Most investors came of age during a persistently disinflationary environment. Given the disinflationary demand

shock caused by the coronavirus pandemic, that backdrop is likely to endure for the next several years. However,

the combination of massive unconventional monetary policy and the increasing willingness of policymakers to

take advantage of historically low interest rates and embrace the aggressive use of fiscal policy could eventually

set the stage for a medium-term shift in the inflation backdrop.

How do the GFC and COVID crises differ?Despite an enormous monetary policy response to the global financial crisis (GFC), inflation remained historically

very low. Why? In my view, there are two primary reasons: low money velocity and heavy deleveraging by banks,

households and, eventually, governments. But that was then and this is now. The conditions surrounding the GFC

are quite different from those we face today.

Exhibit 1: Fed shifts focus

Monetary policy stimulus today is much bigger, deeper and broader than during GFC

Monetary policy is more focused on Main Street and less on Wall Street

No bank delevering (for now)

= GFC

= 2020

$$

$

$$

In reaction to the GFC, the US Federal Reserve and other global central banks printed oodles of money in order

to thaw frozen credit markets and revive economic growth. But much of that money did not get into the system

and the velocity of money — the frequency with which money changes hands in a given period — fell sharply.

The reasons for this were the deleveraging and risk aversion. As the crisis unfolded, banks shed bad assets,

homeowners defaulted on mortgages and governments adopted fiscal austerity too soon, all while the economy

was struggling. Households, banks and corporations, scarred by the crisis, were eager to hold cash, thus the

money that did make it into the system sat idle, changing hands infrequently and thus restraining inflation. So

what we learned from the prior crisis is that the supply of money alone won't kindle inflation and that demand

plays a very important role.

The Case for (Eventual) InflationInvestment Insights

August 2020

Author

Erik Weisman, Ph.D.Portfolio Manager and Chief Economist

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Investment Insights The Case for (Eventual) Inflation

Why this time might be different1. The policy response has been immense and swift: The scope of the global policy response to the

pandemic, both monetary and fiscal, far eclipses earlier episodes. Additionally, today's aid is more focused

on getting the money into the broader system, concentrating on Main Street more than Wall Street and on

households and businesses rather than financial institutions. Moreover, while the pandemic is far from over,

the banking system has thus far not been forced to delever, unlike during the GFC.

2. Policymakers are unlikely to commit the same mistake again: The question will be whether fiscal

policymakers repeat the error they made following the GFC, when they adopted austerity early in the

expansion, beginning around 2011. Today, that premature belt-tightening is viewed as a mistake, especially

in Europe, where a sovereign debt crisis subsequently engulfed the eurozone. Perhaps deteriorating debt

profiles will force aggressive fiscal austerity again, but with yields pegged at (or below) zero, there should be

additional scope to forestall fiscal normalization.

3. Politicians may be thinking the unthinkable: Though there is a reluctance on the part of many

officeholders to embrace Modern Monetary Theory (MMT) by name, some are increasingly comfortable

adopting parts of it in practice. MMT asserts that a country can issue huge amounts of sovereign debt with

little or no negative ramifications if it 1) can issue debt in its own currency, 2) has a very large negative output

gap (that is to say that its economy is running at well below potential) and 3) can finance deficits at close to

zero cost. While such an idea was until recently unthinkable, one consequence of the pandemic has been an

opening of the Overton Window, which describes the range of policy ideas the public, and policymakers, are

willing to entertain. The scope of the economic damage wrought by the pandemic appears to have forced the

window wide open.

4. It looks like we're monetizing the debt: A further factor that seems different this time is the extent of the

Federal Reserve's monetization of US Treasury debt. While there are important semantic disagreements over

what constitutes monetization, the combination of accelerating sovereign debt issuance with heightened

central bank buying of that debt raises a red flag. But not all prior episodes of heavy Fed government debt

purchases have resulted in inflation. Fed buying of Treasuries during the two world wars coincided with

inflation, while the GFC episode did not. Here's why: During the world wars, there were positive output

gaps (the economy was operating above full capacity) and the money being printed was making its way into

the broader economy, which was the exact opposite of what happened during the GFC. The adoption of

something resembling MMT on a sustained basis, coupled with debt monetization and a closed output gap,

could upend the disinflationary dynamics of recent decades.

