy. Nonetheless, as the threat of inflation becomes more apparent, we have seen the Federal Reserve become less dovish in tone. Their last policy meeting resulted in a 1.00% increase in its inflation forecast for 2021 (2.4% -3.4%) and provided hints on the possibility of tapering the size of its asset purchase program later in the year, while noting that two rate hikes could be instituted as early as 2023.
In summary - shutting out the noise
We will attempt to isolate some basic facts to provide some guidance as to possible expectations. Two key things to look out for is the trend of inflation and the adaptability of the posture of monetary policy makers to new data that possibly contradicts their expectations.
It is still unclear whether inflation in the U.S. is here to stay, and June's 5.4% CPI YoY increase does not offer much clarity on the long-term trajectory. It would be easy to paint the uptick as a real threat in the long term given that it was the largest jump since August 2008, but the upsurge was largely driven by the rise in used car prices, which was partly sponsored by the temporary surge in road-trips, as people enjoyed the free movements that were restricted at the heights of the pandemic. Hence, this could be momentary. Contrarily, there is the possibility that the global semiconductor shortage will continue to drive prices of used cars upwards for an extended period, as the shortage has forced major car producers to cut back on production. So, it could go either way, and time will be the ultimate deciding factor. Should inflation rate continue to rise after the summer season, there will be clarity to this debate, and the evidence will suggest that inflation will constitute a long-term problem for the economy.
Also, all eyes are on the Federal Reserve, as the more pessimistic scenarios would be worsened by policy tardiness. Should signs of an uncontrollable inflation start to manifest, there will be a need for a gradual reversal in policy posture, through the gradual reduction in the size of the asset purchase program and the normalization of interest rates. Sudden and desperate policy actions to tackle inflation will send shockwaves through the global market, as the consequential strengthening of the dollar will cause massive repatriation of funds across the globe. On the SSA front, we would expect a bearish knee-jerk reaction in our Eurobonds and equities market.