Yesterday, US president Joe Biden managed to get another $1.9trn in spending signed off for the US economy.
The big concern for markets is that this is going to cause inflation to take off.
So investors were very relieved to learn – also yesterday – that so far, inflation has been pretty tame in the US.
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Will that state of affairs continue? Or are we right to be concerned?
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Inflation isn't taking off just yet, but it's coming
Markets breathed a sigh of relief yesterday.
They've been getting worried about inflation. They think if it rises too fast, the Federal Reserve will also raise interest rates earlier than expected. As a result, bond yields have been rising. In turn, all the hottest stocks in the market have been falling.
But consumer prices in February in the US rose by 1.7% on last year. And the “core” measure, the one the Fed cares about, went up by 1.3%, which was a little below expectations.
So that cheered everyone up. Enough so that the latest sale of ten-year US Treasury bonds went very smoothly.
Of course, that's probably a bit premature. The economy isn't rip-roaring ahead just yet. There’s very likely to be an unexpected inflation surprise on the upside in the reasonably near future. And that's all before we even consider the latest near-$2trn getting pumped into the US economy.
You can read more about Joe Biden’s big stimulus package here. But the main takeaway from a UK point of view is simple: it means the US economy will grow by even more this year than it was already expected to.
Just to be clear – the nature of that growth is not important from our point of view over here. It's just an influx of money over and above the money that's already floating around the world. That all has to go somewhere, which means increased overall global demand.
(That said, to my mind, handing people $1,400 each – even if they don't need it – isn't the worst way for the government to spend money. No one knows better what they want and need than individuals. It's a very “free market” way to boost public spending. If you called it a tax cut instead of a handout, Republicans might even have voted for it.)
OK, so we know this is going to boost demand. We’ve already got a lot of pent-up demand. In lots of countries, lots of people have more savings than they did. And for all that being stuck in the house has been quite psychologically trying, I suspect that most people will be raring to go when the lockdowns are properly lifted and we're all vaccinated.
So we can expect a big surge in demand. That's pretty clear.
What about supply? Supply has been battered by lockdowns. That doesn't mean it won't come back. But it won't come back as quickly as demand. I realise that this sounds very simplistic – it is – but sometimes simplistic pictures drawn with fat crayons are far more honest than precision-tooled decimal-point-perfect forecasts that turn out to be complete nonsense.
So, here's the crayon drawing. You lock someone in their house and cut off half of their spending outlets, but you maintain their income. Once you let them out of the door, they'll spend that money. No, you won't get two haircuts (the classic smart-alec reply to this argument). But you might get one haircut, then celebrate with a nice meal you wouldn't have previously had.
Also, on the supply side, half the hairdressers in town have shut down permanently. As have half the restaurants. So the survivors are charging more. And for the moment, you’re happy to pay, because you’ve got more money, you probably want to support these businesses at some level, and you’re absolutely gagging for a good night out.
So, that all points to a surge in inflation at some point. The question then becomes – why would this become permanent or structural?
What could make inflation a long-term problem?
As Dylan Grice of Calderwood Capital once told us at a MoneyWeek roundtable: if there's one thing that the last decade or more has taught us, it's that no one really knows what sparks inflation.
So this is all conjecture. And so is whatever you read from anyone else.
But my main point would be that inflation is a process, not an event. When it starts off, it'll be welcomed in lots of ways, because inflation is what the authorities have been trying to encourage for decades.
This is precisely the reason that it will become entrenched and become a problem. Because it won't be tackled early in the process. And by the time it does become a problem, it'll be much harder to tackle, and it'll take a lot more effort. You just have to look at what Paul Volcker had to do in the 1980s to tackle inflation at that point.
I'm not saying we'll get a repeat of that. (Although it’s worth noting that my reluctance to contemplate double-digit inflation says something about how complacent we’ve all got, even a sceptic like me). But inflation of even 4% and above in developed markets would be quite the bucket of cold water for most investors.
Yes, we saw this in 2011 (inflation in the UK even spent some time above 5%, believe it or not), but that was driven by a surge in commodity prices against an extremely weak macroeconomic backdrop. I think it's hard to argue that today’s economy is anywhere near as weak as it was back then.
This all means that you need to consider your asset allocation very carefully indeed. This is something we've been writing a great deal about in MoneyWeek magazine. If you're not already a subscriber, you can get your first six issues, plus a beginner's guide to bitcoin, absolutely free when you sign up.
