The Fed Could Tolerate Higher Inflation And What It Means For Various Asset Classes

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by: Long/Short Investments

Summary

The US Federal Reserve is in the midst of what should be a short tightening cycle, up to an overnight rate of 2.00%-3.50% before it plans cutting.

For the Fed to get more impact out of its main policy tool, it may allow inflation to come in above its target in order to push rates higher.

This will give more of a cushion off which to cut rates in the future.

I explain how this (possible) new thinking on inflation could impact various asset classes.

In this article, I discuss recent Federal Reserve research that explains why US inflation beyond the Fed's 2% target may be needed - or at least useful - in the years ahead. This will help increase nominal interest rates and provide a higher rate from which to lower from going into the next recession. This will help the stimulative impact of adjusting the overnight rate.

The Fed appears to be satisfied with the idea of letting inflation run past 2% in the near-term. I explain that this is beneficial for stocks (NYSEARCA:SPY), commodities, and precious metals, a headwind for bonds and the US dollar (NYSEARCA:UUP)(NYSEARCA:UDN), and mixed for emerging markets (NYSEARCA:EEM).

Overview

The federal funds rate, also known as the "overnight rate," is likely to stay relatively low in the US over the coming years. The Federal Open Market Committee (aka FOMC) believes that neutral rate - or rate at which inflation and unemployment are kept in equilibrium - will get up to around the 2.75%-3.00% mark over the long-run. One member thinks it could be as low as 2.50%, while two believe it's still somewhere in the 3.50%-3.75% range.

(Source: federalreserve.gov)

This contrasts heavily with opinions from a few years back where median opinion remained around 3.75%-4.25%.

During the last tightening cycle undergone from 2004-2006, rates rose from 1.00%-5.25% before being cut in August 2007 over concerns regarding subprime loans in the housing sector.

If rates remain low, this has implications for inflation.

In two papers presented at the Brookings Institute (one hyperlinked above and one here), the authors argue that increased demand for safe-yielding, liquid instruments such as US Treasuries will continue to keep a lid on yields.

Historically, 10-year Treasuries have traded at a premium 0-400 basis points above the federal funds rate. There have been some exceptions, such as just before recessions when the yield curve inverts in response to an adverse credit event.

(Source: Federal Reserve Bank of St. Louis)

If the 10-year remains mostly within a band of 2.2%-2.8% over the next 6+ months as I think is most likely, this will render it more difficult for the Federal Reserve to raise rates. If market demand for Treasuries is high enough such that yields fail to move above 2.8%, the Fed would increasingly flatten the yield curve as it moves rates higher.

One main implication of a flatter yield curve includes reduced profitability for banks, which borrow at the short end of the curve and lend at the long end. The more the front end and back end of the curve compress, the more bank profits become sapped.

The current spread between the 10-year and overnight rate is currently 1.50%. This number is likely to decline further assuming the Fed raises rates another two times in 2017. If 10-year yields fail to materially increase over the coming years, say to 4%+ (as I don't think they will), this will factor into the Fed's decision to keep rates lower than whatever the 10-year might come to.

Lower rates provide an environment in which inflation can thrive and is one of the key factors behind raising rates to begin with. The economic theory goes that lower rates work to cheapen capital costs, which incentivizes business investment. Part of this investment goes into human capital (i.e., more labor is hired). At a certain point, this hiring leads to a saturated labor market. The lack of substitute workers leads to greater bargaining power among the existing workers for higher wages. Corporations pass off the cost of higher labor by increasing the costs of products and services, leading to price inflation.

At a certain point, the increase in inflation outweighs any beneficial impact on employment, so the central bank will allow some slack to exist in the labor market. Hence there will always be some level of unemployment that is in the best interests of the overall economy.

So the general line of thinking is that high demand for safe assets keeps 10-year yields down, which keeps US interest rates down, which provides an environment in which inflation could increase. Accordingly, it would be difficult for the Fed to have the policy tools in place to control inflation as it has in the past.

This in turn may cause the Fed to allow inflation to exceed its 2% target, potentially revise its target rate upward to around the 2.5% mark, or state it in the form of a desired range instead (e.g., 1.5%-3.0%). Headline inflation at the end of February stood at 2.7%, the highest of any monthly reading since March 2012. Core inflation, which excludes volatile energy and food prices, currently stands at 2.2%.

The first paper covered by a group of New York Fed economists argues that the reasons behind the drop in the real interest rate since the mid-1990s is mostly a function of global demand for liquid, safe-yielding assets. The researchers found that of the 150-bp drop in the real interest rate, 100 bps is attributed to demand for these relatively risk-free assets.

There are a few different explanations for this, all of which could be true in some fashion:

1. Global demographics are aging, which is a natural consequence of a broadening base of medical knowledge, better technology, and higher overall standards of living. People consume less as they age, which causes a slowdown in growth. Moreover, as people begin living more into old age, this increases the burden on governments to increasingly spend more on entitlement programs (notably social security and healthcare). The more that is spent on these programs, the less that can be allocated elsewhere, which leaves governments less able to support economic growth as they may have been previously.

2. As more of the world's needs become fulfilled, innovation slows, which drops growth rates in conjunction.

3. Emerging markets are steadily growing wealthier. Two of the wealthiest emerging markets, China and India, account for 37% of the world's population and are growing their economies at 6%-7% annual clips. This means that standards of living are doubling every 10-12 years.

