[The Editors' Verdict] When Dormant Inflation Awakens

Kim Kyung-soo, Professor Emeritus at Sungkyunkwan University

Recently, as the recovery of the real economy has been slow and signs have emerged that the COVID-19 pandemic is not being properly controlled, pessimism about the global stock market rally is rising. The global COVID-19 death toll is approaching the level seen in April, when the infection spread peaked. If countries reinstate lockdown measures, economic activity will contract, and the stock market will inevitably face corrections. In addition, there are many other factors that could act as negative influences on the market. These include delays in vaccine development, worsening US-China conflicts, a recurrence of the US presidential election situation from 20 years ago, or the possibility of large-scale corporate bankruptcies...

Even if these risk factors materialize, investors have already experienced that the decisive factor is the response of the US Federal Reserve (Fed), the main actor in the global financial cycle. This is known as the Powell put, where the Fed intervenes with stimulus measures when stock prices fall below a certain level. Just as an investor exercises a put option to control the risk of loss on held assets, the Fed’s rescue measures have continued from the 1987 Black Monday, the Mexican peso crisis, the Asian financial crisis, the Long-Term Capital Management (LTCM) crisis, Y2K, the dot-com bubble, the global financial crisis, and the COVID-19 pandemic crisis. The stock market adage "Don’t fight the Fed" means that investments should be aligned with the Fed’s monetary policy. The strategy is to invest aggressively during rate cuts and conservatively during rate hikes.

However, the Fed is not omnipotent and can be powerless in the face of inflation. Inflation is like a public enemy to investors. Since March, the core monetary indicators M1 and M2 money supply have surged at the speed of light. However, the velocity of money, calculated by dividing nominal GDP by these two monetary indicators, has fallen to the lowest level of the 21st century for two consecutive quarters. Despite the increase in money supply, inflationary pressure has actually eased.

Meanwhile, inflation expectations as predicted by the government bond market have been rising since late April. Typically, expected inflation is inferred by subtracting the yield of Treasury Inflation-Protected Securities (TIPS) from the expected Treasury bond yield. The yield spread between these two bonds with a 5-year maturity rose from around 0.1% in March to over 1.5% by mid-month.

Gold, which is a safe-haven asset but also hedges against inflation risk, is showing a steep price increase trend. The gold price is drawing a rising curve comparable to that of 1980, when inflation peaked, and 2011, during the Southern European debt crisis. If the rising gold price were due to a preference for safe assets, the value of the US dollar should also be rising. However, the dollar exchange rate against major trading partners has shown a clear downward trend since July. The dollar exchange rate against emerging markets, which peaked in April, has stabilized since July. Ultimately, inflation expectations are also emerging in the foreign exchange market.

During the global financial crisis, inflation expectations were widespread but did not materialize. However, experts believe the possibility of inflation is higher now. The COVID-19 pandemic and increased production costs due to the weakening of the global value chain (GVC) are cited as reasons. Unlike more than a decade ago, fiscal dominance caused by central banks absorbing government debt while managing significantly increased fiscal deficits is inevitable. "We are not thinking about raising interest rates. We are not even thinking about thinking about raising interest rates," said Fed Chair Jerome Powell in June. The Fed is expected to maintain zero interest rates until the end of 2022 and has indicated it will tolerate inflation exceeding the 2% target. However, it is uncertain what the Fed can do for investors when long-dormant inflation awakens.

Kyungsoo Kim, Professor Emeritus, Sungkyunkwan University

This content was produced with the assistance of AI translation services.