Inflation, longer term, that once started, accelerates and is difficult to harness is the biggest risk I see. The geometry of the situations is multifold, but with every aspect pointing to higher inflation.
First, you have a fundamental backdrop of growing demand, particularly in emerging market nations, for a finite supply of raw materials. Food, minerals, land, even fresh water. As these populations migrate to cities, urbanize and increase their incomes from current subsistence levels, their demand for commodities personally, and in their industrial efforts will multiply, while supply grows arithmetically by a percent or two, if not shrinks.
Second, you have extremely easy monetary policy, for unprecedented periods. The ease is measured by the real Fed Funds rate. Normally, the Taylor Rule, history and other models of real interest rates, suggest that a “neutral” real Fed Funds rate is +2%. So the Fed Funds rate may be 4%, inflation may be 2% and the difference, the real Fed Funds rate +2% would be considered “neutral.” During periods of overheating, typically a +4% real Fed Funds rate has been required to “put the brakes on” and cool an overheating economy, or accelerating inflation. During periods of weakness, when inflation falls, unemployment rises and real GDP growth hovers around zero or less, a stimulative real Fed Funds rate of 0% is required. Over the past four years the real Fed Funds rate has gravitated down to –2%, and QE (the balance sheet expansion of the Fed, and other central banks) has amplified this by extending the negative real money market rates out the curve into the seven-, 10-, and even 30-year sectors of the bond market.
Third, you have the difficulty in exiting. Fighting accelerating inflation is always hard. You have the normal political pressure (from presidents, senators, representatives and other politicians up for election) to accept the bargain of short-term gain through easy policy, at the expense of much greater long-term pain associated with high inflation. But currently the huge balance sheet, unprecedented not just in size, but [also] in the maturity and low coupon of the fixed-rate securities holds. On a mark-to-market basis, these could wipe out Fed capital with a small rise, 40 basis points or so, of market yields! Though not marking to market is optically preferable, it doesn’t change the reality. In particular, the mark-to-market simply quantifies the ongoing cost of carry securities with low, long-term, fixed coupons. Similarly, whether the Fed exits by selling securities, or instead finances them at somewhat higher short-term rates (needed to offset the inflationary effects of the Fed continuing to hold large quantities of long-dated Treasuries on its balance sheet) the cost is roughly the same. The challenging financial position that the Fed will be put into by these dynamics will erode [its] political independence, at best. As an investor, I think it prudent to register the increased inflation risk associated with this unusual situation, particularly because current policies only increase this dynamic.
Excerpted from "Brynjolfsson: The Armored Wolf in pursuit of alpha"