- Inflation drives the link between stocks and bonds. During periods of high inflation, stocks and bonds move in the same direction—diminishing the diversification benefits.
- There are some forces aligned that could support higher than expected inflation: loose fiscal and monetary policy, a drastic increase in the money supply, and a shortage in labor supply.
- But there's an incredibly strong deflationary force at work as well: an aging workforce.
Inflation has been on everyone's mind lately. But there are interesting implications for investors beyond higher prices in the economy.
Inflation drives the correlation between stocks and bonds
About the expert
Jurrien Timmer is the director of global macro in Fidelity's Global Asset Allocation Division, specializing in global macro strategy and active asset allocation. He joined Fidelity in 1995 as a technical research analyst.
For the past 20 years or so inflation has been in the sweet spot to produce the most negative correlation possible between stocks and bonds (which in turn has made the 60% stocks/40% bonds model so successful).
But since 1900, whenever the long-term inflation rate was above average (above 3-ish%), the correlation between stocks and bonds has almost always been positive. That means that a traditional 60% stocks/40% bonds model, made up of the S&P 500 (SPX) and Bloomberg Barclays Aggregate Bond Index, was not the ideal mix for asset allocation during those times. During the inflation days of the late 1960s and 1970s, cash and gold were better diversifiers than long bonds.
So what about inflation? We know there is cyclical inflation, now that the economy is reopening. April's Consumer Price Index (CPI) report showed a dramatic year-over-year increase of 4.2%—higher than many people were expecting.
The link between the money supply and inflation
Since the global financial crisis (GFC) in 2008 and then COVID-19 last year and now a fiscal spending wave "accommodated" by the Fed, the money supply has been growing at a rate rarely seen in history.
The chart below shows that until the 2000s, whenever the money supply has soared, inflation has tended to follow. So it's tempting to connect the dots here. However, this pattern hasn't worked since the 2000s, but I will get back to that in a moment.
The Fed, interest rates, and inflation
It's pretty clear that both fiscal and monetary policy are expansive these days. With April's employment report missing estimates by a mile (in total contrast to many other indicators), the Fed now has even more reason to stay lower for longer. It's possible, however, that the nonfarm payrolls report was understated due to seasonal adjustment effects (which could be understandably out of whack after last year).
In the top panel of the chart, Lower for longer: fiscal and monetary policy, I show the gap between the unemployment rate and what is considered full employment. Right before the pandemic, that was at −1, meaning the economy was actually a little bit beyond capacity. Then during the pandemic, that spread rose to 10%, which is huge—one of the worst ratings we've ever seen. It's closed very quickly and gone down to 1.6%. But now, you can see, it's leveling off a bit.
If that gap remains unfilled, and it causes the Fed to keep interest rates lower for longer even though inflation is creeping higher, that would put the market on notice that maybe we're going to have some inflation that lasts beyond the short-term transitory inflation we are seeing now.
So it seems intuitive that the seeds for an entrenching of inflation expectations are being sown. While the base effects of the current pandemic-induced inflation spike will dissipate, the risk is that the "gains" now being made in the inflation gauges will stick, and that the CPI will start a series of higher highs, much like it did during the late 1960s.
Counterpoint: Deflationary forces in the economy
Which leads me to the counterpoint: Whatever inflation seeds are being sown by policy makers need to overcome powerful demographics-induced deflationary forces. Let's go back to the chart above that showed M2 vs. the CPI. The relationship between M2 growth and inflation broke down during the 2000s. Why was that? Well, we had globalization and technological innovation, but we also had an aging labor force.
Take a look at the same chart, but now with the growth rate of the US labor force added in the bottom panel. See a pattern? When money growth was rampant during the 1970s, the labor force was growing as well. Then when M2 growth peaked, it coincided with a deceleration in labor force growth. Now M2 is growing fast again, but labor force growth is declining.
Could this be the thing that prevents a surge in M2 from spilling over into structural inflation? I don't know, but to me, it seems more than plausible. Plus we know from Japan (which is 10–15 years ahead of the US in terms of demographics and money printing) that inflation is not a given even when the printer is going full tilt. Japan completely monetized its debt and it has zero inflation to show for it.
There are many important differences between the US and Japan, but my point is that it is not necessarily a foregone conclusion that longer-term inflation is a given. My assumption is that inflation will likely get more sticky going forward, but I don't think we want to lose sight of this counterpoint.