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U.S. Fixed Income

Will Massive Stimulus Efforts Fuel High Inflation?

Stephen L. Bartolini, CFA, Portfolio Manager
Mike Sewell, CFA, Portfolio Manager

Fiscal and monetary response has raised inflation fears.

Key Insights

  • While the fiscal and monetary crisis response may have staved off deflation and prevented a deeper recession, it is by no means inflationary.
  • High inflation is unlikely to be a serious threat coming out of the current crisis due to multiple factors, such as below‑potential growth and subdued demand.
  • Though inflation is likely to remain subdued, investors should remember that an allocation to TIPS can provide a hedge against unexpected bursts of inflation.

The U.S. fiscal response to the coronavirus pandemic has so far totaled around USD 2.9 trillion in combined government spending, tax relief, and credit support. This deficit spending has helped offset the deep decline in aggregate demand caused by consumers staying at home and nonessential businesses closing. Although government aid provided a lifeline to households and businesses while activity largely ground to a halt, it has only made up for about half of the demand shortfall. While the fiscal response may have staved off deflation and prevented an even deeper recession, it is by no means inflationary, as some observers fear.

On the monetary front, the Federal Reserve responded to the COVID‑19 crisis by further expanding its balance sheet by about USD 2.8 trillion, pushing total assets above USD 7 trillion, as it launched a multitude of facilities intended to inject badly needed liquidity into fixed income markets and restore orderly market functioning. The balance sheet expansion occurred at a much faster pace than that seen during the 2008–2009 global financial crisis (GFC).

Following the GFC, market participants had similar concerns that the spike in the monetary base from quantitative easing (QE) would result in runaway inflation. However, that scenario failed to transpire. Since September 2008, core consumer price index (CPI) inflation has averaged around 1.8% on an annual basis and fell as low as 0.6% in 2010, compelling the Fed to engage in additional rounds of QE.

Economic Slack Should Mitigate Inflation

(Fig. 1) Actual, estimated, and potential U.S. GDP (quarterly)

As of May 31, 2020.
Sources: Congressional Budget Office, U.S. Bureau of Economic Analysis, and Federal Reserve Bank of St. Louis (FRED). CBO estimated GDP covers second quarter of 2020 through fourth quarter of 2021. Potential GDP ends fourth quarter of 2021.

Several Factors Working Against High Inflation

Similar to the GFC experience, we believe that high inflation is unlikely to be a serious threat coming out of the current crisis due to multiple factors:

  • Inflation tends to follow economic growth, and the current recession has resulted in a large output gap, with gross domestic product (GDP) forecast to run well below potential. It will probably take several years for the economy to get back to operating at full capacity; while the recovery is expected to be robust as the stalled economy powers back up, it is also expected to be flatter on the upside than it was on the way down.
  • Demand is likely to remain subdued in the wake of the crisis as households increase savings and cut spending to fortify their finances, while corporations look to conserve cash and reduce leverage to maintain credit ratings.
  • While the monetary base has dramatically increased due to Fed asset purchases, the growth in the money supply will not necessarily flow into the economy. Similar to the post‑GFC period, banks may be hesitant to lend amid concerns about losses on consumer and real estate loans, instead maintaining large reserve balances at the Fed.
  • The U.S. unemployment rate spiked to 14.7% in April, the highest level on record. While the unemployment rate posted a surprising decrease in May, we still think it is likely to only gradually trend lower. Job losses are likely to be permanent in some industries, and automation is poised to increase at an even faster pace in response to the virus. As such, wage pressures are likely to remain muted.
  • Industries hit hard by the pandemic may have reduced pricing power for some time after social distancing measures are eased. For example, airlines, lodging, and travel services could see continued muted demand as people remain skittish about leisure and business travel.
  • Oil prices have rebounded from their April nadir but remain relatively low as supply continues to exceed demand. While we could see a further rally in prices as quarantines are lifted and producers cut output, the longer‑term crude outlook remains bearish due to ongoing productivity gains and a shift away from fossil fuels.
  • As the world’s reserve currency, demand for U.S. dollars remains strong as global investors continue to view the dollar as a key store of value. This contrasts with other, less stable, economies that have seen inflation and hyperinflation when the money supply increases dramatically. 
Opening Quote It will probably take several years for the economy to get back to operating at full capacity… Closing Quote

