Inflation is all investors can think about right now. How high will it go? How long will it last? Can it be curbed in the US without a major recession?
There are useful comparisons to be made with the era of high inflation in the 1970s and early 1980s. But there are also many factors today that are unique to our moment, and they make it unusually difficult to predict exactly how quantitative tightening will play out. Below are three inflation “wild cards” that are worth considering.
The first is the way in which the financialisation of the economy could have an impact on the Federal Reserve’s efforts to tamp down inflation. Decades of low interest rates, coupled with several major bouts of quantitative easing following the 2008 financial crisis, raised both asset prices and debt levels.
Retail investors are more exposed to stocks than they were a decade ago thanks to the growth of target-date funds that invest more in equities on the front end of their time horizon, as well as the gamification of trading. We have all grown used to an economy in which paper wealth grows. So, what happens when asset prices inevitably fall as interest rates rise?
It is possible that this could put more strain on government budgets than expected. As analyst Luke Gromen noted in a recent edition of his newsletter, US tax receipts have become much more correlated with rising asset prices over the past two decades than they were in the past. Indeed, the two have been rising and falling roughly in sync since 2001. If markets stay down, that implies that tax receipts would go down, too. The federal deficit would increase accordingly – and cause the US government to borrow more at a time when rates are going up.
That could, in turn, create difficulties with the balance of payments and force the central bank into a U-turn in order to drive down rates again. Given that foreign investors are less willing to fund US deficits these days, this is a risk that needs attention. It’s a complicated process that could play out many ways, but the point is that America’s dependence on easy money and a stretched-out business cycle for many decades could have a complex and worrisome macroeconomic ricochet effect.
A second major wild card in the inflation cycle is housing. While pandemic-related stimulus created a housing boom in many countries, it is not the same kind of boom that we saw in the run-up to the financial crisis. As a recent TS Lombard report pointed out, low rates account for only about a third of the increase in property demand.
What’s more, there has not been the same surge in mortgage applications throughout the pandemic that there was in the run-up to the subprime crisis. Mortgage lending over the past few years is of a much higher quality and the majority of it is tied to fixed interest rates. This means that even as rates rise, we are not going to have the massive amounts of forced selling by those who can no longer afford their homes that we saw then.
What about first-time buyers? Research from the New York Fed assumes that every 100 basis point increase in mortgage rates reduces property sales by about 10 per cent. But that is in a “normal” housing market, which the post-pandemic market is most certainly not.
Working from home, which clearly is not going to go away for many companies and employees, has resulted in major geographic shifts in the housing market, as people look for more space in places farther away from their jobs. While the dust has yet to settle, one new academic paper found a strong correlation between property price increases and those parts of the US in which people are more likely to work from home.
So, what’s the bottom line? While the most speculative markets may see a decrease in housing inflation and price corrections as rates rise (I am already noticing this in some rural areas outside New York, where second-home owners overpaid at the peak of the pandemic), many areas may remain robust.
As the Lombard report points out, Covid-19 has altered the pattern of internal American migration. This trend may turn out to be similar to the way in which the post-second world war mass adoption of the automobile led to the growth of the suburbs and spread the population westwards.
It seems clear that today’s population growth is in both the west and the south of the country. Coupled with a demographic bulge of people in their thirties, the prime homebuying age, this may keep housing markets at a national level stronger for longer than many people think.
Finally, there is the question of US labor markets. While much has been made of rising wages, an overheated labor market and the stickiness of pay rises, I think it’s quite possible that this part of the inflation problem is being overblown.
While annual consumer price inflation in May was 8.6 per cent, wages were up 6.1 per cent, according to the Atlanta Fed’s wage tracker. That’s hardly within the 2 per cent target, but not enough to keep pace with inflation. Inflation itself is being driven not by employee demands or pandemic stimulus but by long-term Fed policy and politics – namely, the war in Ukraine. How the latter will end may be the biggest wild card of all.
frog @ faroohar @ ft.com