As emerging markets become more prosperous, they in turn increasingly demand safe havens to store their wealth. US government debt is one of these traditional safe havens as the largest and one of the most stable global economies. Unless a new type of fixed-yield instruments emerges as an even safer haven (while still maintaining reasonably positive yield) demand for US Treasuries is unlikely to abate. As demand increases, prices go up and yields fall.

This also puts pressure on the real interest as well. Even as the Fed is beginning to seriously pursue a tightening cycle, with rates at 0.75%-1.00% (0.875% effective), this produces a real rate somewhere in the -1.4% to -1.8% range.

If rates continue to remain this low, that means in basically every recession we have from here on out we're likely to get lower-bound rates at 0.00%. The Fed has thus far avoided negative rates and chosen quantitative easing ("QE") instead.

Lower peaks in the federal funds rate leads to less wiggle room in how stimulative a rate cut can be. If the Fed lacks the policy tools to counter business cycle fluctuations (i.e., the inability to drop rates further), this will lead to recessions that could be worse in both length and severity.

If the Fed has to continually resort to QE to dampen the effect of recessions, the additional liquidity it puts into the system to try and stimulate the economy will continue to pull forward more growth into the future. This will reduce the long-run growth rate of the economy, which is already estimated by the Fed at just 1.8%.

If the Fed allows inflation to exceed its 2% target, this will allow the real rate to become more negative. A 0.00% federal funds rate and 3% inflation (real rate of -3%) would inherently be a more accommodative monetary policy stance than a 0.00% federal funds rate and 1% inflation (real rate of -1%).

The papers' authors propose a few solutions.

One solution is to simply move the inflation target above 2% as mentioned previously. Whether this is a new hard figure or a general band would be at the discretion of the Federal Reserve. The Fed's internal data is telling it that 2% is around the rate at which employment, consumer and business confidence, among other factors, are appropriately balanced.

But for the sake of having the policy tools at its disposal when the next recession hits, allowing inflation to increase above the 2% when the federal funds rate is above 0.00% could help offset for the deflationary/disinflationary periods that typically accompany a recession. This would help push out nominal growth and give a boost to certain risk assets (e.g., stocks, real estate), before the Fed is ready to begin cutting again as the higher rates begin suppressing growth.

Increasing inflation too far above the target, however, such that it becomes out of whack relative to expectations, can undermine confidence in the private sector and cause unwanted changes in consumer behavior.

Nevertheless, if nominal rates are held around zero, allowing nominal growth to overshoot its expectations could be beneficial as a means of finding a way to move rates higher than the Fed would be able to do otherwise. For example, if the US economy were to achieve a period above-trend real growth (e.g., 2.5%) and inflation (e.g., 3%), this could give the Fed a chance to move the federal funds rate to 4% or greater. This would give the central bank an ample cushion to lower nominal rates during the down points of the business cycle.

Either way, the Fed may have some level of rumination to do on the subject of inflation, and how it addresses the phenomena moving forward.

Influence on Financial Markets

If the Fed does tolerate higher inflation rates in the future as a means of finding a way to get more out of the federal funds rate, this will have a few main effects on various asset classes.

Stocks - Positive; one way to hedge against higher inflation is to invest in stocks, as corporations generally pass down higher inflation costs to consumers.

Bonds - Negative; higher inflation rates eat into fixed yields, reducing their return in real terms. Investors address higher inflation (or inflation expectations) by moving into other asset classes until yields rise enough to properly compensate them for the increase.

Part of the reason why we saw such a large amount of sovereign debt trading in negative nominal terms over the summer (and a decent amount today) had to do with the fact that many investors expected inflation to be negative. Thus a bond yielding -0.5% would actually return positively in real terms if inflation was at -1%, as was the trend in some economies such as Switzerland and Japan.

Commodities - Positive; higher inflation is generally priced into commodity prices. Inflationary environments as a whole have generally been positive for oil, such as the inflationary spike in 1980 wherein it took another 24 years before prices made new all-time highs.

(Source: Federal Reserve Bank of St. Louis)

US Dollar - Negative; higher domestic inflation generally has an adverse impact on the domestic currency, as its purchasing power decreases.

Precious Metals - Positive; gold (NYSEARCA:GLD) and silver (NYSEARCA:SLV) have traditionally been hedge's against inflation.

Emerging Markets - Mixed; the influence of higher US inflation can affect emerging markets through two main channels: commodity prices and the US dollar.

Higher commodity prices are normally favorable for emerging markets as these countries generally have export-based economies. Exporting natural resources is one of the most straightforward means of establishing a workable economic system and boosting the country's wealth. However, many of these commodities are priced in US dollars. If the dollar depreciates, the effect could be offset.

The negative influence of inflation on the US dollar is a mixed influence for these economies. A sizable fraction of emerging-market debt is denominated in dollars to provide it with greater legitimacy to foreign investors. If the dollar depreciates to a degree and yields increase on this debt due to inflation bleed-through effects, this makes it less attractive to investors. It would, of course, depend on how much debt it has denominated its own domestic currency along with other world currencies.

A depreciation in the currency of a notable trading partner is also taken as a negative event, as its purchasing power decreases and therefore less goods are generally demanded.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am net long the US dollar.