“We think that the U.S. economic slowdown underway will put downward pressure on inflation for the next four to six quarters. Inflation is a lagging indicator of economic growth, and it will likely reach the point this year where it ceases to be a major concern for Federal Reserve policy makers, who will then shift their focus to easing monetary policy to address a soft economy.”
So wrote John Brynjolfsson, managing director and portfolio manager at the giant bond shop PIMCO in his February commentary. The bond market this month seems to agree with Brynjolfsson’s bullish scenario for fixed income. The return of buying the 10-year Treasury Note pushed the yield to under 4.80% by last week’s close, down from around 4.90% in late January. The buying may or may not have legs, but for the moment, a cautious optimism has the floor.
Nonetheless, this is no time to take a nap or mindlessly commit gads of long-term money to bonds. Consider that while Brynjolfsson sees 2007 as a generally positive year for bonds, the longer-term outlook isn’t quite so rosy. “Beyond the five-year horizon,” he wrote, “we are very concerned about inflation, largely based on the growing mountain of obligations, liabilities and unfunded promises being heaped upon the government and corporations by demographic shifts.”
In other words, to pay for the government’s growing pile of unfunded obligations, such as Medicare, Medicaid, Social Security, and so on, the likely course will be printing more money. Firing up the printing presses has historically had a strong appeal for a politically driven town like Washington. After all, printing money to fill a financial gap isn’t immediately obvious nor especially painful early on–attributes that have massive appeal for pols trying to extract themselves from tight political corners.
But if there’s no blatant price to pay in the short term for dispensing freshly minted dollars to pay for increasing demand on government services, the strategy reveals itself in time. Inflation, in short, rises when governments print more money than economic growth requires.
Of course, expecting higher inflation based on this scenario requires buying into the party line of monetarism, to which your editor subscribes. As it happens, so does PIMCO’s leadership. Again quoting Brynjolfsson, “There is a broad array of economic thinking going on at PIMCO—Keynesian, Monetarist, Neoclassical to name a few. But nearly all of us concur with the late great Milton Friedman, who argued that ‘inflation is always and everywhere a monetary phenomenon.'”
By our reckoning, the bond market isn’t pricing in the longer-term threat of inflation that Brynjolfsson speaks of. Maybe that’s because long yields are lower because of an excess of foreign purchases of Treasuries. Or maybe investors overall are overly focused on tomorrow vs. 10 years hence. Nonetheless, the inflation risks spawned by government spending are quite real, and strategic investors should pay heed. For supporting evidence, start by looking at the following chart, courtesy of the Congressional Budget Office: