Inflation: A Passing Phase or Major Threat?

Stephen Dover: Sonal, you very correctly predicted that inflation would be higher than expectations last year. And as we roll into this new year, what are your thoughts around inflation, especially relative to expectations?

Sonal Desai: I'd say that, clearly I'm not expecting that inflation is going to be as far away from expectations as it was last year. I would just note that at the same time, I think the market is being somewhat sanguine about what will happen in the second half of this year. In the second half of this year, there's expectations that inflation will drop down very sharply. And, I think that might be optimistic because a lot of the factors which are driving inflation, I don't think we’ll be completely done with, we will not be done with these factors as we get closer to the second half.

Stephen Dover: John, what are your thoughts as we roll into 2022?

John Bellows: There's no question that the inflation increase over the last three months has been more significant than most expected, us included. It's become very challenging for consumers facing high prices. There's challenges for businesses to keep up and obviously, challenges for policy makers. So, we are in the middle of a very difficult inflation environment.

Western Asset’s view is the inflation's going to moderate. I think we are in the peak of that inflation right now. And I think the outlook over the next six to 12 months is for a moderation in inflation. And, as we've thought about this question, you have to start with a degree of kind of humility about the uncertainty related to COVID.

You know, COVID has contributed a lot to how we've gotten here, the disruptions to supply chains, the shift in of the supply curve, especially in the auto sector, which has driven up car prices, labor supply. All of that is COVID related. And if you think out six to 12 months, big questions about what happens to COVID and where do we go? And so, I think that I just want to note that degree of humility, with regard to the uncertainty.

That said, what do you do? What do you do as an investor with that type of uncertainty? And, I do think that the way forward is to return to your basic economic models, what drives inflation, and try and build a view, again, from, kind of, the basic supply and demand.

So, here's how I'd think about that. The basic inflation model has three components: it's got a supply shock component, it's got a demand component, and it's got an expectations component. And, as you work through each of those three components, I think, on each one of them, the outlook is for moderations.

First, on supply. There's no question that the supply constraints are more significant than most people expected. That's driven up prices, but this is one of the things that's most reliable, empirically, in the historical record which is supply shocks lead to very sharp increases in inflation, followed by sharp decreases in inflation. You know, you look at say a ‘73 to ‘74, kind of your classic supply shock that was on the energy side, very sharp inflation throughout that period. But then, starting in ‘75, inflation fell, and inflation fell sharply as that supply shock, you know, moved further into the past. And so, again, there are supply constraints today that's driving up prices, but one of the most reliable, patterns in the inflation data is that supply shocks have another side. There's another side to that price mountain, if you will. So that's point one.

Point two is demand. And, I think this is the one component that would generate ongoing inflation pressures. If you have demand above potential creating an excess of activity, which then drives up prices for inputs. And here, I think there's reasons to be cautious. You know, we had very strong demand in 2021, but a lot of that was 2021 related. It was related to the reopening. It was related to the fiscal stimulus. And as we get further away from both of those, I think the arguments for continued demand at 2021 levels become increasingly challenged. And I think demand is actually, you know, potentially weakening now, but certainly going to weaken as we go through the year.

Final point is on inflation expectations. If you've got into an environment where expectations are for higher inflation and maybe the Fed’s [US Federal Reserve] irresponsible, that creates a little bit of a self-fulfilling process where people expect higher prices and so they raise prices. I would actually interpret the inflation expectations perhaps a little bit differently than what you suggested in that I think they're pretty stable. You know, five-year, five-year inflation, relatively stable. University of Michigan Consumer Surveys, very high on the one-year number, longer-term, very stable. And, I think there's going to be a real tendency to, once we get through the pandemic, for people to move on, you know, you don't extrapolate what happened during the pandemic to the post-pandemic environment. On a lot of dimensions, I think inflation can be no different.

Sonal Desai: Actually, John, I agree with so much of what you said, and I think it's really a question of degrees that we're talking here because I do think there will be moderation. There's no doubt. We aren't going to be sitting on 7-7.5% inflation. Clearly, that's not going to happen.

But, if I were to take your three points, one by one, on the supply-side, one of the concerns that I do have is that, in fact, some issues such as the chip shortages, they may have more legs. And essentially, what you would see is that those chip shortages have some more structural elements going on. We know that Intel is going to make a new factory. All these things are true, but that just means that it may take longer than mid-year. So, first of all, it's not that I think that supply shortages are here forever. It's just that it's not clear to me that they will wind out already in mid-year.

The second issue on demand, I think the one caveat I would have, and certainly we're not going to see a fiscal spend this year like we did last year, so that fiscal demand goes away, but we still got around, you know, at last count $2.7-2.8 trillion in household savings and households are running them down. And so, I'd have some concern that demand continues to be supported from that aspect of the considerations.

