HedgeTalk: Will COVID-19 Federal Stimulus Bring Inflation?

By: John Trefethen, Director & Co-Founder

While inflation isn’t, nor should it be, the current focus of the Federal Reserve (“Fed”) – at some point the US economy will feel an inflationary tailwind from the multi-trillion dollars of stimulus that the Federal Reserve System has poured into the US economy. This is the most ambitious effort in history to stimulate the economy, or at least to prevent it from collapsing. Its eventual impact seems almost certain. Before the coronavirus shock, inflation in the US appeared tame by standard measures. But the macroeconomic framework has been altered in recent weeks to combat the fallout from shuttering the economy to combat Covid-19. Many economists have projected that the central bank’s portfolio of bonds, loans and new programs will grow to between $8 trillion and $11 trillion, which would be over twice the value reached after the 2008-09 financial crisis, and half of today’s value of total US annual economic output. Following the 2008-09 financial crisis the Fed’s balance sheet swelled to $4 trillion. Many thought hyperinflation would follow, but that never materialized. Instead, we saw annual inflation that fluctuated from 1% - 3% for the following 10 years. However, prior to coronavirus becoming a full-blown global crisis, there was already a modest upward bias with the inflation rate growing from 1.9% to 2.3% between 2018 and 2019. There should be concern that the rising federal debt needed to support the current amount of stimulus programs will drive inflation higher. At some point, if central banks create too much money, they will produce an increase in inflation – too many dollars chasing too few goods. One “natural hedge” in the economy that could hold inflation down is a high unemployment rate. The amount of unemployment necessary to offset inflation is not known – it would demand historically high levels. This is an outcome that can create a host of other undesirable consequences including less tax revenue. Less tax revenue can lead to higher government borrowing, canceled or scaled-back programs, and deferred infrastructure projects. Absent a soaring unemployment rate, the only way for Fed intervention to restrain inflation is to increase interest rates. For now, the Fed's focus will be to continue doing what is necessary to keep the economy afloat. But when this passes (and it will…), we will be left with trillions in pledged government spending and federal debt that will be more than twice what it was before the 2008-09 financial crisis (80% of GDP today compared to 35% just prior to the financial crisis at the end of 2007) and larger than at any time in US history other than immediately after World War II. We will almost certainly eclipse that record before this is finished. The likely result is inflation and higher interest rates. For businesses that are most directly impacted by inflation, now is the time for them to use tools to manage this risk. Some of the most effective tools are financial instruments that can be used for risk management. Having them in place now, and ready to deploy when the timing is right, will be prudent preparation for the uncertain times going forward.