Key Takeaways
- Multiyear highs in a number of US inflation metrics as the economy reopens has some observers fretting over the possibility of a more durable shift higher in prices and what that may mean for equity portfolios.
- Though price levels in the US were quite volatile for much of the 20th century, inflation has remained subdued since the mid-1980s thanks in part to the Fed’s success in keeping expectations anchored.
- Looking forward, we believe the Fed will be margin-ally successful in generating inflation consistently at or slightly above its 2% target, in keeping with its recently adopted average inflation-targeting policy framework. A structural shift to meaningfully higher prices is less likely, but not inconceivable if the Fed-financed stimulus tap remains open indefinitely.
- Rather than trying to discern among the range of infla-tion scenarios possible in the years ahead, First Eagle’s Global Value team focuses on building all-weather port-folios composed of businesses we expect to be resilient across economic regimes.
The reopening of the US economy as vaccination levels continue to climb has large swaths of the country enjoying more normal seasonal activities this summer—and inflation metrics spiking to levels not seen in decades.
Current inflation numbers likely come as little surprise given the heady cocktail of pent-up consumer demand, ongoing fiscal support and large base effects from 2020’s depressed price levels. If transitory, as the Federal Reserve insists it will be, this episodic burst of post-Covid inflation would represent little more than a bit of noise amid 40 years of moderation. Of greater concern, if lesser probability, is that such a surge—amid a backdrop of massive public and private indebtedness, significant and ongoing fiscal stimulus, and a Fed determined to drive inflation higher— may awaken long-dormant structural impulses and lead to a durable shift higher in the pricing environment.
While inflationary conditions are not necessarily a death knell for stocks, changing dynamics may complicate the decision-making process for investors that seek to mitigate the ravages of rising prices over time by focusing on gener-ating attractive real rates of return. With this in mind, First Eagle’s Global Value team focuses on constructing all-weather portfolios that can perform in multiple environ-ments, rather than relying on tactical shifts in response to inherently unpredictable metrics like inflation.
A Strong Fed Anchor Has Kept Inflation Low for Decades
As shown in Exhibit 1, price levels in the US were quite volatile through much of the 20th century. This volatility came to a head in the 1970s and early 1980s as a conflu-ence of factors—rising social spending commitments, oil and food price shocks and the collapse of the Bretton Woods system among them—left policymakers unable to contain the inflationary pressures they had unleashed. The decade-plus Great Infla-tion period featured not only rising price levels but also high unemployment, slug-gish economic growth and deteriorating productivity (aka, stagflation), before an extreme tightening of the money supply ultimately brought inflation to heel by the mid-1980s. Pricing pressures have remained subdued in the Great Moderation that followed despite challenges ranging from the dot-com bubble to 9/11 to the global financial crisis.
The Fed attributes much of the price stability evident in recent decades to its anchoring of longer-term inflation expectations through better inflation targeting and manage-ment of private-sector expectations. However, the Fed’s anchoring success also has made it difficult to drive inflation higher when necessary, which was among the reasons cited for its August 2020 shift to an average inflation-targeting framework, a significant change in Fed orthodoxy.1 To maintain the credibility of its expectations anchor, the Fed since the 1980s has rarely tolerated inflation above its 2% target and has acted to cool the economy if rates even approached that level. Now, however, it will actively seek to generate inflation somewhat above 2% to offset the sub-target levels that have prevailed since the global financial crisis. It’s reasonable to think that a period of above-target inflation may reset expectations at moderately higher levels—or, in a worst-case scenario, potentially unmoor them.
Aggressive Policy Countermeasures Buoyed Markets and Economy, at Significant Cost
The Fed’s response to the dislocations of Covid-19 was rapid and forceful. With policy rates already near their effective lower bound when the pandemic hit, the Fed rolled out all the facilities it implemented to fight the global financial crisis—including very large-scale asset purchases—as well as new, more -targeted programs. These initiatives appeared to soothe jittery investors and to enable risk assets to mount an astonishing comeback from their initial selloff in February and March 2020. The swift develop-ment and so-far successful rollout of vaccines combined with multiple fiscal spending packages have brightened the US economic outlook for 2021 after 2020’s 3.5% GDP contraction. The June edition of the Fed’s full-year 2021 GDP forecast called for growth of 7.0%, up from a 4.2% forecast six months prior; the economy grew at a 6.4% pace in first quarter 2021.2
The cost of this recovery, however, was staggering. As shown in Exhibit 2, the Fed grew its balance sheet by about $3 trillion from March to May 2020 to reach $7.2 tril-lion; by the end of June 2021 it had eclipsed $8 trillion in size. The balance sheets of other major central banks depict a similar pattern.
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