A user’s guide for distinguishing between reflation and inflation

January 14, 2021

3:15 pm

A user’s guide for distinguishing between reflation and inflation
  • In a fragmentary work on the philosophy of psychology published in 1953 after his death, Ludwig Wittgenstein addressed the phenomenon of how our impressions of what we see (or experience more generally) could change even when the object in question was unchanged. He used a visual example of the duck-rabbit (see below) to help unravel what he considered to be the ‘conceptual unclarities’ around how we describe what we see. If one sees a rabbit (or a duck) when one first looks at the picture, what if anything happens when one subsequently sees the other? Is it just how we describe it or talk about it, or has something ‘real’ actually changed? Once one has seen the duck-rabbit, can one just see the duck or the rabbit as before?
Rabbit / duck
Source: : Independent.co.uk
  • A slightly more puerile example below shows Sesame Street’s cookie monster watching tenderly over the Madonna and Child. Once seen, not only can it not be unseen, but it dominates one’s view of the picture to the exclusion of everything else.
Bas-relief of the Virgin Mary
Cookie Monster
Source: Shutterstock.com
  • This is not just idle speculation during a slow-news week. The point being illustrated is one about inflation and how investors (and economic agents more generally) come to change their view of the world during a period of inflation, and how this change of behaviour is shown in asset price movements. While CPI or the PCE deflator measure inflation on an ongoing basis in purely numeric terms, was something ‘different’ happening say in the 1970s when inflation was running rampant?
  • The task here is to find out whether there is a meaningful way in which investors can monitor whether the market is shifting from a prevailing view of reflation (back to the way things were, good) to inflation (something happening which hasn’t really been a problem since the 1970s, bad). The question behind this is a simple one – did something happen in 2020 (or is something going to happen in 2021) which has changed the monetary status quo which means reflation is just a signpost on the road to ‘proper’ inflation?
  • As it is a market question, the starting point is a market measure of inflation, the breakeven on 10yr US Treasury TIPS. The graph below shows a current reading of 2.07%, slightly exceeding the Fed’s medium-term goal of 2% but more importantly showing a sharp recovery from the March 2020 lows when the economy and markets were in free fall following the outbreak of the Covid-19 pandemic. As it stands, this can be interpreted as a good example of reflation, and Fed quantitative easing (QE) policy has very much been aimed at effecting this outcome, not least because the Fed itself has been an aggressive buyer of TIPS and therefore its very action is aimed at giving the impression of reflation.

Sources: Bloomberg, 11th January 2020.

  • A 10yr forward inflation price of 2% is quite nice; in-line with the Fed’s target and therefore nothing too outlandish. This is the sort of inflation which one might call healthy (at least as far as the target is concerned), and is the sort that has allowed stock markets (especially in the US) not only to recover but to seek out new highs as the reflationary recovery is on track.
  • But wait, that’s not all. A key component of inflation expectations is the oil price, and both Brent and West Texas have recovered back to $50+ per barrel or around their pre-Covid-19 levels. This again suggests a fairly healthy reflationary recovery, even with movement restrictions still in place.
  • The graph below shows a slightly different picture. The blue line is the Commodity Research Bureau’s raw industrial commodity price index (a broader commodity basket designed to eliminate biases from the commodity futures market) while the yellow line is the nominal yield on 10yr Treasuries. Something a bit odd seems to be happening here.

