Control of the US budget is about to be taken over by a former central banker. Given that central banks around the world have been calling for governments to start using all the money they’ve printed to boost their economies more aggressively, that suggests we can expect a lot more spending. In turn, that implies a more inflationary economy.
That makes sense to me. But today I want to have a look at if there are any potential flies in the ointment.
Yellen seems highly likely to spend, spend, spend
Janet Yellen, the boss of America’s central bank, the Federal Reserve, before current governor Jerome Powell, is going to be sworn in as US Treasury Secretary today (for UK readers, that makes Yellen the American version of Rishi Sunak).
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While Yellen was at the Fed, she followed the script that was written during the Alan Greenspan days. In effect, there’s no problem so big that throwing more money at the system won’t solve it. Or at least patch it over. However, following the 2008 crash, throwing money at the system wasn’t enough. Because quantitative easing (QE) just pushed up asset prices. That created as many problems as it solved.
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So the new central bank mantra became: “We can provide the money – but now the government needs to step up and get it into the economy”. And now the central banker who printed the money is the person in charge of spending the money. That’s not someone who’s going to be scared of a bit of deficit spending.
Yellen has already confirmed this: her speech today apparently acknowledges “the country’s debt burden”. However, she says, "right now, with interest rates at historic lows, the smartest thing we can do is act big. In the long run, I believe the benefits will far outweigh the costs, especially if we care about helping people who have been struggling for a very long time."
For what my view is worth, at this stage I believe that erring on the side of spending too much is indeed the right course of action. Coronavirus is not the result of colossal mal-investment or rampant moral hazard (that was 2008). It’s a natural disaster whose impact – combined with the effect of the containment measures – has shut down many otherwise viable businesses. It’s right to support them and to support individuals, because if you don’t, we’ll be a lot longer getting out of this hole than we need to be.
But from an investment perspective, my view is irrelevant (as is yours). This is the path of least resistance. This is the path that will be followed. This is what we’ll get. So it’s no wonder that a lot of people think we’re going to see an inflationary dénouement to this bubble – even if not this year, then very soon.
There’s a column in this morning’s FT from Wharton professor Jeremy Siegel, headlined: “Higher inflation is coming and it will hit bondholders”. Siegel has a fondness for equities and so his column is more of a bearish call on bonds. I suspect he thinks that inflation will only get to the point where it hurts fixed income, but won’t get to the point where it hurts equities significantly (which history suggests starts when inflation gets to about the 4-ish percent mark and rising).
I think he’s right on inflation rising, but perhaps a little too optimistic about the idea that bond yields can rise without really giving certain parts of the equity market a painful shoeing.
But I digress. We’ve been talking about inflation for a while here. What I’m wondering about today is what could derail this scenario?
One key risk to the inflation scenario
The most obvious risk that I can see to the inflation scenario comes from the one economy to have already rebounded. China’s GDP growth for 2020 came in at its customary level of 6.5%. Everyone is entitled to treat Chinese GDP figures with even more scepticism than you’d treat the average set of official statistics, because when Chinese officials miss targets, they are at risk of losing their jobs, their liberty, and on occasion, their lives.
Yet in this case, it looks about right. China rebounded strongly in the second half of last year, having both entered and exited the coronavirus disaster earlier than everyone else (because, of course, it started there). Note, by the way, that China did this without a vaccine.
On the one hand, this is good news. If China had this strong a rebound without a vaccine – and arguably, with a much more threadbare welfare system propping up the population – you’d think the return to confidence in the rest of the world would be commensurately greater. So China’s strong recovery bodes well for the rest of the world in 2021 (eventually, at least). That in turn, suggests the inflation story is a good bet.
On the other hand, as John Authers points out in his Bloomberg newsletter today, China’s recovery does give some cause for concern. The rally has been driven by pretty much the same thing as China’s 2008 recovery. That is, a focus on selling goods abroad (demand for kit for working from home has helped) and building property and infrastructure.
The problem is that it’s this focus that has led to China’s economy being so unbalanced in the first place. And it looks as though China might try to rein it all in. It’s interesting, for example, to note that China hasn’t really been fazed by the ongoing strengthening of its currency, the yuan, against the US dollar in the last year or so. Until very recently, China had seemed to favour a weaker currency.
If China tightens monetary policy, it may not matter. After all, the US and most other big economies are going to be spending heavily. That’s plenty of replacement demand right there, and I suspect it’ll be enough. However, it could lead to a few bumpy moments in the shorter term, as Authers notes, “as China had recently been contributing to the liquidity gushing through the world”.
This is something we’ll be keeping a close eye on in MoneyWeek magazine. If you don’t already subscribe, get your first six issues free here.
