Are Central Banks Too Late to Tackle Inflation?

Transcript:

Stephen Dover: So, let's jump right into this, Sonal, some consider the recent [US Federal Reserve] Fed comments hawkish. You said that's wishful thinking. Tell us about this unpleasant inflation arithmetic.

Sonal Desai: I have argued that the Fed has been behind the curve now for a while, and the greater behind the curve a central bank gets the harder it is to bring inflation down. At the end of the last Fed meeting, Jerome Powell's comments were taken by some to be hawkish, where he essentially validated market pricing of seven 25 basis-point rate hikes over the course of the year. At the time, I thought that wasn't enough. And I think that today, and since then, in fact, Fed rhetoric has become a bit more hawkish, and we are now talking about potentially a few 50 basis-point rate hikes. I think, at a bare minimum that's going to be needed.

To take it a bit further, when I think about unpleasant inflation arithmetic, it's a very simple calculation I do. I look at the amount of inflation we already have, and I look at what's baked into assumptions about year-end inflation. And at the start of the year, essentially, you would've needed deflation close to the end of the year to achieve consensus expectations around 3%, 3.5%. Today, I'd say where we are right now, if we had 0.4% inflation for the rest of the year, you would still be at an inflation rate, which was quite high at the end of the year, certainly higher than what the Fed is anticipating. Over the last 12 months, inflation has averaged 0.6% month on month. If we were to see inflation at around those levels or a little bit less than that, what you would end the year with would be inflation of around 7.5%. So substantially negative real rates, which makes bringing inflation down much harder.

Stephen Dover: So, John, let's turn to you and your thoughts on that, do you think the markets are underestimating the magnitude of the monetary policy tightening that's ahead?

John Bellows: You know, actually, if I could, I'd just like to start with a compliment for Sonal. She was warning about the risks of sticky inflation and more Fed and, you know, clearly over the last two months, we've gotten exactly that. So, compliment to Sonal for that call. You know, in contrast, we started the year looking for a moderation in 2022, we thought the growth was going to moderate after an exceptional year last year. And we thought a lot of the inflation that we got had kind of pandemic-related forces behind it, and as the pandemic receded some of those forces would normalize and so would inflation. You know, two months into the year, as I said, that has not transpired. Growth's been, kind of, okay and inflation's been sticky on the upside.

That said, our view is the outlook for moderation remains fairly compelling. When you think about what's happened over the first two months of the year, nothing's really changed the kind of underlying observation the pandemic is now behind us or is moving further and farther behind us. So, too, is the fiscal support that came with it. So, too, is the reopening. And so, too, are all the supply constraints that were related there. So, I think the moderation due to the pandemic receding remains a very important part of the outlook. And I would add, the one other thing that's happened in the first two months of the year is we now have substantially higher oil prices, $40 a barrel higher on WTI [West Texas Intermediate crude oil], that could point to higher inflation, especially in energy and food in the near term, but it also is a growth risk. You know, it's a growth risk because it erodes real disposable income, and we were already looking for moderation in growth. And I think this adds some downside risks to that view. So again, we haven't got the moderation in the first two months of the year. I think it's still a compelling kind of base case for where we go from here. And if anything, what we've seen a adds to the growth risks, not detracts from it.

Stephen Dover: So, John, maybe if you could just develop that a little further and talk about supply chains and wages and housing and those components of inflation.

John Bellows: Yes. So let me take each one of those in turn and, as I do so, the broad theme is that each one of these has a pandemic-related factor in it and that's going to recede. So let me start with supply chains, we all know the stories here, auto production and microchips and what that meant is that auto prices were going up last year, big contributor to CPI [consumer price index], but it looks like we may have turned the corner there. Auto inventories are going back up, used car prices are coming back down. It's not happening in any one month, but it is happening. And so, I think that's kind of the straightforward one. Turning to the other two, labor markets and housing, I think have a similar flavor. So, let's do labor markets.

One fact about the US economy over the last year is the labor market has been very tight—high wage gains, job openings are very high, quit rates are high. We all know the statistics. I think there are tentative signs that the peak tightness may be behind us. Quit rates have actually come down a little bit. Job openings have come down. Labor force participation rates are actually going up. That's a sign of supply returning and last month—it's only one month—but last month, average hourly earnings was flat month over month. That's a big change from where we've been. And even if you look over the last six months, you do see a declining trend in average hourly earnings. So again, the idea is that last year labor market was very tight. As we go forward, that's unlikely to persist.

