MASTERCLASS: Inflation - May 2021

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  • 53 mins 54 secs
The economy seems to be roaring back and investors are increasingly worried about inflation. Two experts discuss the current macroeconomic environment, the Fed’s new framework, their expectations for inflation, and much more.

  • Jeff Schulze, CFA, Investment Strategist - ClearBridge Investments
  • Matt Bush, CFA, CBE, Senior Economist in the Macroeconomic and Investment Research Group - Guggenheim Partners



Jenna Dagenhart: Welcome to this Asset TV Inflation in Focus Masterclass. The economy seems to be roaring back, and investors are increasingly worried about inflation. Joining us now to share their expectations given the current macro environment, the Fed's new framework, and much more, we have Jeff Schulze, investment strategist at ClearBridge Investments, and Matt Bush, senior economist in the macroeconomic and investment research group at Guggenheim Partners.

Jenna Dagenhart: Everyone, thank you for being with us. Let's begin with COVID-19 and a broad look at the economic recovery. Jeff, is the economy as "turned up," quote/unquote, as Powell says it is? Do you think the Fed's projections of 6.5% GDP growth and 4.5% unemployment are realistic, especially last year when the economy shrank the most since World War II?

Jeff Schulze: Thanks, Jenna, for having me on the program. And yes, the economy is as turned up as Powell mentioned. In fact, if you look at consensus expectations, if it did come in as consensus expects, this would be the strongest growth that you've seen in the US, on a real basis, since 1984. But I'm a little bit more optimistic than the Fed on both the economy and also where the unemployment rate will be at the end of the year. I think the economy will come in at 7% when all is said and done, and I think the unemployment rate could actually be in the low 4% range.

Jeff Schulze: And looking at it from an economic perspective, we're pretty bullish on the US economy because of several pillars. And the first is really the US consumer. If you look at household net worth versus pre-COVID levels, it's up $18 trillion, or 17.3%. Now this is not exactly what you would see or expect coming out of a recession, but the reason why household net worth is up so much is you've had robust financial markets, you've had a strong housing market as well, you've had a lot of stimulus, and you've had forced savings.

Jeff Schulze: But thinking about the consumer, I'm really anticipating the consumer to go gangbusters here in the second and third quarter, as we reach herd immunity, and you get revenge spending or deferred gratification. After the last stimulus package that we saw in March, consumers have accumulated excess savings, above and beyond pre-COVID savings levels, of close to $2.2 trillion. And you obviously saw this in the retail sales print, in March, coming in at a very, very healthy and rare 9.8% print.

Jeff Schulze: So I think the consumer is going to be a very important determinant of this above-trend growth that we're going to be anticipating. The other aspect is you're going to see a massive inventory restocking cycle. Inventories have continued to go down, and as of today, inventory levels are levels last seen since 2012, and this is despite a very dramatic effort to do restocking. And talking about that stimulus package, I think you're going to see continued pressure on the inventory levels. And when you have massive inventory restocking cycles, that usually is a very nice tailwind to economic growth, and maybe more importantly, it's going to unleash some business spending, and potentially an industrial CapEx cycle as producers try to bring on spare capacity.

Jeff Schulze: But the last part of the equation is the labor markets, and you're going to see a very robust labor market recovery. Out of the 8.4 million jobs that were lost versus last February's peak in employment, 78% of them are in COVID-sensitive industries, and as you have a re-engagement with services, you're going to see very fast job creation. And you saw this in the March jobs report, with a positive 916,000 job creation month. Out of those jobs, 73% of them were in COVID-sensitive industries. And it wouldn't be a surprise to me if you get maybe 1 or 2 million plus job creation months here as we move through the second quarter.

Jeff Schulze: So if you put all of these variables together, this is a very strong concoction for not only good economic growth, but an unemployment rate that's going to surprise to the downside.

Jenna Dagenhart: Yeah, unemployment is falling, retail sales are soaring, as you mentioned, and manufacturing recently had its strongest reading in almost four decades. The biggest problem really there was the supply to keep up with the demand. So, a lot to be optimistic about. Matt, how are you interpreting different macro indicators and reports?

Matt Bush: Yeah, thanks, Jenna. I think what we're seeing is a few different trends play out in the data. And the first trend really is the continued impact of the pandemic. And where we're seeing that show up now really is in the area of increasing supply constraints. So, we're seeing that in the manufacturing sector, where international supply chains are increasingly backed up due to factory shutdowns overseas, some labor shortages in some supplier countries in our supply chains. And we're also seeing an increasingly, in the labor market domestically, if we look at the NFIB's survey of small businesses, the percent of businesses with positions unable to fill right now is at an all-time record high, even with the relatively high unemployment rate.

Matt Bush: And the reason for that is one, we have people still scared to go back to work for fear of getting infected. And number two, we have generous unemployment benefits that may be changing the equation for getting back to work now versus later. And so, for the near term, we do expect that those supply disruptions will cause near term inflationary pressure, but we do expect that they are somewhat temporary. And as the pandemic gets better, both domestically and internationally, we should see those supply constraints start to ease, and price pressures ease as well.

Matt Bush: The more positive trends in the data that we're seeing are related to the fiscal boost from massive fiscal stimulus, both in 2020 and 2021. As Jeff mentioned, we have a very positive consumer outlook given how much household incomes have risen. And that's boosting goods spending in particular, as seen in the blowout retail sales report. And we think there's a lot more room to run in that story, given the amount of excess savings we see in the consumer, which will likely top out at around $2.5 trillion.

