While the recovery of commodity prices was largely foreseen as major industrial centres recover from COVID, the rise in American bond yields has alarmed markets. Having surged above 1.7%, up from below 1% at the beginning of the year, the 10-year treasury yield tells but a small part of the story. The steepening of the yield curve has signalled the beginning of a new mini credit cycle, with the move upwards the most aggressive since 2008. The key drivers of this are related to one another, and unfortunately growth is not a commonality. Both inflation and credit risk have been thoroughly revived, and what poses a greater threat is the degree to which either force begets the other; this will only be driven further by a congress eager to act on the whims of the American people.
While the stimulus package translating to a promised $1,200 in personal payments was blocked by Democrats, and then moderate Republicans in late 2020, President Biden could no longer rely on partisan division to halt the process, receiving the American Rescue Package to sign late last week. The figure, initially intended to add to the $800 payments begrudgingly passed by congress and thus total the initial target of $2,000, was revised up to $1,400. This was accompanied by funds for unemployment benefits, earmarked until September; the prior package approved in December of last year was due to expire this month.
What is telling is the eagerness with which stimulus is pursued, even when the immediate threat of a lockdown-driven recession has largely subsided. Economic advisor to President Obama Lawrence Summers remarked on this in a recent OpEd; while the response in 2009 could have been quicker, the stimulus response after the United States slipped into recession was around half the output gap, while Biden’s plan would be roughly three times the output gap. National debt is set to skyrocket beyond $30 trillion, and the risk of this round of stimulus spurring inflation is considerably higher than in 2020, as payments will target households with a lower savings rate. The rationale behind the stimulus has shifted from crisis management to equity; amending the failures of the prior administration’s response and scoring an early political victory are clearly the Biden administration’s primary objectives.
This new amenability toward expansionist policy has been paralleled on the monetary side. Mario Draghi, former head of the European Central Bank, was noted as a reluctant dove, willing to do “anything it takes”; this largely involved monetary easing against the wishes of German economic advisors. His successor Christine Lagarde has taken the Promethean step of suggesting inflation be allowed to persist above its target rate. Former Fed Chair and current Treasury Secretary Janet Yellen has expressed Biden’s satisfaction with Jerome Powell, especially given Powell’s bloodless capitulation to markets. Looking to remain in lockstep with Europe, the federal government’s fiscal and monetary arms are now united in the goal of faster growth, higher inflation and a larger budget deficit to complement a gargantuan balance sheet.
For close to a decade monetary policy has led the fiscal side kicking and screaming into some semblance of demand-side expansionism. By this point however, in which money supply has ballooned as a result of a system flush with brand new money, the risk of greater velocity is such that its marginal effect will be far greater than under a conventional monetary base. Both money supply and money velocity together are required for manageable inflation, and the risk of building up one side of the equation while restraining the other is that when the accelerated circulation of an ever-greater money stock does occur, the effects on the value of money are considerably more intense. A stimulus plan which goes above and beyond replacing disposable income and encourages an expansion of discretionary spending will do just that.
Markets are already shaken as the Fed has upped its CPI forecasts, indicating either a lack of faith in, or recognition of the unwillingness of, policymakers to tackle structurally higher inflation. Typically, monetary policy is better positioned to rein in transient spikes in inflation, with the notable exception of the policies employed by Paul Volcker, ending decades of high inflation following the second world war. There is no doubt higher rates will keep a lid on prices, but increasingly corporate balance sheets are structured such that normalising rates would necessitate a brutal deleveraging. Aggressive tightening can certainly work again, but the costs to aggregate demand are likely too great for any one administration to stomach.
Sam Triantafillopoulos is a Research Analyst with the University Network of Investing and Trading, specialising in monetary policy and fixed income markets.
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Disclaimer: The views expressed in this article are solely that of the author’s, and do not necessarily reflect the position of UNIT nor the University of Melbourne. The advice given is general in nature and does not consider an individual’s personal financial circumstance. Transacting off this information is done so at one’s own risk, and individuals are encouraged to consult a finance professional before making investment decisions based off of this article.