Ferdinand Magellan’s circumnavigation around the globe was a historical accomplishment wrought with unending challenges, suffering and strategy mistakes. While the expedition accomplished the first passage around the world, it came at a tremendous cost. Of the 260 sailors and fleet of five vessels, only 18 sailors and one vessel returned to Spain after the 3-year voyage. (Magellan himself never circumnavigated the globe. He was killed in the Battle of Mactan in the Philippines.)

When Magellan presented his expedition proposal to King Charles of Spain, he used a map depicting his planned route to the Spice Islands through or around South America. But a critical part of the map was missing, the part showing a waterway from South America to the Spice Islands. We know that part to be the single largest waterway in the world, the Pacific Ocean. Like most explorers in the Age of Discovery, Magellan had no way of comprehending the size of the Pacific.

Much like Magellan’s expedition, the cost and suffering of the current economic recession has been greater than most anticipated. The economy was in peril and if the earth were flat, the financial industry would have sailed right over the edge.

The governments of the world have embarked upon unprecedented intervention, including massive stimulus programs and monetary expansion. Policy responses appear to have averted catastrophe, and like Magellan’s landfall on Guam, the economy has found temporary shelter. However, the primary objective for U.S. and global policymakers is not just to avert the collapse of the financial system, but to help turn the economy toward recovery.

Policymakers had a map for navigating through fiscal and monetary policies, but like Magellan’s map much of the course was obscured or unknown. To return to economic normalcy, we would have to continue navigating through uncharted waters.

To help steer the economy back on track, the U.S. and global governments are trying to reflate the economy, using fiscal and monetary stimulus in order to expand output. Because central banks were worried about deflation rather than inflation, global central banks coordinated the easing of target policy rates to the lowest on record. For example, Federal Reserve easing of interest rates is typically utilized to help inject liquidity into the financial system, but never before has the target rate been 0%. (Fig. 1.)

Due to signs of stabilization within some sectors of the financial and economic markets, forecasts for a sharp rise in inflation have intensified recently. Commodity prices have been rising and there has been an abundance of media articles questioning whether inflation risks are imminent.

In order to understand the market’s shift away from deflationary concerns and directionally toward inflationary concerns, we examine the market’s current inflation watch indicators, monetary policy and fiscal policy.

Inflation Indicators

The Consumer Price Index and Purchasing Price Index are two primary, but not exclusive, economic indicators that report on the degree of inflation that has already worked its way into the economy. Because the markets are forward-looking however, there are a number of useful indicators that when viewed together help identify how the market may be discounting the prospects for future inflation: government bond yields, commodity prices and the U.S. dollar.

Yields on U.S. Treasuries spiked in May and June, as the markets discounted improvement in economic sentiment and the potential for inflation. (Fig. 2.)

In one camp, rising government bond rates prove that monetary and fiscal policy is working, enabling the markets to return to normalcy. In another camp, rising interest rates signal that inflation expectations are taking hold, threatening to destabilize the real or perceived economic recovery. Or said differently, how will the massive and aggressive monetary and fiscal policies of today be unwound?

Inflation expectations are also influenced by the current market environment for commodities with emphasis on oil. From its recent low in December 2008 through mid-June, oil prices increased more than 100%, from $34 to $72. This impressive rally has occurred simultaneously with a spike in the Treasury Inflation Protected Securities (TIPS) breakeven rate. (Fig. 3.)

TIPS are structured to increase the principal of the security based on positive movements in the rate of inflation. A reversion of TIPS breakeven rates toward the longer-term average of around 2.5% may indicate that inflation fears affected the back up in Treasury yields toward 4%. The TIPS breakeven rate does not signal that inflation is upon us, rather that inflation expectations are starting to take hold.

The U.S. dollar is another widely watched indicator of inflation, among other things. The equity market lows in March corresponded directly to the U.S. dollar’s high. The U.S. broad trade weighted dollar fell almost 10% from this year’s high. The dollar has the potential to decline when risk aversion abates and the markets consider the long-term impact of U.S. policies. Often, a declining dollar signals that foreign investors are turning away when they are being counted on to finance U.S. debt.