Matt Bush: And so all this sort of pent-up saving, as the economy reopens, as spending opportunities normalize, should continue to power the consumer forward. Not only that, but we still have more fiscal spending on deck. We expect another $2.5 trillion or so in net fiscal stimulus by the end of this year, first concentrated in a large infrastructure package, along with R&D spending. The second package concentrated in childcare, healthcare, that'll also be a stimulus. Yes, these fiscal packages will be paired with tax increases, but we expect that the tax increases will be phased in much more gradually than the spending. And so, we will see net fiscal stimulus from these packages over the course of the next few years.

Matt Bush: The third thing I think it's important to point out in the data is just the trend in the early beginnings of reopening the economy. We're seeing COVID-related restrictions ease in a number of states. And as vaccinations continue, and the COVID metrics get better, we see a lot of the more COVID-sensitive industries start to improve. So, we see airfare starting to tick up. We see more restaurant activity. We see better hotel activity. And that's going to be an ongoing tailwind. even as sort of the fiscal support starts to fade a little bit, we should see a tailwind from a shift from goods spending to services spending.

Matt Bush: And so overall, I would agree with Jeff's outlook for strong growth this year. We're somewhere in the 7.5% to 8% range, just given the strong fiscal tailwind and the continued boost from vaccinations improving the COVID situation.

Jenna Dagenhart: Given the strength that we're seeing, a lot of people are now wondering what it means for inflation. The Fed's calling for a transitory rise in inflation above the key 2% level this year. Jeff, do you think a rise in inflation will truly be temporary? Or could it continue into 2022 and beyond?

Jeff Schulze: I think it's going to be temporary. I think the Fed has this right in the fact that it is indeed transitory because of a lot of the things that Matt had mentioned. Obviously, we're lapping the year-over-year prints that we saw as the economy shut down, so that's naturally going to increase inflation. You have a tsunami of demand for the services side of the economy, but you just don't have the supply as most of these companies have cut to the bone in order to survive, and, as Matt had mentioned, the global supply chain bottlenecks.

Jeff Schulze: But as you get to next year, those bottlenecks will start to go away as a lot of both developed and emerging economies reach herd immunity, but also the year-over-year prints are going to be a lot more difficult when you have high inflation this year. But I think maybe the key determinant on why I'm not optimistic on inflation reaching higher levels in 2022 and 2023 is the fact that you're going to have labor market slack. And we did some analysis, and we looked at both high inflationary regimes and low inflationary regimes, going back for the last 65 years.

Jeff Schulze: And typically, at the beginning of an economic expansion, you see dis-inflationary forces for the first three to four years of that cycle. And the key reason why you see dis-inflationary forces is you have an abundance of labor slack. So, I don't think we're going to see much higher inflation until we can close the output gap for employment. So, to do a quick exercise to see how quickly we can close the output gap of inflation, i.e., where's the US economy supposed to be with their employment numbers, you can go back to February of 2020, and peak employment was 152.5 million jobs.

Jeff Schulze: Assuming, again, that we never went into a recession, trend job creation was about 2 million per year. So that would have meant that we would have had to create 2 million jobs in 2020, 2 million jobs in 2021. So, by February of 2022, the US economy theoretically should have 156.5 million jobs, essentially closing the output gap for employment. So today, we have 144 million. So, the difference is a little bit over 12 million. So, in order to close that, we would have to create 1 million jobs per month over the next year.

Jeff Schulze: Now, I certainly think that we could get 1 or 2 million job creation months over the second and third quarter as we reopen the economy. To have that over a 12-month period is very, very unlikely. If we cut that in half, and that's still an optimistic number, 500,000 jobs created per month, to close that gap, we wouldn't be at full employment until the middle part of 2023. And even at 500,000 per month, that is a very high number.

Jeff Schulze: To put it in perspective, back during the global financial crisis, we were creating a little bit over 200,000 per month. So long story short, I would be fading the higher inflation story over the next couple of years. I think this is transitory. And until we can close the gap that we see in the labor markets, you're not going to see materially higher inflation, which in my opinion, is probably going to be 2023, or maybe even 2024 at this point.

Matt Bush: Jeff, I completely agree on your labor market analysis. We took a similar approach in looking at the employment to population ratio, which New York Fed president, John Williams, mentioned getting back to the pre-pandemic level on that ratio as sort of a key barometer for policy. And so, what we did is look at where trend population growth is. And then just taking Bloomberg consensus employment growth forecasts, we extrapolated out what the employment to population ratio will look like given that Bloomberg consensus job growth. And we don't get back to the pre-pandemic, 2019, employment to population ratio until 2024 at the earliest. And so, I agree that this degree of labor market slack is going to persist for quite a while, and that will put downward pressure on inflation going forward.

Jeff Schulze: It will certainly be a lot more than what we saw during the global financial crisis, but I think people really do underestimate how big that gap is at this point.

Jenna Dagenhart: Yeah, those are great points. And, Matt, building off of that, how does your outlook for strong economic growth relate to your outlook for inflation?

Matt Bush: So as I mentioned, we do have a strong growth outlook for 2021, somewhere around 8% this year. Even into next year, we see above 3% growth, just given this vaccine and fiscal tailwind. But I think the mistake that really the consensus is making is assuming that strong economic growth automatically means higher inflation. And I think there's two reasons for believing this is not the case. The first is just a statistical reason. Looking at the data over the past 20 years or so, if you compare real GDP growth to core PCE inflation, which is the Fed's target, we see a very modest correlation overall, somewhere around 0.4.