Sources: Bloomberg, 11th January 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

  • What this shows is that while commodity prices have recovered sharply, nominal interest rates have not risen as one might have expected. If inflation expectations at 10yr have recovered to 2%, this means that the problem lies in real rates. They are still stuck around -1% when this time last year they were at 0%. Why is this? Simple really – Fed QE is suppressing real rates, and their ‘open mouth’ policy is suggesting that they aren’t going to hike rates any time soon, even if inflation rises above the 2% target. This is the new average-inflation policy explained during the course of summer 2020.
  • Negative real rates are not the sort of thing you’d expect to see if the economy was simply going to get back to normal and therefore this means this ‘reflation’ theme has a bit of a problem. All else equal, negative real rates reflect capital destruction within the economy from negative real levels of growth. This is the sort of thing you’d expect to see from a heavily-indebted economy (and one which has become even more indebted in 2020 due to the pandemic and how it was dealt with).
  • In a normal economic cycle, inflation starts to emerge at the peak as the economy reaches full employment and therefore any further growth in demand, especially if it is credit-fuelled, starts to make the economy overheat. Usually at this stage, the central bank starts to hike rates, reducing demand for credit, reducing consumption and inducing a period of balance-sheet repair, aka a recession.
  • What if there is something different going on, and this isn’t a normal cycle but one where financial assets are responding to radical monetary and fiscal policy, and therefore something is happening to the money system itself? The graph below of US M2 money shows the vertiginous rise in money from Fed QE. The difference this time (as opposed to 2008-‘9) is that 2020 saw massive US deficit spending (15.2% of nominal GDP according to the latest Fed data in November 2020) and with the Democrats now in control of the Senate and a Biden administration inbound, the fiscal driver behind the Fed’s QE is likely only to increase exponentially. This may be why US 10yr nominal yields are not tracking commodities per the graph above – too much debt weighing down the economy and therefore real rates, but also the prospect of a Biden spend-a-thon necessitating even more Fed activism, this time in terms of a yield-curve control policy similar to that operational in the 1940s.

Sources: Bloomberg, 11th January 2020.

  • Fed yield curve control in the 1940s saw real rates fall sharply and inflation rise, although nominal rates were of course controlled by the Fed, thus making the deficit manageable. Real economic growth was however very high, especially after the end of World War II, but as inflation pushed over 10% the Fed had to abandon the policy in March 1951.
  • The market often tends to do what it is used to and especially in the bail-out era, it tends to be risk-on and Panglossian in the extreme. While QE does look very much like a repeat of the asset friendly versions that have gone before, 2020 was in fact different from a deficit-financing perspective, and this factor will likely continue with the Democrats in charge in the US. The scale of the monetary intervention then takes on a different character, and one has to ask whether the old and rarely used term of debasement is now the correct descriptive term to be used.
  • Debasement of the coinage was often a wartime expedient brought on by massive government expenditure. If extreme enough, it led to something called Gresham’s law taking effect, meaning bad money drove out the good. People tried to get rid of the newly debased money they had as quickly as possible and exchange it for goods. In a financialised, fiat-money world, rampant stock markets could well be interpreted as early symptoms of Gresham’s law taking effect. The problem for markets right now though is that the assets which have been rallying are the ones which do well in periods of reflation but not during inflation. This includes growth stocks – hence the Nasdaq’s strong performance.
  • So far, financial assets have done very well, especially stocks. If reflation is to become inflation, then commodities will continue to rally but the stock market could falter, or at least its leadership could change with value factors outperforming growth. Amongst the commodity suite itself, there is one which acts as the ultimate bell-weather both for debasement and the subsequent inflation it causes, and that is gold.
  • The graph below shows gold from the start of 2020 and it did ok. It struggled in the latter half of Q3 and Q4 due to some quite market specific issues relating to the paper futures market. There have been three occasions since August of a $100 slam-down of the gold price and this has cautioned investors from adding to their holdings, even as other fiat-debasement trades like bitcoin have prospered. Gold’s failure to push on shows the market is still in reflation mode. One ought to be in doubt though that if gold starts to move, it’s not that inflation is coming, it’s that it has just arrived. At that point the commodity market will no longer be the duck of reflation but the rabbit of inflation (so to speak).

Sources: Bloomberg, 11th January 2020. Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.

[1] CPI = Consumer Price Index, PCE = Personal consumption expenditures
Unless otherwise stated, all opinions within this document are those of the RWC Diversified Return Investment Team, as at 14th January 2021.
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