One constant theme about 2020 has been to expect the unexpected.
Already this year, a global pandemic led to an economic shutdown which caused the stock market to crash 35%. Then, the stock market has staged a 66% rebound and climbed to new highs. The economy has done better than expected, although so many have been left behind.
Inflation
Another potential surprise is that inflation and inflation expectations are starting to perk up and the potential to keep climbing.
This would be a surprise given that inflation has been depressed for the last decade. From 2009 to 2020, the CPI has mainly been between 0 and 2.5%. There have been a few prints above 2.5% which have generally coincided with periods of optimism and a few around 0% that were periods of pessimism.
Anytime, inflation started to move higher above 2%, something brought it lower. In 2011, there was the European debt crisis which lasted until the middle of 2012. From 2014 to 2016, oil crashed from $100 to $25. In 2018, we got above 2.5% again and we had the trade war and the Fed hiking rates.
Typical Dynamics
Currently, inflation bottomed around 0.2% in May and has moved higher with a 1% reading in July. Given that inflation hasn't been a threat for the last decade, most investors don't seem worried. This is evident by the low yields of long-term bonds. For example, the 10-year Treasury note is yielding 0.66%.
Inflation matters for a variety of reasons. It tells us how much demand there is in the economy. In the early parts of recovery, inflation is a positive sign that economic activity is returning to normal levels, as the economy hits some capacity constraints.
However, this recovery has been unique, and the lack of persistent inflation is due to the lack of a robust recovery. Later in a bull market, inflation is a warning sign as it begins to have negative effects. It also signals that the central bank and federal government's ability to support the economy is compromised.
This was evident in 2008 when there was little the Federal Reserve could do to support the economy given that oil was trading at $150 and the CPI was at 4%. In contrast, the Fed could be aggressive with little worry about adverse effects in March of this year as the CPI was under 2%.
Why This Time Could be Different?
We have a unique situation in which monetary stimulus is at record levels, and the Fed is committing to it for an extended period of time. In the last Federal Open Market Committee meeting, Chairman Jerome Powell reiterated that they won't raise rates until the end of 2021. Additionally, the Fed has stated that it's going to potentially raise its inflation target and tolerate higher levels of inflation for longer periods of time.
Additionally, the federal government has pumped fiscal stimulus into the economy. Deficits have been more than $1 trillion in the last couple of years, and more than $2 trillion this year. Before the Republicans were concerned about deficits, but under President Donald Trump, they have abandoned these concerns. Although the short-term fate of fiscal stimulus is uncertain, it's likely to be deployed again especially if the economy starts deteriorating. Ironically, deficits are not a concern, because all the warnings of inflation over the past decade have failed to materialize.
The coronavirus has dented demand less than expected, and there's still a considerable amount of monetary stimulus still circulating. In terms of supply, the coronavirus has disrupted supply chains which are leading to bottlenecks in various industries which can cause upwards pressure in prices. And even prior, investments in supply were not as strong.
An example is housing, where demand has increased, but new construction has lagged. Another example is oil. Rig counts are down and over the last 5 years, investments in new projects have dried up. If demand returns to pre-coronavirus levels, oil would go into a deficit between supply and demand which would cause prices to rise and feed into the rest of the economy.