Matt Bush: And that's even accounting for the 18-month lag between economic growth and inflation. And what that regression shows is that to get 2% core PCE inflation on a reliable, sustainable basis, you need real economic growth above 5%. Now, that's doable this year just given the deep hole that we're digging out of and all the fiscal tailwinds at our back. But on the more medium-term basis, the US economy is not primed to grow at a 5% rate, let alone a 3% or 4% rate. And so, for that reason, we don't expect that going forward we're going to be able to reliably hit 2% inflation.

Matt Bush: The second reason to sort of discount all this concern about higher inflation is a more theoretical perspective, and that's thinking about this concept of overheating. So, a lot of this analysis is pointing to the risk of GDP exceeding potential GDP over the coming years, and that leading to price pressures. Now, it's easy to look back historically and see at times when GDP went above potential GDP, we saw higher inflation. But that's because we have the benefit of hindsight in coming up with these potential GDP estimates.

Matt Bush: In real time, these are very uncertain metrics to measure, and they get revised heavily over time. And what we saw over the course of the last cycle was as the economy continued to underperform coming out of the GFC, we saw potential GDP continually revise down toward actual GDP. We think, going forward, we'll actually see an opposite trend this time around. The US economy is going to outperform, potential GDP is going to be revised up because inflation is not going to rise.

Matt Bush: We see a similar thing if we think about the concept of the natural rate of unemployment, which again, is supposed to be this level below which inflation takes off. Going back to 2013 or so, looking at the Fed's own estimates, they thought that the natural rate of unemployment was above 5%. Well, we crossed below 5%, inflation never rose, and what we saw was the estimates of the natural rate of unemployment continuously revised down over time to now where they stand at about 4%. And so, these measures of potential or natural rate are really uncertain in real time, and are not a good forward-looking guide, and often get revised in terms of what actually happens with the economy. And so, we think that'll be the trend this time around.

Jeff Schulze: In regard to the natural rate of unemployment, I think it could be structurally higher, though. You make a great point there, Matt, that I think it could be structurally higher because of the accelerated restructuring of the labor markets. If you think about the shifts that happened during the recession, you saw most prominent being the move from offline retailing to online retailing. And a lot of the unemployed workers are not going to be able to return back to their original industries, which is going to require up-scaling and reallocation processes.

Jeff Schulze: So long story short, I do think that the natural rate of unemployment is potentially higher during this cycle. And if it's higher, that means that we could run into potential wage inflation quicker than what we saw during the aftermath of the global financial crisis. So instead of it maybe being 4%, which was the Fed's projection for last cycle, maybe it's going to be something a little bit structurally higher. But I think that's an interesting point, and it's obviously something that we're monitoring at ClearBridge as well, and whether or not we could see the labor market slack that I talked about just a minute ago, come to an end quicker than anticipated, but also, bring about some higher wage inflation and some higher overall inflation with it.

Matt Bush: So I think the flip side of that story about higher rate of unemployment is that one reason for that, as you mentioned, is sort of these labor-saving technologies and processes that were adopted during the pandemic. And what that means is that productivity growth is likely to be higher post pandemic because of things like eCommerce, telemedicine, online learning, as well as saving on office space costs and travel costs. So even if we do see some wage pressure, I think that will be offset somewhat by higher productivity growth. And so that'll probably limit the degree to which higher wage costs are passed on into consumer costs. And so, I don't think it'll have a very meaningful impact on the overall consumer price inflation story.

Jenna Dagenhart: Taking a closer look at fixed income, Jeff, where do you see the 10-year ending this year? Will we have another taper tantrum?

Jeff Schulze: I don't think we're going to have another taper tantrum. It certainly felt like that in the first quarter. And the reason why I don't think we'll see a true taper tantrum this time around is that coming out of the global financial crisis, the Fed was still really developing its toolkit. It was working on its communication skills. And there was a view that when QE was going to come in, so i.e., the taper, the Fed was going to be raising rates along with it.

Jeff Schulze: So they weren't two separate ideas, but one idea. And I think the Fed has done a very good job of communicating that they are indeed very separate, and you will see a taper first, and then conditions warranting, that rate hikes will come along with it. So, I think it's a different dynamic, and even though you did see a strong move in the first quarter, I think the move higher's going to be much more measured.

Jeff Schulze: But the reason why I think you're going to see higher interest rates is because usually if you look at the yield curve, represented in the US by the two 10 year. The yield curve is usually steepened up by about 2.5% over the last three cycles. And so far, we're close to 1.5%. So, we've retraced about 60% of that move. Also, I think right now with negative real rates on the 10 year, I think that's a situation that you would have in a deflationary environment, and that was certainly the fear coming out of the crisis. But now, I think inflation risks are going to start to be embedded into the price of a 10-year treasury, which all things considered, should push the compensation that investors are requiring higher, i.e., higher 10-year treasury rates.

Jeff Schulze: So I think the 10-year treasury will rise from here. I think it probably goes through 2% to two and a quarter as we get through the second and third quarter and this very robust economic growth. But ultimately, I think it settles in around 2% overall. But maybe the key point here is it's going to be much more of a grind higher rather than that stampede or the one-way street that we saw back in the first quarter because right now, US 10-year treasuries look very attractive to international investors on a currency hedge basis.

