Inflation Rears its Head

As 2014 gets underway, the once-tame inflation beast is rattling its cage. US inflation expectations recently reached an eight-month high. Let’s examine why—and how investors should respond.

To be sure, US inflation remained relatively benign over the course of 2013, at least by the official numbers. When the final reading of the consumer price index (CPI) is released on January 16, it will likely come in between 1.3 percent and 1.6 percent for the full year.

Even using the methodology in place prior to 1980 to calculate the CPI will probably produce a reading in the neighborhood of 8.5 percent, below last year’s reading of 9.7 percent and well below the greater than 10 percent readings in the final years before the financial crisis.

While the Federal Reserve has initiated its much anticipated taper, deciding at its last meeting to begin easing back its bond purchases by $10 billion per month, the Fed has never made a smooth exit from aggressive stimulus. The Fed is typically well behind the eight ball on its exit decisions, waiting too late to tighten policy and creating asset bubbles and rapid interest rate increases.

Leadership changes at the Fed are among the reasons we suspect an unruly exit from quantitative easing (QE).

As we wrote on November 15 in “The Fed: More of the Same,” new Fed Chairperson Janet Yellen has said time and again that she agrees with the easy money medicine the Fed has been dosing the economy with for years. Her educational background also puts her firmly in the Keynesian camp, having been a student of James Tobin, who studied under Alvin Hansen.

Alvin Hansen’s 1938 book Full Recovery of Stagnation argued that without aggressive government intervention to foster demand, America faced long-term employment stagnation, a key tenet of Keynesian economics. His 1941 tome Fiscal Policy and Business Cycles fully embraced Keynes! ’s theories of economics and was one of the first major works of that school of thought published in the US.

Hansen was a key advisor to President Franklin D. Roosevelt and played a decisive role in shaping the New Deal policy that helped stabilize the American economy following the Great Depression.

Thanks to that academic lineage, Yellen is concerned about economic stagnation as borne out by her own statements that getting back to a baseline growth scenario isn’t enough. Rather, as the economy reaches its baseline, she believes that monetary and fiscal policy should remain extremely easy to recoup lost growth as well.

That’s the same line of reasoning that helped create the housing bubble, as former Fed chair Alan Greenspan maintained a monetary policy that was too accommodative for too long. Because of cheap money and rising inflation, investors flocked into real estate as if they believed the party could never end.

If Stan Fischer, President Obama’s nominee for the Fed’s #2 position, is confirmed, that view of overshooting equilibrium will be further entrenched at the central bank.

Even if you know nothing else about Fischer, you’ve likely heard that he is a QE skeptic. He has publicly said that QE is dangerous and that the Fed doesn’t have any business giving guidance three years out, because it doesn’t really even know what will happen in the next year.

Largely thanks to those remarks, the markets seemed leery when the idea of Fischer’s nomination was floated in the press, almost as if the perception was that QE would come to a crashing end.

That couldn’t be further from reality.

While Fischer is understandably concerned about asset bubbles, he’s no stranger to pushing the limits of monetary stimulus. As the head of the Bank of Israel, he grew its balance sheet by more than 120 percent between 2008 and 2012, taking it up to 31 percent of Israel’s gross domestic product.
Not! coincidentally, he was also Ben Bernanke’s thesis advisor. Between Yellen and Fischer, odds are monetary policy will remain too soft for too long.

Rising Expectations

The market seems to be coming around to that pessimistic view, as US inflation expectations jump to their highest since May.

Inflation expectations, as measured by the difference between yields on 10-year nominal Treasury notes and Treasury inflation protected securities (TIPS), have risen to 2.28 percent from a low of around 2.10 a month ago.

After investors lost money in TIPS last year for only the second time since the product was introduced, it looks as though most market participants are beginning to see greater inflationary risks. As economic growth strengthens, unemployment falls and slack is removed from the economy, inflationary pressures will build as the Fed overshoots equilibrium.

That bodes well for commodities, most of which nosedived in 2013 as the market began to anticipate a taper and emerging market demand cooled. But with economies around the world returning to growth, commodity demand and prices should firm.

Coupled with growing inflation expectations, these trends will be particularly positive for gold, which finished 2013 with a 28 percent loss. While we can’t see gold getting back to $1,800 per ounce this year, we wouldn’t be surprised to see a rebound to at least $1,400/oz if inflation expectations hold steady.

If the Fed is forced to beat a hasty retreat from QE thanks to shifting sentiment, jittery investors will likely look to gold as a safe haven as that process unfolds.

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