GMO Quarterly Letter

What Happened to Inflation?
And What Happens If It Comes Back?

Ben Inker

A year ago, the US economy seemed poised for a significant shift. On one hand, inflation was running at the Fed’s target level, unemployment hovered around most estimates of full employment, and a new president was coming in promising a fiscal boost and policies designed to increase economic growth. On the other hand, after close to a decade of doing everything it could to boost the economy, the Federal Reserve was promising to, if not take away the punchbowl, at least begin diluting the alcohol content. Something looked likely to give, in a way that would give us a significant clue as to whether interest rates would ever be able to go back to the levels that we all used to think of as normal. The year has actually turned out to be more confusing than expected, playing out in a way that did not align with either of our scenarios. This leaves us with continued uncertainty about where interest rates will wind up. But it also leaves me, at least, increasingly convinced that a significant inflation shock would be just about the worst thing that could happen to today’s investment portfolios. Unlike most of history, it seems plausible that a meaningful inflation increase from here would impose worse losses on portfolios than a depression would. Depressions are bad for risk assets and good for high quality bonds. Inflation is very bad for high quality bonds and modestly bad for stocks. Today, not only would bonds do particularly badly given their very low real yields, but stocks could get hit worse than you’d otherwise expect given their high valuations. The saving grace from inflation-driven losses is that they would primarily come from a fall in valuations, not impairments to future cash flows. As a result, we wouldn’t be all that much poorer if we judge by the amount of future spending a portfolio could sustainably support. But the loss of paper wealth could be massive. This doesn’t mean such an inflation surge is inevitable, or even particularly probable. It is, however, something that investors should have in the forefront of their minds when they think about what could go wrong for their portfolios.

What have we learned about Purgatory and Hell?
I believed that we were going to learn a good deal about the probabilities of Purgatory and Hell because the recovery from the financial crisis seemed to finally be over. The US economy was around full employment, inflation was at the Federal Reserve’s preferred level, and the Fed was preparing to embark on a significant tightening cycle for the first time in over a decade. In the years when the economy was still stumbling through its slow recovery from the crisis, it was hard to really get a good feel for how close the economy was to its potential and how quickly inflation would return once spare capacity had been used up. But with the unemployment rate below 5% and inflation creeping up, it seemed we had worked our way through the lingering effects of the crisis. Exhibit 1 shows the core CPI as of the end of 2016, against an estimate of the Fed’s target level.1

After a long period of lower than target inflation, we seemed to be getting back on track. Similarly, GDP growth seemed to be in line with target levels, although perhaps trending a little soft versus the Fed’s estimate of potential GDP, as we can see in Exhibit 2.

We had been running slightly under the Fed’s 1.8% estimate of potential GDP growth. For a secular stagnationist, this could have been seen as evidence that the economy was beginning to soften again, presaging a dip into recession if the Federal Reserve were to go ahead with its plan to raise rates.