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Is it time to start worrying about inflation?

Is it time to start worrying about inflation?

As the US economy gets an infusion of ultra-easy credit and multiple rounds of big-time government spending, questions are growing about whether it’s a cocktail that will cause a big jump in inflation.

While vaccines are being deployed around the world, it will be many months before they stem the Covid-19 pandemic. That’s why the Federal Reserve says it’s not going anywhere and will keeping juicing the US economy. President-elect Joe Biden wants Congress to open up its wallet for a third package of aid amounting to $1.9 trillion. The US needs a robust response—its economy is in a deep hole, with the unemployment rate stuck stubbornly at nearly 7%. The concern is whether the government’s response to the crisis will have unintended consequences.

On the positive side, investors are increasingly optimistic that the US will rebound from a deep economic contraction. You can see that in the yield curve, which is the gap between short-term and long-term Treasury bond yields. The 10-year US Treasury bond is seen as the safest, most easily traded asset in the world. When investors are fearful, they tend to buy up these securities, pushing down Treasury bond yields and causing the yield curve to invert. When they are hopeful, the opposite happens and the curve steepens as expectations for inflation increase. The gap between the yield on 10- and 2-year securities is at its steepest level in more than three years.

“The yield curve is upward sloping and that is good news,” said Campbell Harvey, a finance professor at Duke University who pioneered the yield curve’s use as a forecasting tool for recessions. “The issue is the level of growth,” he said in an email on Jan. 9. Ten-year government bonds yield about 1.1%, which is less than the 1.4% rate of inflation in the 12 months through December. That investors are willing to lose money through inflation suggests they aren’t that optimistic.

Harvey points out there are three ways to pay off heavy loads of government debt—higher taxes, increased inflation, or rapid economic growth that leads to a boon in tax surpluses. He thinks higher inflation is the most likely way out.

Inflation in small doses helps keep the economy ticking over, but an overdose can be destabilizing. A sharp increase in prices can drive investors to sell a government’s debt, causing interest rates to climb, making refinancing more expensive and dragging down the economy. High inflation also erodes the savings of retirees and other investors.

Bond investors, who are especially wary of price increases because they eat into their fixed returns, think the rate of inflation will exceed what it was before the pandemic. The breakeven rate gives a sense of what professional traders are expecting: the rate is the difference between Treasury bonds and Treasury Inflation Protected Securities (TIPS), which are linked to the Consumer Price Index (CPI). The 10-year breakeven rate signals investors are betting inflation will rise to about 2.1% in the next decade. It’s not exactly Argentina-style hyper inflation, but that would signal the highest expectations for price increases in the US in more than two years.

In the past, investors have worried about inflation because the Fed and other central banks have been buying just about every bond in sight—a maneuver known as quantitative easing (QE). The idea is to keep interest rates low, making it easier for consumers and business to get cheaper financing, and to spur investors to put their cash into riskier, higher-yielding assets like corporate debt and the stock market.

US policy makers added trillions of dollars to their balance sheet after the 2008 financial crisis. If you thought that chart looked scary, it’s been downright frightening since the Covid crisis.

The thing is, QE didn’t didn’t spark much inflation after the financial crisis. Every big country that pursued this policy—the EU, US, Japan—had the opposite problem, and their central bankers have spent the past few years worrying about deflation. As Jens Nordvig, economist and founder of Exante Data, writes, the events that followed turned “old monetary theories on their head!”

A short answer as to why this happened is that the money ended up as bank reserves and was never deployed into the broader economy. The Fed is able to maintain control over those reserves by paying interest, dialing the rate up or down to influence bank lending. You can read a long answer in this seminal staff report (pdf) from the Federal Reserve Bank of New York.

Could this time be different? Unlike in 2008, the banking system isn’t shattered, which means lenders could have a bit more confidence to do business. Congress will soon consider its third aid package for the economy, which would put the total support at multiple times the $787 billion dished out during Obama administration. And the Fed has given many indications that it’s willing to tolerate higher inflation than normal. Last month, David Andolfatto, an economist at the Federal Reserve Bank of St. Louis, wrote that “Americans should prepare themselves for a temporary burst of inflation.”

There’s still a lot cutting against a rapid increase in prices. Lots of people have lost jobs, and legions of businesses have gone under, which could make it difficult to get people back to work. But this time the Fed and Congress have been moving forward in lockstep with aggressive policy. Institutional investors aren’t betting on runaway inflation, but many seem to be persuaded that prices are going to climb at least modestly higher.

If persistent, Nordvig thinks these twin policies can, finally, generate inflation. “This is why we are about to enter a new regime,” he says.

This article is auto-generated by Algorithm Source: qz.com

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