• John Prior


The topic of inflation has dominated the airwaves in recent months. It’s not all that matters to markets but when you look at the way markets react to incoming data and various missives from central bank talking heads, it is almost all that matters. There have been plenty of recent data points, indicating that prices are going up. On 12th May, US Core CPI registered a month-on-month gain of 0.9% which is the highest reading since 1982. The prices of everything from copper to lumber and used cars to shipping are going through the roof.

The key word at the centre of the great inflation debate is “transitory”, i.e. are the current price increases that we are seeing a short-term phenomenon due to temporary Covid-related issues or something more pernicious. So far, those in positions of authority have fallen very much in the transitory camp, which of course should come as no surprise.

Their task is an unenviable one. In the aftermath of the pandemic, government debt levels in countries such as the US and the UK have exploded to levels that are unprecedented in peacetime. The current policy agenda dictates that they will continue to expand into the future. Historically rising inflation would have meant rising interest rates, but with debt where it is that is no longer an option.

For example, with US Debt/GDP at 130%, if interest rates rise materially, interest expense will quickly take up a huge portion of tax receipts. On a recent interview on CNBC, legendary investor Stan Druckenmiller highlighted that if US 10-year yields rose to 4.9%, which is the Congressional Budget Office’s (CBO) official projection, annual interest expense will exceed 30% of tax revenues. Were this to occur, it would trigger a debt spiral and the destruction of the US Treasury market as well as just about everything else. This will be avoided at all costs. The time for normalising rates can only come after the debt has been significantly reduced, one way or another.

The only way out of this problem is to get nominal GDP (real growth plus inflation) growing rapidly and at a rate far above the cost of the debt. However, a necessary consequence of this strategy is that the bond market is going to get destroyed in real terms. The real fireworks start if the bond market realises its fate and capital tries to escape. At this point, the choice will be between letting rates rise as bond holders flee into more finite assets, destroying the economy and sending the country careering towards nominal default, or the central bank printing the money to buy every bond that is sold. Hence the central banker’s job is to facilitate the government’s drive for nominal growth while simultaneously convincing the bond market that it is not about to be boiled alive.

Circling back to the current inflation narrative, on Wednesday, minutes from FOMC meeting illustrated the predicament. “A number of participants remarked that supply chain bottle-necks and input shortages may not be resolved quickly and, if so, these factors could put upward pressure on prices beyond this year. They noted that in some industries, supply chain disruptions appeared to be more persistent than originally anticipated and reportedly had led to higher input costs. Despite the expected short-run fluctuation in measured inflation, many participants commented that various measures of longer-term inflation expectations remained well anchored at levels broadly consistent with achieving the Committee’s longer-run goals.” The Fed sees “inflation” and “not inflation” in the same paragraph.

To our mind the real decision has been made and that is the only one that is politically feasible. Governments will spend and central banks will do what they must. While they will do their best to talk tough, the notion that central bank independence will somehow stand in the way can safely be discarded. Robert Skidelsky writing in Project Syndicate put it in the following blunt terms.

“The fact that fiscal policy is now driving monetary policy in the United Kingdom cannot be admitted, and not only to maintain the perception of central-bank independence. More fundamentally, admitting that the Bank of England is an agent of the Treasury would destroy the intellectual edifice of current macroeconomic theory.” It is hard to disagree.

US Inflation Swap Forward 5Y5Y

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