Jeff Schulze: Now, when you're an international bond investor, you don't want to deal with moves for the dollar. You're really just looking for yield pickups. And the yield pickup that you're seeing right now from Japanese and European investors are at levels that you've traditionally seen much more involvement, and much more demand for US treasuries. And it's, in my opinion, going to be one of the reasons why you've seen the 10-year treasury drop here over the last month when we get that data in a couple of weeks.

Jeff Schulze: So long story short, I do think we're going to see higher 10-year treasuries. But I think it's going to be a very slow move higher, ultimately settling in at 2% at year end. But higher treasuries doesn't necessarily mean bad equity market returns. If you look at every 10-year treasury rising rate and experience that you've seen since 1962, when the 10-year treasury has moved up 1.5% or more, the S&P 500 has been up 11.9% on average, with a hit rate of being positive around 85%, and the Russell 2,000 did even better at 16.7% average return, with a hit rate at 78%. So, I think higher rates – we're only halfway through that story. But it doesn't mean equity markets can't continue to march higher from here.

Jenna Dagenhart: So is there a level for the 10-year where you think the equity markets would run into difficulty?

Jeff Schulze: Yeah, it's certainly going to be a choppy environment as we move higher. But I think the equity markets are going to be just fine really until we get closer to 2.75%. Stocks are cheap compared to bonds on a relative basis at this point. I think there's a lot more wiggle room on how high that 10-year treasury can ultimately go before it seriously disrupts the market's trajectory.

Jenna Dagenhart: At what level does inflation begin to affect equity markets?

Matt Bush: In terms of inflation, I think it only becomes a problem for equity markets when it starts to pull forward the timing of Fed rate hikes. And I think given the Fed's new framework, given our expectation that inflation is going to disappoint relative to consensus, and given already sort of overly hawkish expectations for those rate hikes, I don't see that as very likely.

Matt Bush: The most likely reason why we would see rate hikes get pulled forward further is if we saw a concerning un-anchoring of inflation expectations to the upside. And that would be particularly a concern if that was due to these supply constraints causing more and more inflation that we talked about. Demand-driven inflation would be fine for equities given earnings would be strong in an environment where demand growth is just really strong. But if we see just more and more supply disruptions, particularly if it's driven by more and more COVID disruptions overseas, and that causes inflation, that could be a problem for equity markets.

Jeff Schulze: Yeah, Matt. Great points. And from our analysis, we looked back to the early 1970s, and we found that equity multiples really don't tend to de-rate until you see inflation broach 4%. So obviously CPI could get to maybe 3.5%, maybe 4% as we go through the summer here and we get this inflation scare. But again, our core view is that CPI and PC are going to come down as we get into 2022 and 2023. So based on the prints that we saw for inflation in March, it doesn't appear, at least at this point, that the markets are too concerned about it either.

Jenna Dagenhart: Matt, when we talk about inflation, does it matter which index we look at?

Matt Bush: Absolutely. The Fed has chosen the PCE Index as its preferred inflation gauge. And that matters because it has significant differences compared to the CPI gauge, which is also widely followed. Probably the biggest difference is different weighting schemes between the two indices. So, if we look at core CPI, for example, shelter inflation is a huge component of that. It's over 40%. And that matters because shelter inflation tends to run hotter than overall inflation, and also is pretty correlated with GDP growth, which means that core CPI runs higher and at a more correlated rate with GDP than does core PCE.

Matt Bush: So on core PCE, there's a much lower weight of shelter, below 20%. And that's replaced by a much higher weight in healthcare. And healthcare is influenced much more by policy changes than it is by economic growth, which is why, as I've mentioned, the correlation between core PCE and real GDP is pretty weak overall. The San Francisco Fed has done a really good analysis, breaking down the core PCE index into different components based on what sort of external factors it's sensitive to.

Matt Bush: And so it looked at the number of cyclical categories in the core PCE index, which are categories sensitive to unemployment and GDP growth. And that's only 40% of overall core PCE. The other 60% is more sensitive to more idiosyncratic factors, industry specific issues, things like the dollar, commodity prices, or financial market prices. And what we've seen over the past decade or so is that these acyclical categories have run lower than overall inflation. And again, healthcare is the big one there.

Matt Bush: And so what we see in the data right now is that healthcare inflation has been boosted over the past year and a half by temporary healthcare policy measures related to COVID that have increased payments to hospitals, for example. And so that has boosted core PCE inflation. Those measures expire at the end of 2021. So, as we go into 2022, healthcare policy becomes a drag on core PCE. And given the weight of healthcare in the core PCE index, that's actually a significant drag.

Matt Bush: So we would expect going forward the core CPI is going to run hotter than core PCE, given the booming housing market that'll eventually show up in rental inflation. But it's these more idiosyncratic, policy-driven factors, particularly healthcare policy, that'll remain an ongoing drag on core PCE, particularly if the Biden administration sort of goes forward with more healthcare policy changes.

Matt Bush: We saw in the mid-2010s, after the Affordable Care Act was passed, significant disinflation in healthcare from that policy. And so, if we get more policies like that, that'll be an ongoing drag on core PCE going forward.

Jeff Schulze: And one thing I'll just mention, Matt, all great points, is core PCE's healthcare component is around 18% of the index, so it's a fairly large contributor, which again, is going to act as a large headwind. But all really great points.

