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THERE MAY BE A REGIME CHANGE UNDERWAY as we move from a monetary policy-dominant environment last cycle to globally loose fiscal policy supported by dovish monetary policy. Many of the elements driving this transition were in place before this year, but responses to the COVID-19 pandemic may have accelerated the trend. We believe this development has increased the likelihood of the economy exiting the current deflationary regime. This evolution is globally applicable, but we will mostly focus this paper on the US, given its major role in the global financial system.
In our experience, it is very difficult to predict long-term inflation levels, as it is a complicated process with many offsetting forces that no one fully understands. Even the US Federal Reserve (Fed) recently effectively admitted they are unable to project inflation accurately, instead pledging to shift to an emphasis on average realized inflation. Forty years of disinflation appear to have chipped away at policymakers’ fear of inflation. Congress seems no longer focused on the negative consequences of deficits and central bankers are more concentrated on generating inflation and tight labor markets than limiting upside to inflation. Importantly, while the COVID-19 response is hopefully a shorter-term dynamic, the change in policy preference could be more structural. We think this change increases the risk of a policy error leading to higher inflation as governments are running a real-time fiscal and monetary policy experiment with unknown outcomes.
We therefore believe that while deflationary outcomes remain a risk, the tail risk of structurally higher inflation is the greatest it has been in decades and isn’t fully captured in current market pricing. In this paper, we outline the current policy landscape, the differences between this environment and what transpired after the global financial crisis (GFC), potential paths to higher inflation, key industry dynamics, and the investment implications of a new high-inflation regime, which could be dramatic given that the financial system has become levered to low inflation and low interest rates.
To put our current inflation outlook in perspective, let’s first outline our framework for thinking about inflation sources and expectations. Prices are impacted by the intersection of supply and demand. Demand can move cyclically, creating periods of short-term inflation driven by factors ranging from credit cycles to fiscal policy. Historically, supply-driven inflation has been fueled by…