There has been much discussion lately about whether we will have inflation or deflation, and I think the answer is “yes.” We’re experiencing inflation already, and we’ll likely experience it more, both cross-sectionally and longitudinally. But, as economies recover from the pandemic-induced recession, deflationary pressures may also come into play.
Cross-Sectional Inflation: Here, There, Not Everywhere
When I say I expect inflation to occur cross-sectionally, I mean price increases are occurring at various points in time for different goods and services around the world.
For example, we’re seeing some inflation now in commodity prices. But I expect inflation to occur soon in hospitality and leisure. There is a good bit of pent-up demand in those areas, particularly around those that are travel related. The human species is sociable and doesn’t like being locked down. When we get the opportunity, we will likely dine out and travel.
The price of future consumption rising is the same thing as asset prices rising because assets represent saving for future consumption.
What’s interesting is that the types of things that have seen price pressures are not the types of things that will likely see price pressures later. It’s actually the reverse. This is called the reopening trade or, conversely, the closing trade—referencing industries that will do well as economies reopen and industries that will do well if they stay closed, respectively.
And that brings up the other aspect of this discussion, which is the price of assets. We’re beginning to see the price of future consumption rise, and the price of future consumption rising is the same thing as asset prices rising because assets represent saving for future consumption.
Longitudinal Inflation: Fiscal, Not Monetary
Secondly, we are seeing fiscal policy—more than monetary policy—driving inflation.
Central bank balance sheets have expanded quite dramatically, but that has not yet caused widespread inflation. Central banks do not create money; they create reserves that can be used for certain things. If those reserves are not used, they sit in the central bank. The credit facility is not functioning now as it normally would, so the reserves that are being put in the system are not being lent out (or creating money) in the system. One could argue that, in fact, central banks are not stimulating at all.
Now, central banks do control interest rates, which is an alternative way of stimulating, but the banks have pretty much run the course on that, especially in Europe (and less so in the United States).
In my opinion, the economic weakness we have seen is not a normal recession.
I recently heard at a conference that inflation is a factor of fiscal policy more than monetary policy, and I think we are beginning to see that. Checks are being written to a portion of the population and are being spent in certain ways. That affects some prices, but not others. For example, the wealthier of those who get checks tend to be more savers than consumers, and that affects asset prices, not grocery prices.
What we see now, then, is a relatively weak economic environment with a lot of inflationary activity driven predominantly by fiscal policy. But, as economies begin to recover, we should see some of the reserves that the central banks have created circulate in the system, which will result in monetary policy driving inflation as well.
In my opinion, the economic weakness we have seen is not commensurate with a normal recession. It is a COVID recession. It was a hundred-year flood in terms of its magnitude, and it was astoundingly short, maybe one of the shortest recessions ever.
Fiscal policy and spending have come together to blow up the balloon to an enormous size and, in some form or fashion, some air needs to be let out of that balloon over time.
But that’s not the type of recession that ultimately and fully “cleans up” the system—a cleaning that is actually healthy and beneficial for an economy. As the system begins to get cleaned up this time, I think deflationary pressures could come into play, and that could be an environment driven by central banks raising interest rates. Fiscal policy and spending have come together to blow up the balloon to an enormous size and, in some form or fashion, some air needs to be let out of that balloon over time.
Unfortunately, we’ve seen this before. In the early portion of the last century, there were many similarities to today’s environment: inequality, high debt levels, the creation of the Federal Reserve. Everybody was quite pleased with all of that, and we experienced the Roaring ’20s—a stimulative environment. The ultimate reckoning was pushed out further and further, but when it came—in the form of the Great Depression—it was quite painful.
That said, such an environment can still present opportunities. In the same way that certain industries benefited from the pandemic, there are exposures that would benefit from a higher inflationary environment, and those are ones that we will seek to gravitate toward when/if this environment takes hold.
Inflation or Deflation?
So, I think we’ll see this discussion of inflation or deflation going on for quite some time. The question will be, “When will inflation come, and will we see inflation or deflation first?” And, because this evolution isn’t yet certain, how exactly our portfolios shift from here is still the subject of team analysis and debate. There’s also reflation to consider, which my colleague Tom Clarke will discuss in an upcoming post.
Brian Singer, CFA, partner, is a portfolio manager on and head of William Blair’s Dynamic Allocation Strategies team.