Core Inflation Set to Fall Over the Next Year

Against this backdrop, our economics team’s models are currently forecasting annual core CPI inflation in the U.S. to fall from 2.2% in the first quarter of 2020 to around 1.2% in the four quarters ending June 30, 2021, amid a faster rate of core goods deflation and a sharp deceleration in non‑energy services inflation.

Break‑Even Curve Should Flatten

(Fig. 2) Break‑even spreads across maturities

As of May 29, 2020.
Source: Barclays Live. © 2020 Barclays.

Breakevens Reflect Low Inflation Expectations

Break‑even spreads, a market‑based measure of inflation expectations based on yield differentials in same‑maturity nominal Treasuries and Treasury inflation protected securities (TIPS), are pricing in low future inflation. Ten‑year TIPS breakevens fell as low as 50 basis points1 (bp) in mid‑March as equity and credit markets sold off. Despite a recovery in inflation expectations as risk appetite improved, as of early June, 10‑year TIPS were pricing in inflation of only about 120 bp over the next 10 years. At such depressed levels, there is scope for breakevens to expand despite subdued inflation pressures.

However, with real (inflation‑adjusted) rates on TIPS in negative territory, upside for TIPS breakevens will likely require nominal Treasury rates to break out of their recent tight range and move higher. For this to happen, economic data will need to transition from no longer getting worse to actually starting to improve. Specifically, we expect the shorter‑maturity segment of the break‑even curve to move higher as the data begin to look less dire and very low near‑term inflation expectations become more aligned with moderately higher longer‑term inflation expectations.

Moreover, the break‑even spread curve is correlated with the Cboe Volatility Index (VIX), the closely watched measure of implied equity market volatility. The break‑even curve has tended to steepen at times when the VIX is elevated and flatten when the VIX falls back to calmer levels. With volatility appearing to moderate, we believe that shorter‑maturity breakevens can widen even in a scenario where longer‑term inflation expectations remain muted and longer‑maturity breakevens trade sideways. 

TIPS Can Provide a Useful Hedge Against Unexpected Inflation

Finally, although inflation is likely to remain subdued, investors should remember that an allocation to TIPS can help preserve real value in portfolios over longer time periods and provide a hedge against unexpected bursts of inflation.

What We're Watching Next

In the nominal Treasury rates market, the shorter‑maturity segment of the curve is anchored near 0% due to the Fed’s zero interest rate policy, which is expected to remain in place for the foreseeable future. Meanwhile, movements in long‑term rates have driven the shape of the curve; the curve has flattened on days when risk aversion is higher and demand for safe havens increases, and steepened when risk appetite is stronger and long‑term Treasuries sell off. With this dynamic likely to remain in place, we see potential for the Treasury curve to steepen into the back half of 2020, driven by higher long‑term yields as the growth outlook improves.

1 A basis point is 0.01 percentage points.

Key Risks—The following risks are materially relevant to the strategy highlighted in this material:

Debt securities could suffer an adverse change in financial condition due to ratings downgrade or default, which may affect the value of an investment. Fixed income securities are subject to credit risk, liquidity risk, call risk, and interest rate risk. As interest rates rise, bond prices generally fall. In periods of no or low inflation, other types of bonds, such as U.S. Treasury bonds, may perform better than Treasury inflation protected securities.

Important Information
This material is being furnished for general informational and/or marketing purposes only.
The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, nor is it intended to serve as the primary basis for an investment decision. Prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date written and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

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