The dollar may weaken for other reasons as well. For example, over the recent cycle the dollar has acted as a safe haven for risk-averse investors. As market volatility declines and risk appetite increases, the need for the dollar as a safe haven diminishes.

Monetary Policy

As financial turbulence intensified during the economic downturn, the Fed responded forcefully by flooding the banking sector with liquidity and easing monetary policy aggressively. The Fed’s balance sheet has doubled in the past year, from about $860 billion to $1.8 trillion. By buying up long-term U.S. Treasuries, the Fed hopes to depress rates (including mortgage rates) and create more affordable housing and refinancing opportunities.

Additionally, the Fed has set a moving target for its federal funds target rate, an interest rate banks charge each other, between 0% and 0.25%. During the Great Depression, the average discount rate of the seven leading economies never fell under 3%.¹

The fact that current monetary policy is more accommodative than at any other point in history may help prematurely fuel inflation expectations. In normal times, monetary policy is the primary tool for helping generate sustained increases in aggregate demand. When aggregate demand increases enough, the Fed may increase the federal funds rate as a check on inflationary forces.

While intending to halt the free fall in asset prices, this current policy favoring re-inflation over disinflation may lead to future accelerations in price inflation in excess of a recovery in economic growth. In order to contain inflation, the Fed will need to unwind its balance sheet. Upward movements in inflationary expectations may reflect the uncertainty as to how the Fed may accomplish this task.

The velocity of money is the rate at which money is transacted in everyday business. (Fig. 4.) Accelerating velocity is typically a sign of excess public activity relative to savings. Excessively high velocity indicates a potentially overheated economy and may consequently exert downward pressures on the equity markets.

By providing funding support to banks, the Fed expects that banks will start lending the money. When the public transacts money faster than the Fed can circulate it, velocity increases placing upward pressures on interest rates.

Fiscal policy

The largest government spending package in U.S. history is set to bolster the economy. Approximately $787 billion has been targeted for categories such as tax relief, health care, education and training, and state and local government fiscal relief. The purpose of fiscal policy response is to create economic expansion, or demand, by increasing federal expenditures. The federal budget deficit is expected to increase fourfold this year, from 3.2% of GDP to 13.1%. (Fig. 5.) Federal stimulus spending coupled with declining tax revenues have contributed, and may continue to contribute to, the budget shortfall. According to the International Monetary Fund (IMF), by 2014 government debt of rich countries is expected to equal 114% of GDP, a level never seen before in peacetime.

There are two primary concerns with regard to current fiscal policy. First, how will the federal government pay off the massive debt caused by the stimulus measures? Second, what happens if private investors and foreign governments fail to step in and buy? There is widespread concern over how the U.S. will pay off the massive deficit. This concern runs deeper when considering the massive debt burden is occurring during a time when the population is aging and health care costs are rising. According to The Economist, “left unchecked, demographic pressures will send the combined public debt of the big rich economies toward 200% of GDP by 2030.”

Most economists agree that government inaction would likely have resulted in a deeper recession as the private sector focuses on repairing balance sheets and increasing savings. If the stimulus package will lead to inflationary pressures, they are most likely to occur next year. Of the $787 billion stimulus package, about $46 billion has been paid out.

The massive global stimulus and depressed inventory levels may provide a sharp boost in GDP over a short-term period. Yet, longer-term it may be challenging for businesses and consumers to leverage themselves up and spend freely again. Thus, the Federal government is borrowing and spending to replace the demand that typically is driven by the private sector in an economic recovery.

The federal deficit may reach $1.5 to $2 trillion next year. If there is not enough global demand for U.S. Treasuries, the Fed may buy them creating the groundwork for continued weakening of the U.S. dollar and high future inflation.

Public debt historically rises in the years after a financial crisis. Economies can recover from high debt burdens with real growth and fiscal restraint. Congress and the administration, now and in the future, will have to consider ways to roll back the massive deficit or the markets will eventually discount the burden of federal debt and higher long-term interest rates.

What to Watch For

In the 1970s, a spike in commodity prices preceded increases in the Consumer Price Index (CPI). Year-over-year comparisons of CPI, however, may not support a spike in inflation this year, despite the recent increase in commodities. On a year-over-year basis, commodity prices are still negative.