And the last point, on inflation expectations, again, I do agree with you. There's a lot of stability in the longer-term expectations. But simultaneously, as we get to February of this year, I think on my calculations, we would've probably had inflation above 5% for almost a year. As we get to the middle of the year, inflation would've been probably quite substantially above that sub 2% level we've seen for decades for over a year on current tracks. And, I think that that in turn leads to demands for higher wages, and we might be in a situation where we're encountering a combination of relatively strong demand because of that healthy consumer, low debt, solid consumer balance sheet, strong savings, together with supply restrictions coming both from labor and from goods. So, you're seeing a combination of factors there.

So, I think those are the issues which give me some pause about the general consensus that second half of the year inflation will drop off very sharply. Base effect, absolutely, but I think some of the other factors might keep inflation higher for a bit longer.

Stephen Dover: John, why don't you respond to that? But particularly, could you talk a little bit about labor and how that fits into your, sort of, three-prong model?

John Bellows: There's certainly question on timing. And you know, you get things like Omicron and shutdowns because of zero-COVID policies in China that could delay it.

I do think there are arguments for a faster normalization than you might expect. And so, let's just do the chips and supply-side and chips because Sonal mentioned that. I think one of the features of 2021 is that a lot of people worried about their chip supply. And so, they over ordered, you know, they all said, “Well, I don't have enough chips and so I'm going to order, you know, twice as much as I need, so I don't get in the situation again.” And so, you saw just a very big increase in orders. And so, that's what's created these, kind of, back logs.

Well, at some point, those orders get filled and it's very possible that, you know, quicker than you might think, that people have too much chips because they over ordered. I think that that phenomenon could be happening in a lot of places. You might see that in—and I'll do labor more in a second—but, you might see that in the labor market, as well.

You know, you have record job openings right now. That's certainly been a decent measure of wage gains to date. But, it's not clear to me that, you know, people aren't just putting up job openings because they realize the labor market's tight and once labor market loosens up, you know, those job openings start to go away a little bit.

So, I do think there's been a little bit of, kind of, front loading the ordering, some restocking, some inventory rebuild and once that's filled, you know, that could turn around. So, I think there's a lot of uncertainty on the timing. And, I think Sonal’s points there are well taken. But, I do think there are arguments for why this could correct actually sooner than you think.

In terms of the labor market, what I would say on the labor market is I think that's another one of the COVID impacts that surprised people, certainly surprised us, just how constrained the supply in the labor market has been. When you look at the kind of rough statistics, it's striking that real GDP levels are back to pre-trend levels. And yet, the number of jobs in the labor market is 5% below where it was, you know, on kind of a trend basis. It's a very remarkable discrepancy that real GDP back to pre-trend and have a labor market 5% below where it was pre-trend on a jobs basis. Remarkable in terms of that divergence.

What's even more remarkable, though, is to have that divergence and to have what looked like tight labor markets. So, how can that be? How can you have the number of jobs be 5% below where it was on a trend basis and yet, tight labor markets. The only way you can kind of square that is if you have constrained labor supply. And again, I think that's one of been one of the impacts of COVID is that constrain on labor supply.

So, what do we think about that going forward? You know, I think there's very good reasons to be optimistic on labor supply as we move forward. The historic experience is pretty clear that tight labor markets eventually increase participation. You saw this very clearly in say ‘18 to ’19. You know, we had a tight labor market in ’18 and participation increased in ‘19. So, I do think that's going to happen. I think that's probably a long, multiple quarter process, rather than a, you know, multiple month process.

But, it could be a multiple month process. It could happen faster. And the reason it could happen faster is the degree it's related to COVID, to the degree it's related to that extraordinary fiscal stimulus last year, both those things moving behind us, you could actually see a faster snap back. So, I guess my main response here is that Sonal is right to say the timing's questionable. You know, it could be multiple quarters, rather than something short. But I think there's a chance that it's actually faster than that.

Stephen Dover: Sonal, when you look at inflation, and John's talking about timing, we're talking about inflation being high and then sort of when it might moderate, but I'm wondering your views on looking at inflation over, say a five- or 10-year period. You know, the TIPS [Treasury Inflation-Protected Securities] aren't looking at extraordinary inflation, you know, depending on whether it's five- or 10-years, it's something around 3% or 2.5%. Do you think that, again, the market is under-anticipating what long-run inflation might be? Or do you think that's about right?

Sonal Desai: So, you know, that's a really interesting question, Stephen, because I think on the five-year, 10-year horizon, there are a couple of points I would make. One is in a matter of two years, the Fed doubled its already enormous balance sheet to its current, close to $9 trillion, which is where we're sitting, yeah? We went from, I think it was around 4.5, 4.2, to 9 trillion, 8.75, whatever, that, that level. And, we've seen this repeated around the world. So, we are looking at a massive monetary overhang. Simultaneously, you had an explosion of government debt. That also is so something which is well recognized. Over a five- to 10-year period, I think we will face a little bit of a reckoning as some of this comes in. What could make the market wrong in being sanguine? Well, one of the things to me is if the Fed, at this stage, actually reacts quite strongly. Not on the interest rate-front alone, but on QT [Quantitative Tightening] or tightening.