Finally on housing—housing, too, I think had a lot of kind of pandemic-specific factors. We went through this period last year where everybody wanted more space, maybe they wanted to move. They were moving to a different place because of cause of remote working, whatever the case would be, that coincided with those fiscal checks, a lot of demand for housing and simply not enough supply. What we've seen since, house prices month over month moderate, supply is actually now expected to increase. If you look at single-family [home] supply up something like 50% in terms of the amount of construction relative where we were in February of 2020, similar numbers on multifamily. And now we have higher mortgage rates—higher mortgage rates are certainly going to mean slower house-price appreciation. So, that too does seem like a pandemic-specific thing, very significant to be sure, very large house gains last year, unlikely be repeated again this year. So again, as you kind of think through the inflation outlook, our view is that a lot of what happened in 2021 was unique to 2021, and unlikely be repeated in 2022.

Stephen Dover: So, Sonal, where I get a little bit of confusion is this debate if you will, between these constraints that happened because of the pandemic, because we have limited supplies or supply chain issues or whatever and issues that are around, that we just have too much money going around with fiscal spending and monetary policy. And, can you just help kind of straighten us out on that and how you are thinking about inflation, what's the cause of it? And I suppose the ultimate question is would raising interest rates actually therefore stop inflation if the issue is pandemic-related?

Sonal Desai: So, I think the answer to your question, “is it this, or is it that?” The answer, it's actually both. So, if we are seeing inflation today, certainly supply chains have had an impact, certainly oil prices, energy prices, wheat prices, all of this, as a result of what's currently occurring this year, that is having an impact. But underlying it, there was a foundation which came from monetary and fiscal policy, which was entirely appropriate during 2020, I have only taken issue with how long it continued into 2021. And I think that's where maybe a bit of divergence would come in. I think it lasted too long and thus laid the seeds to what could be eventually a wage price spiral. Totally agree with John, we’re not there yet. We don't yet have a wage price spiral, not at all. But as these workers come back, as they see prices, which indeed are from supply shocks at this point, rising at the gas pump, are we going to see workers demanding higher wages? And are companies going to be in a position to offer them? So that is one reason that I continue to some concerns about legs that inflation could in fact have.

And that, of course, takes you to the last piece of your question, which was: can monetary policy, in fact, address supply shocks? It can't, unless the supply shocks have significant second-round effects. Because while monetary policy in and of itself cannot impact those, the extent to which you've got inflationary buildup, and you have this famous second-round effects of that original supply shock, you will find that inflation lasts longer. And unfortunately, it does require a slowdown. So, the soft landing which everyone talks about might be harder to engineer in the current environment than it might have been in 2021. Let's put it that way.

Stephen Dover: So, Sonal, you're saying inflation's going to be higher than the market expects. Therefore, interest rates are going to be higher than the market expects. Therefore, the likelihood of a slowdown is higher perhaps than the market expects. Is that accurate?

Sonal Desai: So, I'd say inflation, yes, higher than the market expects. On interest rates, to be clear, I'm talking about fed funds. I think the Fed itself is likely in June to guide us toward a higher end point, because currently I think the terminal fed funds rate, which is around 2.75%, let's say somewhere between 2.75%, maybe a bit higher. I think that's very unrealistic because you will barely turn positive in real rate terms. So, inflation-adjusted interest rates will barely be positive. So, I think that fed funds will be higher. And the third point, which is on GDP [gross domestic product] growth, the market, depending on what you're looking at—and I'd be really interested in to know what John's thinking about this—for the market, a lot of observers say that the inverted [US Treasury] yield curve, which we are currently seeing, is an indication that the market is expecting a recession. I actually don't agree with that. I think the inverted yield curve is being driven in large part by the combination of the Fed distorting the long end of the market because it's bought so much of it up. The fact that there's everything from technical reasons like pension funds rebalancing, you have other central banks, which are nowhere near as hawkish right now as the Fed, a variety of causes for the long end of the yield curve to be sloping downwards. I'm not yet convinced that we're going to see a near-term recession caused by the yield curve, certainly, or that the market is anticipating a recession, because consumers actually remain relatively healthy. Next year, I think we can have a different conversation, but this year, it isn't my base case for a recession.

John Bellows: So, I think you're onto the important point, which is the interaction between monetary policy and growth. Most standard economic models suggest that monetary policy works through growth. You raise interest rates, that reduces the amount of economic activity by disincentivizing borrowing, maybe it reduces home prices because you have to pay a higher mortgage rate and then that reduces growth. And by reducing growth, you take some demand out and then that lowers inflation. That is the traditional way that monetary policy affects the outcome, which is inflation. You know, there are other stories out there which monetary policy may affect expectations or money supply growth.

