Why Bond Investors (and Wise Men) Got Inflation Wrong
Among certified wise men like former Treasury Secretary Larry Summers, superstar investor Stanley Druckenmiller, money manager and onetime presidential adviser Steven Rattner, former Bank of England Governor Mervyn King and Olivier Blanchard, former chief economist at the International Monetary Fund, a consensus is forming behind Summers’s warning that “macroeconomic stimulus on a scale closer to World War II levels than normal recession levels will set off inflationary pressures of a kind we have not seen in a generation, with consequences for the value of the dollar and financial stability.”
As persuasive as wise men can sometimes be — inflation fears have driven up yields on benchmark Treasury bonds as much as 0.72 percentage points since December, or the most since February 2020 — Federal Reserve Chair Jerome Powell and Treasury Secretary Janet Yellen say the recovery from the deepest downturn on record depends a lot less on restraining any sudden rise in the cost of living than on returning the economy to full employment. With the infamous exception of the 1970s, history is on their side; inflation averaged 2% during the 1960s and today is barely a shadow of its most robust self during the past six decades, when barriers to full employment became formidable if not impregnable. Inflation worries that have flared among bond investors from time to time during those years have consistently turned out to be unfounded.
The Fed's preferred measure of inflation, the Personal Consumption Expenditure Core Price Index, is hovering at 1.5%, or about 1.7 percentage points lower than the 60-year-average and 0.2 percentage point less than 20-year average, according to data compiled by Bloomberg. Even when the yield on 10-year Treasuries — a reflection of long-term inflation expectations that declined irregularly over the past four decades — tripled to 1.63% from 0.51% last year, it is dwarfed by the 3% it fetched in 2018 and 6% of 20 years ago.
To be sure, the real, or inflation-adjusted interest rate dipped below zero during the last six months of 2019 and remains negative since then, a historically unsustainable market paradox of growing concern to economists. Nevertheless, the demand for Treasuries continues unabated and the absence of inflation pressures in developed economies — especially Japan, the U.K. and euro zone countries such as Germany, France and the Netherlands with bond yields below zero since 2014 — is primarily responsible for such prevalent negative interest rates.
Whether or not real bond yields become more negative as inflation accelerates in the months ahead, Powell and Yellen are more concerned about the labor participation rate, which plummeted 3.1 percentage points during the Covid-19 pandemic to 60.2%, the lowest level since 1973. Labor participation climbed from 58% in 1965 to its peak of 67% in 2000. During the same period, inflation accelerated from 1% to highs of 10% in 1974 and 9% in 1980 before falling below 5% in 1984 and declining persistently since then. Union labor, often cited as a catalyst for inflation, today is 10.5% of total employment, or down almost 50% from 20.1% in 1983.
Runaway inflation was the exception during the past 50 years in part because labor costs were diminishing in the globalized economy and the Fed repeatedly raised its target rate for overnight bank reserves when it detected signs of an overheated economy, paving the way for ensuing recessions. But investor anxiety over inflation, measured by bond trader bets on average annual inflation over 10 years, has proved to be exaggerated in every instance since interest rates peaked in 1981.
Even though inflation was hovering at 4% by 1990 and trending lower, the Fed raised interest rates seven times between 1994 and 1995 to 6% from 3% — a tightening of credit even central bankers belatedly acknowledged was painfully unnecessary. Inflation was 1% by 1998.
The last time investors showed as much apprehension over resurgent inflation as they are expressing today was the end of 2012 and the first few months of 2013. Then, as now, bond prices tumbled and yields rocketed, according to data compiled by Bloomberg.
But inflation already was on the wane, declining from 1.9% to 1.2% at the end of 2015. Labor participation, meanwhile, remains anemic. That's why the American Rescue Plan is needed.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Matthew A. Winkler is Co-founder of Bloomberg News (1990) and Editor-in-Chief Emeritus; Bloomberg Opinion Columnist since 2015; Co-founder of Bloomberg Business Journalism Diversity Program in 2017. During his 25 years as Editor-in-Chief, Bloomberg News was a three-time finalist and winner of the Pulitzer Prize for Explanatory Reporting and received numerous George Polk, Gerald Loeb, Overseas Press Club and Society of Professional Journalists and Editors (Sabew) awards.
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