Jenna Dagenhart: Jeff, what's the bullish narrative for structurally higher inflation?

Jeff Schulze: Yeah, I mean, there's a lot of people that believe that you will see structurally higher inflation, and it's a multifaceted bull case. The first really is about de-globalization. More and more countries are looking inward. They're looking to re-shore domestic manufacturing capabilities and create local jobs. If you look at global trade as a percent of total production, it peaked back during the global financial crisis and has yet to regain its upward trajectory, which has been going up for literally three or four decades. So, if you're going to be manufacturing in a not efficient manner, that means higher production costs, it means higher prices for those goods, higher inflation all things considered.

Jeff Schulze: Also, populism is inherently inflationary. You can see populism trends here in the US, but across a lot of the developed world. And some examples of populism is higher minimum wages, redistribution of wealth from the top 10% to the bottom 60%. And what you're essentially doing is you're creating a lot more demand with the lower income households. And more demand, less supply, all things considered, is higher inflation is the outcome. Also, one of the key reasons why you saw the high inflationary 70s was Lyndon B. Johnson's populism War on Poverty. So, populism is really the second aspect of that narrative.

Jeff Schulze: And the third is the global labor supply glut that you've seen over the past three decades is coming to an end. And maybe one of the single most important economic developments over the last three decades was the rise of China and its integration into the global economy. And if you look at China from the years of 1990 through 2018, the working age population increased by over 240 million individuals. In that same timeframe in the US and Europe, our working age populations increased by a little bit less than 60 million. So, you saw four times the number of individuals come into the global labor supply force.

Jeff Schulze: Also, you saw the Berlin Wall fall in 1989. It brought Eastern Europe into the global ecosystem, with another 200 million individuals. Also, you saw higher female labor force participation rates across the globe. So, if you take all of these dynamics and you put them together, you effectively doubled the labor supply force of the globe, creating disinflation globally. Now, this story's coming to an end. You saw peak working age population growth in China over the last couple of years. And that's going to be declining as we go through the 2020s and 2030s.

Jeff Schulze: Also, you've seen the end of the migration from the farming communities in the Western Provinces to the Eastern manufacturing Provinces. So, you're going to see higher wage pressure in China because of these dynamics. But also, if you think about the dependency ratios, they're actually changing for the worse. So, dependency ratios were getting better over the last three decades because you had more workers than dependents. Workers produce more than they consume. That's dis-inflationary or deflationary all things considered.

Jeff Schulze: Now, with the graying of the US, Europe, Japan, and also China, you're seeing more dependents than workers, and that means people that are consuming and not producing. So that's going to put a premium on the price of labor. And it's going to increase unit labor costs when you see higher wage costs that are associated with it. So, the higher structural inflationary story really comes down to those three components: de-globalization, a move towards populism, and the end of the global labor supply glut that we've been experiencing and enjoying over the last three decades.

Matt Bush: Those are all great points, Jeff. And I agree completely with all of them. I think the key question is how fast will these trends play out? Is this a story for the next few years, or is it a story for sort of the end of the 2020s and 2030s? And I think, in particular in regard to populism, I think that really comes down to what is the political story look like over the next few years.

Matt Bush: If we look at some like the stimulus checks, if you look at survey data on how popular they are, close to 80% of people are very supportive of stimulus checks, including a majority of republicans. This is incredibly popular policy, and obviously was instituted in a pretty unique kind of recession. But given the popularity, it's going to be hard for politicians to avoid the temptation to kind of continue this policy in sort of more normal economic times. And so, I think if we do see kind of politicians take that bait, that'll be a key signpost that we are heading down a more populist path and risking structurally higher inflation.

Jenna Dagenhart: And I'm glad you both bring up historical comparisons. Looking at historical comparisons, Matt, how would you contrast inflation expectations today to the 1970s?

Matt Bush: So I think there are a lot of fears about the 1970s given a move to a more expansionary fiscal stance and what that meant for inflation in the 70s. But I think it's important to acknowledge quite a few differences in the macro environment now compared to the 70s. One of the stories of the 70s was sort of this wage price spiral that developed. And a key reason for that was because union membership was much higher in the 70s. Close to 30% of workers were involved in a union back then. I think it's less than 10% now. And a lot of those contracts had wages indexed to inflation, which is not as common these days. And so that allowed that wage price spiral to develop. That's less likely today.

Matt Bush: Number two, you had two massive oil price shocks in the 70s that really helped un-anchor inflation expectations. We can obviously see temporary supply disruption in the oil market these days, but probably not to the degree we saw back then. Number three is just the demographic story. The demographic story, as Jeff mentioned, has been an important part of the disinflation in recent decades. In the 70s, we had labor force growth approaching 3%. Today, it's well below 1%. And so, I think as we think about the 70s, it's a pretty different macro environment. The Fed at the time misjudged how loose policy was. They misjudged what inflation expectations were doing, in part because they weren't very well measured. The measurements we do have suggest that they were much higher, much more volatile.

Matt Bush: Today, whether you look at consumer expectations, professional forecaster expectations, market-based inflation expectations, yes, they've moved up over the past few months as the economy has recovered from a deep hole, but overall, over the past 20 years, they've been remarkably stable, right around the Fed's 2% target. And so that's allowed the Fed to keep inflation in a much narrower range. And until we see a convincing breakout in these inflation expectations, which we think is very unlikely, I don't think we're headed back to a 1970s scenario.

