Since 1996, the Federal Reserve has maintained an implied 2% target for annual inflation. However, Federal Reserve Chairman Jerome Powell declared in August 2020 that they will allow inflation to exceed 2% for any given year, provided that it averages out to 2% in the long run. Simultaneously, the Federal Reserve has greatly expanded the money supply, mainly by purchasing trillions of dollars of assets.
According to the March 5, 2021 edition of Grant’s Interest Rate Observer, the M-1 money stock—which consists of currency, checking accounts, travelers’ checks, and the like—grew by 351.3% over the past year. The growth of the M-2 money stock, a more exhaustive metric that includes savings accounts, was 25.8%.
While the surge in the money supply may portend inflation, diminished money velocity is acting as a temporary buffer. In essence, money velocity indicates how many times each dollar circulates in a year, such that a higher money velocity indicates more transactions and a greater potential for inflation. M-1 money velocity declined by 77.8% between 2019 and 2020 and M-2 money velocity by 20.5%, apparently diminishing the inflationary effect of the increases in the money supply. However, increased money velocity in 2021 could complicate the Federal Reserve’s attempts to maintain its inflation target.
Some in the market recognize the surging money supply as well as the Federal Reserve’s ambivalence regarding inflation, as indicated by rising yields for 10-year Treasury bonds.
Consider that the yield on 10-year Treasurys represents the federal government’s cost of borrowing over a 10-year period. The higher the yield, the higher the rate of interest the federal government has to pay to bondholders and the less its bonds are worth on the market. Consider also that the law of supply and demand applies to the determination of yields. When market demand for government bonds is higher, yields are lower; when demand is lower, yields are higher.
The Wall Street Journal reports that as of Wednesday’s close, the yield on a 10-year Treasury bond was 1.486%. Yields are lower than they were as recently as February 12, 2020—when the economy was on solid footing—but they have increased significantly since July 31, 2020, when the yield on 10-year Treasurys was 0.508%.
Surging yields are a reflection of declining market demand for Treasurys. The Journal reports, “The seven-year note was sold at a 1.195% yield, or 0.043 percentage point higher than traders had expected—a record gap for a seven-year note auction, according to Jefferies LLC analysts. Primary dealers, large financial firms that can trade directly with the Fed and are required to bid at auctions, were left with about 40% of the new notes, about twice the recent average.”
One explanation for declining demand for Treasurys is the potential for significant economic growth in 2021. Such expectations direct market participants toward investments more reactive to a booming economy than government bonds—e.g., the stock market—and raise the possibility that the Federal Reserve will increase the federal funds rate, which is currently effectively zero. A rate hike would elevate Treasury bond yields and lead to a loss for bondholders who bought in at a lower yield.
Another rationale for rising yields is the potential for inflation, which diminishes the value of bonds by reducing the purchasing power of the money paid out upon redemption. Purchasers of Treasury bonds who believe that they will receive less valuable dollars in 10 years will buy them only with compensation for inflation, i.e., a greater nominal rate of return. Additionally, inflation—like economic growth—could lead the Federal Reserve to increase interest rates, diminishing the value of Treasurys purchased at lower yields.
Investors’ sentiments regarding long-term inflation are reflected by the surging breakeven rate, which is the difference of the yields on the 10-year Treasury bond and inflation-protected 10-year Treasury bonds. As of Wednesday’s close, the breakeven rate was 2.21%, its highest point since the week of August 25, 2014. This differential suggests that investors anticipate inflation in excess of 2% per annum, as the Federal Reserve Bank of St. Louis notes that the breakeven rate “implies what market participants expect inflation to be in the next 10 years, on average.”
However, it remains to be seen whether inflation will actually take root. The Journal’s editorial board suggests that it already has, noting surging commodity prices and the uptick in producer prices, which increased by 1.3% in the month of January—the largest one-month jump since reporting began in 2009. Others, namely the Federal Reserve, are neither convinced nor concerned.