And maybe that can have  a channel that impacts inflation independent of the growth channel. But I think those are kind of second order. I think the main channel to which monetary policy works is by working on growth. And so, really the question is how much is growth going to slow? And does it need much tighter monetary policy in order to slow further? And so, you can see where then we come back to our outlook, which is we think growth is going slow on its own. The income is a lot lower this year than it was last year on a nominal basis because we don't have the [federal stimulus] checks. It's even lower on a real basis. On a real basis, not only do you not have the checks that we got last year, but now you have inflation eroding some of the buying power and therefore meaning that real disposable income is even lower. Traditionally, lower real disposable income is not a recipe for good growth. It's a recipe for slowing growth, for a weaker consumer, for businesses that are a little bit more hesitant. And so, we would kind of point to that as a reason to think growth is going to moderate. Now, if that's right, then monetary policy may not need to do all that much in order to get growth to moderate. It's going to moderate on its own.

Now, if monetary policy is needed to moderate growth, then I think the yield curve signal is pretty straightforward, which is the Fed does more in the near term, and it lowers growth in the future as a consequence. So, that's the way I would think about it. I would focus on the growth channel. That's kind of the one tried-and-true, tested way to impact the inflation outcome. And I think to the extent you're seeing a flattening or even inverted yield curve, the signal is pretty clear, which is the Fed's doing more now and that's coming at the expense of future growth, by design, but it is lowering future growth expectations. I'm not willing to say that means we're necessarily heading to a recession imminently, but it's pretty straightforward. More monetary policy means weaker growth, again, by design.

Sonal Desai: So, I take John's point. It's very well made, but much the way that real income is important, real interest rates are important. And real interest rates are massively negative. So, in fact, monetary policy is going to be far from restrictive if we end the year at say 2% and we still have inflation running anywhere from 5% to 6%. So, in a sense, monetary policy is actually still rather accommodative. That point, together with the fact that consumers have started actually dipping into that, you know, that buildup of savings, which currently we estimated around $2 trillion. These are the savings which came over the COVID period. Those are the two factors which lead me to believe that absolutely, we're going to see a slowdown which will work through the channels that John elucidated, right? Everything from higher mortgage rates, etc., lower housing affordability, all that is, I think, absolutely correct. But I think timing is important here because we used to think that household savings would take them well into 2023. Now with the higher prices, higher CPI, I think those savings start getting exhausted sooner. That's one thing.

Number two, I absolutely think higher inflation brings more people back into the labor market, which is actually a good thing. So, in a sense we’re encountering a strange situation where you have I think, pretty robust labor markets in the face of headwinds, which come from areas like inflation. But as dual-income families—which have become one income families—return to being dual-income families, this assists in keeping the consumer healthy. Looking  forward, the reality is if we have this high level of inflation running substantially toward, to the end of the year, everything that John said comes very, very true. Because then you get that consumer-growth recession, and that's when I said, “I'm not sure the Fed can engineer a soft landing.” So, you might still have high inflation, which will limit how much the Fed can actually respond to slower growth. And at the same time, you will have growth naturally slowing because of how much inflation is eating away into consumers’ real incomes.

Stephen Dover: John, let's just turn to what do you do about this? So maybe a reaction to listening to this conversation would be to avoid fixed income or certainly to have much lower duration or no duration at all. Given what we've discussed how are you thinking about that strategically?