Now the words have started coming out. The verbiage has started coming out because I think the Fed finds itself in a very different situation. Apropos 2018, 2019, when we were talking about the labor market, the Fed situation is a little different, as well, where the market overestimated what the Fed's tightening cycle would look like. And in fact, the Fed underdelivered, and this has happened several times. Big difference between 2018 and now, of course, is 7% inflation versus less than 2% inflation. I think the Fed's degree of flexibility has gone down. I think that inflation has become one of the only, perhaps, bipartisan issues out there, in the sense that both, everyone in Congress, would like to get inflation under control. So thus, the Fed has, in fact, a mandate to try and control it.

So, if the Fed were to, in fact, move in the direction of quantitative tightening sooner and perhaps a bit more aggressively, certainly, than is currently being priced in the market, that in turn means maybe five years down the road, you're not going to get as much inflation. On the other hand, if the Fed takes a gradualist approach as it has done for most of the last 10 years, I think potentially you do get longer-term inflation because at some stage you need pull some of the stimulus back and there's been a lot of it. A lot of it on both sides. And yes, does that mean that growth ultimately starts slowing? Probably. Maybe that's needed, but that's probably a quite different view I think, than John has in terms of what medium-term issues are.

Stephen Dover: Yeah. John, let's jump to you on, kind of, your five- and 10-year view of inflation, what things look like over the longer term.

John Bellows: So, I'll start by saying Sonal is right. We do have a different view on that. Let me just, kind of, walk through it. You know, the first thing I'll say, and this comes back to an earlier observation that Sonal made about the excess savings is, you know, a big feature of the expanded federal debt, and kind of a counterpart of that, was the Federal balance sheet was the direct transfers made to households in 2020-2021. And, Sonal suggests that those transfers have not been spent, but they will be spent in the future. I'm not at all sure those transfers will be spent in the future. I think that, you know, I'd, kind of, offer two arguments.

I think the first argument, if you go back to, kind of, your standard economics 101, Milton Freeman's permanent income hypothesis suggests that a onetime transfer, only a small fraction of that will be spent, what gets spent are the ongoing stuff. So, if you told me that I'm going to get those transfers every year for the rest of my life, I'm going to spend it. But instead, if you tell me this is a one-time transfer, you're never getting this again, permanent income hypothesis, you only spend a small fraction of that.

I think the other, kind of, observation I would make, and everybody who works in, you know, the investment industry is aware of that, is that prior to the pandemic, Americans on aggregate were under-saved relative to where they needed to be. They were under-saved relative to their retirement goals. Certainly, under-saved relative to their needs. And so, if what happened is that during those 2021 and 2020 checks, kind of, caught them up a little bit, well, it doesn't make sense they would then turn around and spend it the next year. Instead, that's just catching them up a little bit in terms of their savings. And, it's entirely possible that they're going to react to that by saving that windfall, rather than spending it.

So, you know, what I'm doing here is I'm going to try and walk through the places where we're a little bit different than Sonal, in terms of the long-term and that's where I'd start. I think a big impact in terms of both the Fed balance sheet and the Federal Government debt was in these transfers. It's not at all obvious those are going to get spent. Those could be saved, and we just move on.

The other two points that I would make have to do with, kind of, that medium-term outlook, and they have to do with, kind of, policy stance. And so, if you go back to, say, March of last year, you know, one of the real fears for some in bond market in March of last year is that the new Democratic government meant a permanent shift in terms of fiscal spending, , much higher deficits, and people were extrapolating forward and saying, “The Democrats are just going to, you know, spend a lot going forward.”

You know, a year later, boy, we've really done a 180 on that. You know, Democrats, not only did they not, you know, kind of spend as much as they wanted, they're struggling to even get anything done, in terms of their Build Back Better. And, you know, the, kind of, just looking at the betting markets, it looks like the house is going to flip in this year, which would mean, you know, absolutely nothing after that. So, I just want to highlight, this is an absolute 180 from where we were last year. Last year at this time, there was a reasonable prospect that we had seen a permanent shift in the stance of fiscal policy and, you know, reasonable people could extrapolate that into higher inflation and ongoing basis. 180, though, in the reality today means that fiscal policy doesn't look that different than it did in say 2010 when we had split Congress and nothing additional got done and we all know, kind of, what that looked like in 2010 to 2018. So, 2016, I should say. So, that's, kind of, point one.