Employment is still contracting fiercely and it will be a long time before the unemployment rate falls to a more reasonable level. The labor markets are the drivers of consumer spending, which accounts for more than 70% of GDP. As long as jobs continue to be lost at a rapid pace, the labor markets will exert deflationary forces. A reversal in job losses and a healthier employment rate may be required before inflation takes hold.

According to ISI Group, interest rate increases are fairly normal at the beginning of economic recoveries, with bond yields increasing 157 basis points (bps) in 1971, 122 bps in 2002, and 387 bps in 1983. In fact, since 1980, in all instances in which the 10-year Treasury yield was 360 basis points or higher than the 3-month T-bill, the 10-year Treasury rate fell over the ensuing four- and 13-week periods an average of -34 bps and -93 bps, respectively. Rising government bond yields may be the markets way of moderating the recovery and therefore keeping inflation in check.

Interested observers can keep an eye on U.S. Treasury yields, particularly in the intermediate to long end of the curve. A reversal in the short-term yield spikes may indicate that the markets’ gyrations from historically low yield levels indicate a sense of normalcy. Continued increases in yields, conversely, may indicate worries over the unwinding of monetary and fiscal stimulus.

Where are we Headed?

In May, the CPI rose less than forecast and generated the biggest 12-month decline in almost 60 years. The underwhelming CPI data lends support to the view that excess capacity will help restrain upward moves in core inflation. If the economic recovery is modest to mediocre, labor and capacity may continue to be underutilized. (Fig. 6.)

In our February commentary, we cautioned investors not to bet exclusively on either an extreme inflationary or deflationary outcome this year. We thought that a rebound in commodity and energy prices would help reduce deflationary pressures. Relative strength in energy and commodity-related companies since market lows in March has helped shift expectations from deflationary to inflationary.

Economic considerations have shifted from a question of when the global economy will bottom out to how robust the economic recovery will be over the medium-term. A few months ago economists and investors wondered whether policy stimulus would be sufficient to halt the economic free fall. Now many are concerned about the inflationary implications of monetary and fiscal policy measures. However, we have not yet recovered economic growth. We have only experienced a moderation in economic decline.

Historically, inflation does not tend to move higher when economies are still weak and there are still deflationary undertones in the economy. There is still much excess manufacturing capacity. Because the recession is highly synchronized globally, there is and may continue to be a significant output gap (the difference between the actual output of an economy and the output at full capacity) leading to falling prices, not inflation. Growth in private sector compensation is falling. While there has been a pickup in some manufacturing surveys, or at least a moderation in the rate of decline, the environment for corporate profits remains challenging.

And if the output gap is not enough to have a deflationary influence, necessary deleveraging will continue to be a headwind toward economic growth. The most critical areas of balance sheet repairs concern household and financial sector debt. In past recessions, healthy recoveries were supported by healthy growth in credit. The challenge coming out of this stress period will be moving the economy forward in the face of tighter credit than in recent recovery periods.

For all the torment over the inflation-deflation debate, neither may end up a significant concern this year. Federal Reserve Chairman Ben Bernanke stated to the House Budget Committee on June 3, “If you look around for signs of inflation and inflation expectations, you are not going to find very much.”

What does all this mean for the markets? Stocks historically tend to perform well when inflationary pressures are low. As risk appetite returns, investors logically sell-off Treasuries they bought as a safe haven. The rise in government yields may therefore be partially explained by the fact that the market is no longer pricing in systemic collapse. Stated differently, it is difficult to view 10-year Treasury yields around 3.5% to 3.75% adversely when in December yields just over 2% represented disaster. The market’s inclination to price in future inflation may not be the most desirable outcome. However, it certainly is preferable to pricing in systemic calamity, as was feared just months ago.

The probability that the U.S. and global economies will need aggressive monetary and fiscal policies far longer than expected is a real one. This very need is itself deflationary or, at a minimum, not inflationary. Not unlike Magellan’s global expedition, the course to full economic recovery may be more protracted, more demanding and more dubious than many may hope.

¹ Wolf, Martin. “The Recession Tracks the Great Depression.” The Financial Times. June 16, 2009.