John Bellows: So, I want to make two points, and they're both about valuations, so what is the market kind of pricing? So, the market currently is pricing nine hikes total from the Fed this year. So, it's already reflecting the Fed doing a couple of 50 basis-point hikes. And I would suggest that that's not consistent with an environment of moderation on either growth and inflation. That's an environment where the Fed feels they continue to behind the curve, they need to do more. And so I think from a kind of valuations perspective, if we do see growth and inflation moderating on their own,  inflation ends up being a self-defeating process rather than a self-propagating one, the Fed needs to do less. Maybe you see that in terms of number of hikes, but I think you definitely see that in terms of the rhetoric. Right now, inflation's high, everybody wants the Fed to fight inflation—they sound hawkish. And in some sense, that's the easy thing to do. If growth's moderating and inflation's falling on its own, it starts to become a lot harder for them to maintain a uniformly hawkish message and starts to become more balanced. And you start to hear them talk about growth risks. So, I think the substantial amount of hikes that are priced into the front part of the curve could be right, but if growth moderates and the Fed changes their tune, I think that that's the place to look. The second point I want to make also about valuations is that during the last, you know, really three months, but especially in the last month, not only have we seen rising yields, but we've seen a spectacular amount of volatility in interest rates. I mean, any day, up or down by 20 basis points in two-year [Treasury]  notes. I mean, you think about that, two-year notes generally do not move by 20 basis points. And I think we've had something like three or four days in the last two months where we've seen 20 basis-point moves in two-year notes. That's a lot of volatility. And for some investors, that makes it hard to invest in any fixed income. There are investment-grade credit investors out there who kind of buy based on yield, they don't kind take out the spread. And so, when you're buying a five-year corporate bond to make, say 60 to 80 basis points on the spread, you don't do that if you could lose 60 to 80 basis points tomorrow on the underlying duration, it's simply kind of the risk/reward there doesn't really work for you. Now, when volatility comes down and it likely will come down because at some point markets find a level and the outlook becomes a little bit clear. When volatility comes down, then those buyers based on yield start to reenter. They start to become a little bit more comfortable with their ability to capture that spread. And that in turn helps the corporate market and other related markets. So those are the two points I would make. I mean, look, we've seen a year where yields are up. Sharply volatility is really, really high right now, both real and implied. And I think you need to think about both aspects of it. So, on the yields up sharply, you know, I think that's reflecting a lot of pessimism about the inflation outlook. If you do get a moderation, you know, those valuations could correct. And then really where I think there's a significant opportunity is on the volatility. Volatility makes it hard for people to engage in fixed income. When that volatility comes down, you could see a real change in terms of risk premium and investors willingness to put those positions back on.

Stephen Dover: Thanks, John, that's really an important point. And maybe what I'm coming to this volatility is just so hard to understand, maybe a little bit scary so people step out of that and that's an opportunity for a professional like yourself.

Let me just have a follow up question with you that you've talked about in the past and that's using duration as a ballast particularly if we were looking at slowing growth.

John Bellows: You know, the theory there I think is very well grounded, which is that during periods of heightened uncertainty, heightened fear, investors prefer safe assets and investors generally downgrade their growth and inflation forecast, which mean higher Treasury prices. Now, one thing that people are observing is this year, you see both bonds and equities down in total return. So therefore, it doesn't look like the negative correlation is there. But I'd actually encourage you to look a little bit harder. And so, you see that days when there's a real big risk-off, so look in late February, for instance, a big correction in the S&P [500 Index], you know, bond yields tend to fall, again, preference for safe assets revising kind of the landscape lower. And similarly, when equities rebounded, bond yields rose. And so, I would just encourage you to look at those correlations, but really, I think it really comes down to your theory. And if the theory is that in times of uncertainty, investors prefer safe assets, pretty straightforward, investors tend to revise down growth and outlook. Then I think there's a role there. Now you do have to be careful about the trends. And so, you do have to be careful about rising inflation and what that means. But I do think kind of the theory there is very well founded and portfolios continue to benefit from the diversification.

Stephen Dover: So Sonal, let's turn to you, given your outlook on inflation, rates, and growth, where do you see opportunities and maybe where do you see dangers with the volatility that we now see?

Sonal Desai: So I would say that we are trying to stay relatively short in our US duration. I think that if you look toward Europe, given their greater dependence on Russian energy, the risk of a recession is certainly greater in Europe than it is in the US. So that's something to consider. So, while we certainly don't like duration in the US, at some stage, I think earlier than the US, duration in Europe starts becoming a bit more interesting. We certainly like the traditional asset classes such as floating rates or bank loans, which actually stand to benefit from a rising-rate environment. So that's another area that we look at. I would also note that people tend to forget that all emerging markets are not identical. There are going to be some emerging markets which stand to benefit a lot from the current commodity price wave that we're seeing between agriculture, metals, energy, all of that. And we are trying to opportunistically find in the emerging market space where we could invest. Something else to consider certainly is the Japanese yen has depreciated a lot, but in an environment where we do continue to see rates rise in the US, there is a solid correlation between the yen depreciation and US Treasury selloff. Now, I would note this because this is another way to get exposure if you're not comfortable, not actually taking that exposure directly via being short to US Treasuries to in fact, consider being short the Japanese yen, because these are other areas where one could find some havens, I would say.

Stephen Dover: Sonal and John, thank you. Very different views on where we're headed with inflation, how the reserve banks might react to that inflation, how that's going to affect rates and even how that's going to affect growth. But we do agree that there's a lot of volatility and that volatility has opportunities within it. So, I want to thank both of you very much.

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