And then, on monetary policy, you know, here, as well, I think last year, you know, people were thinking the Fed had a new framework that made them much different than they had been in the past. The Fed was going to get behind the curve. And so, you know, you could kind of bump up your inflation expectations accordingly. What the Fed has done the last quarter, you know, it doesn't look all that different than what the Fed had done, you know, previously. They've responded to inflation, we've gotten more inflation, they've accelerated their taper. They've pulled up rate hikes, they're talking very hawkishly. The Fed just doesn't look all that different than what you might have thought.

So, you know, as you think forward on that five-year horizon, I don't think policies could look that different than it did pre-crisis: constrained fiscal policy and a Fed that's responsible.

Let me try and sneak in one more point, if I could, on that, kind of, 5-, 10-, 10-year horizon, which is, don't forget about all those secular headwinds to inflation that we were struggling with prior to the pandemic. You know, demographics, technology going up, which means lower inflation, debt levels are very high, which constrain investment and spending. You know, none of those have really been addressed in a sustainable way. And, I think it's entirely possible that a year or two years from now the pandemics behind us and we're kind of grappling with those secular headwinds again.

Sonal Desai: So, John, you've got to let me respond to that. Sorry, Stephen.

So, I agree with a couple of your points and I disagree with another couple.

On the savings rate, I'd say, we we're already seeing some of those savings being spent, right? So, we've gone from over $3 trillion to around $2.7 trillion. So, they are being spent. So, I think the jury's out, I don't think they will all be spent, but they certainly have been a part of the cushion, which has allowed people probably to step out of the labor market.

I actually think, separately, that inflation might be one of the things which drives people back into the labor market, because those savings will not go as far as, perhaps, they would've liked them to go. I think that I would agree with you on. Again, it's a question of timing. I think Goldman's, for example, estimates it'll be almost the middle of 2023, or sometime later than that, before those savings actually would get used if they were spent down at their current rate of spending.

The second one, I think your second point was on fiscal policy. I totally agree that, you know, I'd say that there are two things. One is, last year, absolutely, we did get the $1.2 trillion in the infrastructure package, but I completely agree that Congress is heading towards gridlock probably and in gridlock, very little gets done on fiscal. So, I would agree that there wouldn't be an ongoing fiscal pressure coming from this point onwards. Certainly not the scale we've seen so far.

On the Fed, I would say that the Fed can't get behind the curve. It is behind the curve. Otherwise, we wouldn't see inflation being where it is right now. And now, I think they're speeding up to get back towards the curve, but that's a difference of opinion. And quite a, as you know, I've been a Fed skeptic and a Fed critic for a while now.

And, I think your last point was demographics. And here, I would say, I would note one thing. I see those secular forces, but increasingly there's academic literature, as well, which talks about the different possibilities which come from these demographic forces, including a smaller workforce implying increasing inflation, not decreasing inflation. In the case of China, for example. So far that depressing impact of demographics has been seen in Japan, and only in Japan, in the sense of deflationary impact. And in Japan's case, there were several simultaneous things which happened. I'm not arguing that this is clear because demographics, of course, we all know, plays out in the long, long run. But there, I'm just not sure. I don't know how those demographic arguments will play out over that 10-year horizon.

Stephen Dover: John, you started out by just talking about humility in the portfolio. And I wonder how that also impacts the way you think. And, if you were certain, you might make stronger decisions, but if you have a certain degree of uncertainty, you might make different decisions. So, given that, where do you see opportunities now?

John Bellows: Thanks for reminding me of the humility point. I'm always happy to be reminded of the importance of humility. Look, I think the answer is, you know, what do you do with that from a portfolio perspective is you diversify, you make sure that you have diversification in your portfolio because that is how you deal with uncertainty. And I think that the kind of long history of both markets and financial thought has born out that diversified portfolios do better than portfolios with just smaller positions.

It's important to emphasize that fixed income portfolios have a lot of sources of excess returns. I think that the moderation inflation that we're talking about, not a collapse in growth, but just less, a little bit less growth, actually ends up being fairly favorable for other spread sectors. I think I would go further than that and say, not only is that favorable to spread sectors, but there's some areas where as value investors, we actually think that, you know, prices give you a little bit of cushion themselves because they're already quite low, emerging markets being the number one place on that.

Stephen Dover: Sonal, I'm sure you agree with diversification in the portfolio, but where do you see opportunities? 

Sonal Desai: We particularly like sectors which stand to benefit from the rate environment that we think is going to be… and so, for example, the floating rate space, we like some of the spread sectors such as high yield in a very careful way, precisely because they are somewhat shorter in duration, but continue to yield a little bit of income. Of course, that does give you risk and we need to balance that using other techniques. But emerging markets, absolutely. So, it's very strange—we've got very different economic views, but it is nice to be able to agree on what good management of the portfolio would look like.

Stephen Dover: Well, thank you, Sonal. Thank you, John. And, thank you for the debate.  

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