By Kimberly Woody, Senior Portfolio Manager
“Inflation is taxation without legislation.” ~ Milton Friedman
We have long been concerned that the U.S. Federal Reserve (the Fed) had backed themselves into an impossible corner. With record corporate and government debt and seemingly endless monetary accommodation, it seemed unlikely the world economies could be weaned off support absent major market disruption. COVID-19 theoretically exacerbated an already worrisome situation and a struggling economy. We know debt suppresses GDP and so the Fed is caught in a Catch-22. How do you reflate an economy laden with debt with more debt? The Fed has spent a decade pushing on a string generating little economic growth. But reversing a low interest policy has proved problematic – one only has to look to Japan. Oddly what COVID has left in its wake may be just what the Fed needed to reverse course and reload their toolbox.
The Fed has been unsuccessful in reaching their inflation goal of a sustained 2% (as measured by the Personal Consumption Expenditures Price Index or PCE from the Bureau of Economic Analysis) – until COVID. And now we’ve got more inflation than we’ve seen since the early 1980’s. The root cause of persistent systemic inflation are wages. With strong wage increases only among lower income workers, the durability of inflation may be somewhere in between permanent and transient. Inflation is a regressive tax and higher wages may offset reduced purchasing power among this population which in turn keeps a consumer-driven economy clipping along at a decent pace. The net of all this is an environment with elevated and potentially semi-persistent inflation combined with lower rates. The value of assets is preserved, the economy is spared the crushing blow of an impaired consumer and our record levels of debt begin to fade.
As the reserve currency, the U.S. could very well use inflation to pay off its debt. But we are all well acquainted with the evils of inflation. In fact, inflation has been the Fed’s boogeyman for 30 years. As with assets, inflation also devalues debt. The Fed just may have found a way out of its Catch-22.
Source: Bureau of Economic Analysis
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