Jeff Schulze: Yeah, and what I'd say to that, obviously 1970s were characterized as easy monetary and fiscal policy, but to your point, Matt, unanchored expectations of inflation were really the key driver of that self-perpetuating higher inflationary feedback loop. And they're better measured today. Also, I think it's important to mention that people are used to seeing prices low over the past couple of decades. So, it's going to be very difficult to un-anchor those inflation expectations today. And if the Fed really wants to, they can always get ahead of inflation because there's no limit to how high the Fed funds rate can ultimately go.

Jeff Schulze: Volcker was case-in-point of that in the early 1980s. And also, because we don't have the labor union membership that they once had, it really hurts collective bargaining power, so I do agree with Matt. I think the return to a 1970s style inflation is very unlikely. Pretty much everything that could have gone wrong that decade did go wrong. But how could it change? I think you're going to have to see these three things happen in order to see 1970s style inflation.

Jeff Schulze: You need to see a massive depreciation of the US dollar. I think you need to see depreciation somewhere between 30% and 40%. I do believe that the dollar has peaked and you're on a five-to-seven-year trend of a weaker dollar. Obviously, the twin deficits are a leading mechanism of the dollar, and the deficits have been blown out from a trade perspective because the US consumer's going to be spending a lot more over the next couple of years. But also because of lower shale production, but also, you're going to see much higher budget deficits today and probably in the future.

Jeff Schulze: But obviously dollar weakness is going to be the first component of that. I think you need to see a commodity super cycle. Now, there is a lot of talk of the greening of the global economy and the pressure that that's going to put on industrial metals. But I don't think that this is going to be enough to create higher commodity inflation, nothing like what we saw in the 1970s with the two oil embargoes.

Jeff Schulze: And then last but not least, you need to see monetary policymakers lose their independence and become compliant to accommodating excessive fiscal policy. And I know that it's popular right now to do these large plans and give out stimulus checks. And on the thought process of monetary independence, I think it's interesting when Arthur Burns got sworn in in 1970, President Nixon was asked whether or not the new chair would be independent to set monetary policy. And Nixon replied, "I respect his independence; however, I hope independently that he'll conclude that my views are the ones that should be followed."

Jeff Schulze: So essentially, monetary policy was hijacked by the White House, and that was key in creating inflation, but also un-anchoring inflation expectations. So, I don't think we're there yet. I think there's a lot more that needs to play out here in order to see materially higher inflation, something that approaches what we saw back in the 1970s.

Jenna Dagenhart: Before we talk more about monetary policy, Matt, moving a little bit closer to present day, what can we learn from the last cycle about the outlook for inflation?

Matt Bush: Yeah, I think it's instructive to look at the last cycle, given it's a more similar macro environment. And what we saw coming out of the last recession was, again, fears of inflation really taking off. QE was new at the time. We saw large budget deficits. And there were a lot of concern about these policies causing inflation, or even hyperinflation. There were open letters written to Ben Bernanke at the time warning about the risks of hyperinflation from the policies the Fed was undertaking.

Matt Bush: But for all these concerns, what we saw after 2009 to 2019 was consistent undershooting of inflation relative to expectations. And you can measure this looking at consensus forecasts for inflation. Adding it all up, we were about 20 basis points per year below where consensus expected us to be. And that's even with, by the same measures, the economy outperforming expectations. So, unemployment was lower than expected, GDP was better than expected, but core inflation was still weaker than expected.

Matt Bush: Now you might say, "This is different. We're coming out of a pandemic. The recovery is much faster, so comparing the 2010, 11 period really isn't comparable." Well, let's go to 2018 instead. 2018 we had a low unemployment rate. And at the time, we got a big fiscal boost from the Trump tax cuts. In theory, that should have been inflationary. We briefly saw inflation rise barely above 2%, but by 2019, we were back down around 1.7%. And so, as you think about the environment we're in now, with a big fiscal boost, unemployment falling rapidly, I think that's very important to think about.

Matt Bush: And I think both these experiences tell us about what matters when we think about the inflation outlook. It's not fiscal policy. Fiscal policy, one, is hard to define. It can act in many different ways on the economy. And empirically, it doesn't have much of a relationship with inflation. Number two, it's not monetary policy or the money supply. If we go back in the 50s and 60s, yes, money supply was a good guide to inflation. In more recent decades, what we're seeing is an extremely negative correlation between money supply and nominal economic growth. And that's because increases in money supply have been almost perfectly offset by decreases in money velocity. And one reason for that is higher and higher debt levels restrain money velocity, and that restrains overall inflation.

Matt Bush: So yes, money supply has really taken off over the past year, near all-time high in terms of the rate of change. But that's not a sufficient reason for inflation, especially in a short-term horizon. And I think what the last cycle teaches us is that even with strong economic growth, a tight labor market, it's really important to take into account these powerful secular headwinds to inflation, things like debt, as I mentioned, that restrain economic growth, restrain money velocity. And debt has only gotten higher after the pandemic.

Matt Bush: Things like continued technological change. Again, COVID accelerated a lot of these technological changes that are, by their nature, dis-inflationary. Demographic factors, which in theory, should be inflationary because you have fewer producers and more consumers of goods, but in practice, we see that demographics, whether it's across countries or over time, older demographics tend to be dis-inflationary. That trend has not gone away.

