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Inflation Never Materialized After the Last Crisis. JPMorgan Thinks This Time Is Different.

As the U.S. budget deficit swells, the firm warns investors to brace for inflation.

JPMorgan Chase & Co. is warning investors that an inflation bomb may go off in the aftermath of the coronavirus recession — even though it failed to ignite in the record-long expansion following the 2008 financial crisis.

“Investors would still be well advised to structure their portfolios with an eye to the possibility that it could,” David Kelly, chief global strategist of JPMorgan’s asset management unit, wrote in a Monday note. He recommended real assets such as real estate and precious metals, saying they “can serve an important, although long-redundant role, in protecting a portfolio against the risk of inflation.” 

High inflation may emerge this time around for a range of reasons, including a faster recovery once a vaccination is widely available, potentially looser regulations surrounding bank lending, and a lack of fiscal restraint among Democrats and Republicans, Kelly said. “Both the Federal Reserve and the federal government will likely be in a more expansionary mode.” 

As the U.S. provides workers and businesses with aid through the crisis, budget deficits could swell to an “astonishing” $3.8 trillion this fiscal year, according to his note. By the end of fiscal 2021, Kelly warned that debt levels may rise to 109 percent of gross domestic product — surpassing the record 108 percent of GDP in 1946 when the U.S. added the “extraordinary costs” of fighting World War II.

“Borrowing at this pace, particularly when other governments around the world are also running fast-rising deficits, might be expected to result in higher interest rates, even in a deep recession,” Kelly said in the note.

The U.S. government has enacted four pieces of legislation aimed at helping workers and businesses through the coronavirus pandemic. The Congressional Budget Office estimated they will add $2.7 trillion to federal debt over the next 18 months, according to his note. More aid likely will follow should large parts of the economy remain shut past the summer, Kelly said. 

Meanwhile, the Fed has been “extremely aggressive,” he said, introducing monetary stimulus that is unprecedented in scope and magnitude. Since the end of February, the Fed’s holdings of U.S. Treasuries have risen by $1.4 trillion, while its overall assets — including additional mortgage securities, foreign central bank liquidity swaps, and holdings in new and expanded credit facilities — have risen by $2.4 trillion, according to his note. 

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Many investors had feared inflation and high interest rates and would arise in the long, slow recovery from the great financial crisis. They did not. 

“These concerns were based on the simple monetarist argument that a big increase in bank reserves should lead to a big increase in the money supply and thereafter, a big increase in inflation,” said Kelly. “In retrospect, this turned out to be wrong partly because, for regulatory and other reasons, bank lending and the money supply never increased nearly at the pace of bank reserves.”

In the wake of the pandemic, the Fed may take on a more “indulgent regulatory stance” that encourages bank lending, he said. The current crisis, unlike the one in 2008, wasn’t prompted by a financial bubble. Kelly added that cautious lending to riskier borrowers in the last recovery, along with steadily rising income inequality, had kept a “brake on the demand for goods and services” in the bull market.

“This lack of demand was amplified by fiscal austerity as the budget deficit, as a share of GDP, fell every year from 2010 to 2015,” according to his note. Fiscal austerity under then-President Barack Obama was influenced by fiscally conservative Republicans in Congress at the time, Kelly said. “The record of the last three years suggests that there are no fiscal conservatives left on either side of the aisle.” 

Depending in part on the results of the U.S. presidential elections in November, income inequality may be addressed through minimum wage increases, universal health care, and a more progressive tax system, according to Kelly. “Regardless of the social merits of such ideas, a redistribution of income from upper-income households, who tend to save more of their income, to lower and middle-income households, who have a higher propensity to spend, could also prove inflationary,” he said. 

Meanwhile, the U.S. economy is poised for “a much more rapid rebound” after the pandemic compared to the recovery from the financial crisis, according to Kelly.

“Once a vaccine is widely distributed, pent up demand among the American public for a very wide range of services and goods should be unleashed,” he said. “And, while supply should be ramped up quickly also, the very pace of growth could prove inflationary.”

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