5. Inflation expectations could become unmoored: Inflationary expectations have been well anchored

in recent decades, but that has not always been the case. Expectations plummeted during the Great

Depression, and they vaulted higher in the 1970s. A change in psychology in response to new policies along

the lines of MMT and debt monetization can't be ruled out. Alternatively, if we repeat the post-GFC mistake of

imposing fiscal austerity too soon, we could potentially see inflation become unanchored to the downside. In

either case, the Fed will need to be careful not to lose credibility.

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Investment Insights The Case for (Eventual) Inflation

6. Governments would welcome some inflation: How have countries historically reduced unsustainable

debt burdens? The surest way is through default, but that's clearly not an option for the US or other highly-

rated developed countries. The preferred method is to grow your way out, with GDP rising faster than debt,

reducing debt as a percentage of GDP. Against a low-growth background and deteriorating demographics,

the prospects of growing our way out of debt are poor. Another way to try to address an unsustainable debt

profile is via austerity, but as we've laid out above, that can be self-defeating. Countries can also attempt to

depreciate their currency as a way out of debt, but if all trading partners did so at the same time, this would

serve no purpose, as every currency can't fall at once. Financial repression, which is "artificially" holding

sovereign rates lower than nominal GDP growth, is another method, and one authorities have been trying for

years with only limited success. All this having been said, the one method that we truly haven't tried is inflating

our way out. Yes, central banks printed a lot of money during the last crisis, but deleveraging undermined the

path toward higher inflation. However, if policymakers open the Overton Window wide enough and add MMT

and debt monetization to their toolkits that combination might sustainably lift inflation rates to levels we've not

seen in more than a generation and enough to lighten the country's debt load over the coming years.

A done deal?Can we guarantee that dominoes like MMT, debt monetization, a closed output gap, increasing money velocity

and rising inflation expectations will all fall, resulting in a significant upward inflation path? We can't. And the

baseline remains that inflation will be stuck in a low range for some time. But the addition of long-lasting MMT

would markedly raise the likelihood of higher inflation several years in the future. Indeed, some of these dominoes

likely will fall. Whether enough of them topple to generate real inflationary pressures remains to be seen, but we

should probably assign a markedly higher probability to that outcome than the market appears to be pricing in.

Which assets should benefit?With growth likely to be challenged in the quarters ahead, along with a very large output gap and oil down by

about a third since the start of the year, inflation is unlikely to be a problem for quite a while. Nonetheless, the

prospects are greater that somewhere down the road, prices could run noticeably higher this upcoming cycle

than what we witnessed during the past several expansions. This is not to say that we are expecting anything close

to hyperinflation, or even inflation markedly higher than 3% or 4%, but rather that the trend toward ever-lower

inflation will reverse.

Exhibit 2: Asset classes that have generally benefited from (or helped offset) higher inflation.

TIPS - inflation protected securities

Limited maturity bonds

Floating rate securities

Value equities

Commodities

Real hard assets

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Investment Insights The Case for (Eventual) Inflation

Asset classes that could potentially benefit from, or helped offset, a moderately rising inflationary environment

include value equities, Treasury Inflation Protected Securities (TIPS), limited maturity bonds, floating rates

securities, commodities and hard assets such as real estate and gold. A rising inflationary environment could

potentially disadvantage assets such as longer duration bonds, growth equities and bond proxies such as REITs,

utilities and infrastructure.

On a closing note, if policy makers are successful in generating higher inflation, this could present a new set of

risks. Central banks and fiscal balance sheets are currently socializing profit loss and solvency risk to sustain

employment and household income in the hopes of protecting against the downside to growth and inflation. And

full-fledged MMT would take this socialization to a new level. But capital markets offer two primary functions in

society: capital allocation and price discovery. "Forcing" inflation higher would distort these functions, where the

public policy cure could be worse than the disease. Investors should be prepared for more distorted markets, with

or without inflation.

MFSE-CASE-NL-8/2046618.1

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