There are two pieces of good news to celebrate in markets this week. The first is obvious: a fairly effective vaccine for Covid-19 is emerging from Pfizer and BioNTech. Anthony Fauci, the leading US infectious diseases expert, told the Financial Times he expects a second one soon, too.
This has unleashed hopes of an end to the coronavirus lockdowns in 2021. Investors have duly started positioning themselves for economic recovery: the 10-year Treasury yield has edge up towards 1 per cent and the share prices of value stocks have jumped, while those of many tech groups have declined (the latter were considered the primary beneficiaries of lockdowns).
However, the second piece of good news is not so self-evident, and many policymakers would not label it that way at all: there is rising market chatter about the idea that long-dormant inflation risks could return.
This week Goldman Sachs warned clients that a key theme of 2021 will be a sharp steepening of the yield curve, which charts the difference in short-term and long-term interest rates, amid inflation concerns. British asset managers Ruffer and Willis Owen are talking about this too. They cite charts of 20th-century financial history that show how prices usually jump after recessionary shocks, usually because of government reflation measures.
So are some government officials. “I do think investors need to start thinking about inflation again,” Wilbur Ross, US commerce secretary, told me this week. Mr Ross does not expect to see “runaway inflation”, but he does think that a zeitgeist shift around inflation is looming and it could spark market repricing. This could make investors more wary about bonds, particularly given how many of them the government must sell to cope with yawning deficits.
Officials at the Federal Reserve would beg to differ; indeed, many might deride this chatter as dangerous. After all, they say, the data does not show any price pressure now: the core consumer price index in the US fell sharply during the pandemic and is now running at about 1.6 per cent.
The latest US figure might be an understatement. This week economists at the IMF suggested that global inflation has been undercounted by about 0.23 percentage points during the pandemic because statisticians have not updated their consumption metrics to reflect how the lockdown has changed spending patterns.
However, even if “real” US inflation is nearer to 2 per cent, that remains within the Fed’s target range, particularly given that Jay Powell, Fed chair, said in August that 2 per cent is no longer a ceiling, but simply an average target over time.
Moreover, Fed officials do not see higher inflation on the horizon. That is partly because they expect demand to stay weak for some time: as Mr Powell explained last week, they think the spread of Covid-19 will suppress consumer activity for the foreseeable future. His British counterpart, Andrew Bailey, echoes this view.
The other reason that Fed officials think the 20th-century inflation patterns are unlikely to reappear is digitisation. Even before the lockdowns, consumers and corporate executives were becoming more adept at shopping online for services, goods and labour, stoking global competition. The pandemic has significantly intensified this. If digitisation suppresses labour costs in many sectors for the foreseeable future, it will keep inflation low.
They are probably quite right, unless, of course, a new outburst of protectionism causes digital integration to collapse. This does mean that the current inflation chatter might be overstated, but the sheer fact that investors are talking about these risks is actually a good, not bad, thing.
In the past few years markets have become dangerously addicted to a one-way bet. Inflation pressures had seemed so unexpectedly muted before the pandemic that investors started to act as if they would never return. Then Mr Powell promised in September to keep nominal interest rates at rock bottom levels until 2023. Since then, investors have become even more addicted to free money, or, more precisely, real interest rates that were in effect negative.
This has encouraged complacency around long-term risks in bond markets. It has also sparked the creation of some funky financial structures. Special purpose acquisition companies are a case in point: Spacs have boomed this year. Financiers tell me that investors like them because the structure not only offers a possible long-term equity market upside but also a short-term warrant with a yield slightly superior to T-bills.
Many investors know perfectly well that zero-rate bets will suffer if interest rates suddenly rise. But they also know — to paraphrase the banker Chuck Prince right before the financial crisis — that financiers have to keep dancing if the free money music keeps playing.
That’s why this week’s inflation chatter is good news. It seems unlikely that rapid price growth will in itself pose a risk to the real economy any time soon. What could pose a risk is if the market remains blindly addicted to free money and then experiences a shock when conditions change.
If investors start shifting their portfolios now to embrace a less unbalanced vision of the future, this will help reduce that danger. Fed officials would be foolish to prevent this; whatever happens with a Covid-19 vaccine.