We know that growth and inflation, that is the good kind, are supposed to be closely linked. If economic growth is robust and broad based, it becomes possible for prices to rise in a good way. “Good” here means that prices are rising because incomes are growing, and the labor market is strong, with the labor force participation rate steadily increasing as the unemployment rate remains low.

This situation is one where prices rise because people can afford to spend more (economists call this higher aggregate demand) – the proverbial rising tide that lifts all boats. Price increases under such circumstances don’t outrun growth rates, simply because inflation is, in this situation, caused by economic growth. Should economic growth falter, then inflation will also fall.

What happens when economic growth is not as strong and the labor market is not robust? Quite simply, growth rates will be low, and inflation will also be low as aggregate demand languishes. All of which is still simple and easy to understand because of the linear cause and effect relationship between the variables.

But, inflation is a many headed beast and has causes and influencing factors outside of economic growth. Supply shocks that reduce productive capacity and disruptions in supply chains are two common examples. They also happen to be what producers all around the world have struggled with over the past year, and are still struggling with today.

Of course, Covid induced lockdowns and its ripple effects are the causes of such difficulties, and higher prices the result, creating a situation where economic growth and the labor market are still recovering, even as prices shoot higher. Low growth, and expectations for continued low growth, give us low nominal yields, while supply pressures together with a still recovering (and reopening) economy give us higher inflation. In other words, negative real yields.

This fits with how real yields are more negative in the 5 year tenor than the 10 year one, since higher aggregate demand is what drives expected long term inflation, not supply pressures. As such, 5 year real yields being more negative than 10 year ones speak to expectations of inflation that are not the “good” kind, and will negatively affect economic growth in the near future.   

Consequently, it is quite possible that negative real yields do not reflect expectations of stimulus induced hyper-growth and the resultant out-of-control inflation that so many are warning of. On the contrary, they could be signaling the opposite, that we are headed for a period of time where prices are higher and economic growth lower.

Stagflation, in other words; which really isn’t a rosy projection at all.