Matt Bush: And then lastly, the Phillips Curve remains very flat, reflecting limited pricing power by businesses. And what's happening in recent times is higher input prices are being absorbed in lower margins, as opposed to passed on to consumers given this limited pricing power. And so, these powerful headwinds to inflation that were in place over the last cycle have not gone away, and in some cases, have been accelerated by the changes that the pandemic has caused the economy. I think that's important to think about the story going forward, and not to get too concerned or excited over easy fiscal policy, easy monetary policy, because we saw last cycle that had little bearing on where inflation went.

Jenna Dagenhart: Yeah, talking a little bit more about policy, Jeff, in your recent note, you mentioned how the policy response to the coronavirus crisis compares to previous recessions. What's different this time around?

Jeff Schulze: It's been unrivaled in modern times. Policymakers, over the past 12 months, have done stimulus measures into the US economy of $5.3 trillion, or a little bit over 25% of GDP. If you put that in context, if you look at the last five recessions combined, you look at the change of the budget deficit during that recession and the first year of the recovery, the response today was 1.5 times those five recessions combined. So, we're in rare territory over the last 12 months.

Jeff Schulze: To put it differently, the total stimulus outlay that the US government has done over the last 12 months has amounted to over $43,000 per US household. From a historical context, the amount of stimulus used to fight the COVID war was greater than the total amount spent to fight World War II. So, it's been nothing short of amazing, and obviously with Congress's actions in March, that cements the fact that we're going to see more stimulus for the US economy this year than last year.

Jeff Schulze: Today, we have an unemployment rate that's almost 9% lower than we were back in 2020. So, it's been an unrivaled response, but you're also seeing it on the monetary side as well. Looking at it from a QE perspective, the total QE enacted over the last 12 months was as much of the QE that was done under the entirety of the Yellen and Bernanke era, which is about an increase of $3.5 trillion in the balance sheet. So, it's been a very strong response, both from a monetary and a fiscal perspective.

Matt Bush: I think one other factor on the monetary policy side that I think is important, for credit markets in particular, is the Fed's direct involvement in credit markets last year. And what we saw was it didn't actually have to purchase all that much to have a huge effect lowering credit spreads. And I think the fact that that policy was unrolled, even though that's been discontinued going forward, I think that's going to be a powerful tailwind for credit markets, given that if things do start to turn south, and we head into another recession, markets are going to believe that the Fed sort of is going to step in and remove that tail risk from the market. And that's a powerful reason for structurally lower credit spread over the next several years.

Jeff Schulze: And I might actually take the counter to that is that in the global financial crisis, the Fed couldn't act very aggressively, and there was a limited policy response, at least initially, because it was politically unpopular to bail out the Wall Street fat cats. Where this time with COVID, there really wasn't an enemy. People were losing their jobs, businesses were going under, because of a disease that it was nobody's fault that they acted irrationally for. So, in the next recession, it really depends on why that recession happens. But I think politically, it's going to be important, the reason for that recession, and whether or not the Fed brings out those credit market facilities that they did just a year ago.

Matt Bush: I think their justification, I agree with the political risk associated with it. I think the Fed's justification in the next recession will be they're going to have limited room to cut rates, probably even less room than they had in the last recession. They're going to say, "Look, we don't have anything else to do but to start acting in other markets, like credit markets, given that we can't cut the Fed funds rate all that much, our balance sheet is going to still be at a very large level." Heading into the next recession, they're going to say, "We have limited policy tools. Even our sort of conventional, unconventional tools like QE and forward guidance are pretty much exhausted." And so, we're going to need to get more creative the next recession, even with political risk associated with intervening in credit markets.

Jeff Schulze: Well, let's hope that we get the inflation that the Fed's looking to create, and they can get off the lower balance level that could provide enough rate cutting to give a boost to the US economy. But traditionally, before the global financial crisis, the Fed has usually had to cut the Fed's funds rate by about 5% in order to give the liquidity needed to the economy to get out of the recession. So, to your point, Matt, I think yeah, we're not going to have that much ammunition. And potentially, those credit facilities are going to be an important fallback option for them to give the liquidity to the financial markets and get us out of the next recession, potentially.

Jenna Dagenhart: Spending a little bit more time on monetary policy here, Matt, does the Fed's new framework change how they'll respond to inflation?

Matt Bush: It absolutely does. And given the Fed's inability to consistently average 2% inflation over time, in fact, core PCE has spent more time below 1.5% than above 2% in recent years. The Fed became very concerned about this downward un-anchoring of inflation expectations that would make the zero lower bound rates more constraining. It would constrain their ability to cut real interest rates, sort of heading into a Japan scenario, where they really can never get off the zero-lower bound.

Matt Bush: And so that was the main motivation for the Fed unveiling this new framework. And we think that this new framework is still underappreciated by markets in terms of what it means for Fed policy going forward. A couple indications of what this framework means. One is that the Fed has learned that in a world with a flat Phillip's Curve, where inflation is not very sensitive to the labor market slack, the Fed's learned that they don't have to act preemptively to try to cool the labor market in order to avoid inflation. They can let the labor market run hot.

Matt Bush: This has also taught them that they don't have to rely on forecast in making policy. In 2015, when they started to hike rates, they were relying on forecasts of inflation rising as the labor market tightened, and that didn't materialize. So, the Fed has directly stated that they're not going to look for actual outcomes and not act on these forecasts. Number two, they're now trying to make up for past undershoots of inflation by averaging 2% over time by overshooting the 2% target in good economic times. So, if we look at what that means for sort of timing of rate hikes, if we were still operating under the Fed framework for the last cycle, we would expect Fed hikes in early 2023, maybe even late next year, given low unemployment and inflation sort of under, but kind of approaching 2% target.

Matt Bush: But under this new framework, we have a much different view, because now it's not enough just to be sort of heading in the right direction and the forecasts look on track and us better start hiking just to get ahead of where the economy's heading. Under the new framework, we now need realized inflation overshoot to occur, and the Fed's own forecasts don't see inflation averaging 2% through 2023. And so that's going to be a very high bar for rate hikes. When even the Fed's optimistic, we think, inflation forecasts don't see that average over the next couple of years.

Matt Bush: I think even more underappreciated too is the other side of the Fed's dual mandate, which is the employment side of the mandate. We know we have this new definition of average inflation. We also have a new definition of full employment, and that's what they referred to as full employment as a broad and inclusive goal. And what that means is that the unemployment rate by itself is no longer a sufficient statistic to gauge the health of the labor market. They're going to be one, looking at other indicators of labor market health, whether that's employment to population, labor force participation, wage growth, the quits rate. But they're also going to be looking at sort of demographic disparities in labor market outcomes.

Matt Bush: And so that's the unemployment rate across different racial groups, across different income levels, across different educational groups. And what the Fed has learned is that it really takes a very tight, hot labor market to start bringing down these demographic gaps between different groups. What we've heard the Fed say in recent months is that the 3.5% unemployment rate we saw at the end of the last cycle was not full employment based on their new definition. And so, we think that the Fed is seeking to run the labor market very hot in this cycle, hotter than we've seen in recent decades.

Matt Bush: And in addition to a higher bar in terms of the inflation mandate, it's a higher bar on the employment side as well. And so, we don't expect that rate hikes for several years. And that's going to be reinforced, too, by a final factor, which is just changing structure and leadership at the Fed. There's lots of openings for President Biden to fill right now. There's one vacant governor seat. Chair Powell's term ends early next year. And the two vice chair spots, with Clarida and Quarles, are also up very soon.

Matt Bush: And so looking to 2022, we're going to see a very different Fed, shaped by the Biden administration, which given their political leanings, is going to place even more weight on this broad and inclusive employment mandate. And that's going to reinforce what Governor Brainard has recently called resolute patience at the Fed. And again, we think that takes rate hikes off the table for at least the next few years.

Jenna Dagenhart: Yeah, and we've heard Powell talk a lot about this broad and inclusive mandate. Now, moving on as we wrap up this panel discussion, and looking a little bit further out, Jeff, what are your views on inflation over the next five years and beyond?

Jeff Schulze: Yeah, so if you look at what the market's pricing right now, I think it's a very rational outcome over the next five years. So, from 2026 to 2031, the market is pricing in an overshoot of inflation. And looking at the break evens market to 2.5%, that makes sense. The Fed is purposely being behind the curve right now. They're going to wait to actually see the data materialize before they start to rate hike, do rate hikes, which means they're guaranteeing an overshoot. So, I think that's a very rational pricing, but also looking at the next five years, which is 2026 through 2031, the market does believe that the Fed will act aggressively if inflation gets out of control, and step into financial markets and raise rates. And their pricing in inflation for those following five years at 2%.

Jeff Schulze: So, I think that the market has this right. Again, I think you're going to see an inflation overshoot here because the Fed will be behind the curve here. But I think looking out a little bit further, I think there is a little bit of complacency there. I could see inflation being a little bit higher because of those structural drivers. But again, because of everything that we've talked about, well-anchored inflation expectations, the fact that there's no limit to how high the Fed funds rate can go, you have price transparency, i.e., the Amazon effect. Consumers and businesses have never had an easier time price comparing different products, and that makes it very difficult for price increases to stick.

Jeff Schulze: You also have labor substitution. Since wages are the biggest part of a company's cost structure, if wages start to move higher materially, companies can substitute labor for machinery, and potentially robotics as well. And then also, Matt had mentioned this earlier with core PCE. 40% of that index is cyclical, which means to have an overshoot, those cyclical components are really going to have to overshoot highly to the upside. So ultimately, I think the markets have it right. But more importantly, it doesn't really matter what happens in the back half of this decade, because the markets only look forward about 6 months to 12 months at the very longest, which means that the markets are really going to be looking at this temporary inflationary scare and potentially what's going to happen in 2022. But regardless, reflation needs to happen before inflation. Reflation is good for risk assets.

Jenna Dagenhart: Matt, anything you'd like to leave our viewers with?

Matt Bush: Just that I agree with Jeff's near-term view. I think the main takeaway from all of this is that it's a very positive environment for risk assets. If inflation does come in lower than expected, we're going to see the Fed on hold for the next several years, and that's going to be to the benefit of risk assets. And if inflation does start to run hotter, in all likelihood, it's going to be because demand is running very hot. And that's going to be a positive environment for corporate profits, and that should keep risk assets well supported as well. So, for now, risk on.

Jenna Dagenhart: Well thank you both so much for joining us. Great to have you.

Jeff Schulze: Great to be here. Thank you.

Matt Bush: Thank you, Jenna.

Jenna Dagenhart: And thank you for watching this Inflation in Focus Masterclass. I was joined by Jeff Schulze, investment strategist at ClearBridge Investments, and Matt Bush, senior economist in the macroeconomic and investment research group at Guggenheim Partners. I'm Jenna Dagenhart with Asset TV.


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