Raghuram Rajan: Inflation, Higher Rates and Slower Growth to Come
Plan for long-term Inflation that will be fought aggressively by the Fed, higher policy rates, and slower economic growth, according to Raghuram Rajan.
Rajan is a professor of finance at Chicago Booth. He was a governor of the Reserve Bank of India between September 2013 and September 2016. Between 2003 and 2006, he was the chief economist and director of research at the International Monetary Fund. He delivered a keynote presentation at the Morningstar Investment Conference in Chicago on May 16.
His presentation covered the near-term outlook and the bigger picture changes that will affect investing.
The economic outlook is affected by the pandemic and the fiscal response to it, both in the U.S. and globally, as well as the war in Ukraine and concerns around Fed policy. China’s response to the pandemic is troubling, Rajan said, especially its low rate of vaccination. About 25% of China’s economic activity is now reduced by lockdowns, which has carry-on impacts globally.
The pandemic caused Americans to spend on replacement goods (like Pelotons and food deliveries) and increased demand tremendously. This was amplified by fiscal stimulus that went to consumers. Global supply chains were hit by lockdowns, most recently in Taiwan and China. Labor supply tightened. Typically, he said, in a recession, the labor participation goes up; but for the first, time, it fell at the outset of the pandemic recessions. That was from fear of the virus and the need to stay at home for childcare, according to Rajan.
Labor participation is back, he said, except for those age 55 and older. But there is still unemployment, and the jobs available are not proportional to workers that are available.
Immigration has historically been a supply of low-wage workers, but it has slowed. The number of job openings relative to those unemployed is at an all-time high of 1.9. This is driving up wages, and costs are being passed on to consumers.
Inflation is spreading in both goods and services, Rajan said, which is the greatest fear for central bankers. Workers will demand raises to keep pace with the 8.3% inflation, and that will lead to a wage-price spiral.
Until late last year, the Fed thought inflation would end. Now, however, central bankers are worried about embedded inflation expectations and a wage-price spiral.
Rajan said those fears are justified. There are enough forces embedded in the economy that will show up in inflation over time, like rising rental prices.
The Fed was held back from acting sooner, he said, because it had adopted a new framework that required it to judge that inflation would be sustained before acting. Previously, it could act as soon as inflation was evident. Now it is no longer bound to act preemptively. That framework was because of fears of too little inflation and the need to drive inflation higher.
“Now we are stuck in a world with the wrong framework for the problem we have,” Rajan said.
Politics held the Fed back, he said. “We had the best recovery $6 trillion could buy. The Fed waited before killing that growth to give it the political room to tackle it.”
The financial markets have expected the Fed to rescue them, Rajan said. The Fed did not want the markets to collapse, only "to let the air out slowly.
The Fed is raising short-term rates and contracting its balance sheet, and that will cause long-term rates to rise, which is already happing – mortgage rates are already above 5%. Given the disruption we are seeing in supply chains, Rajan said, the Fed will not stop at 2.5 to 3%; it will go higher.
By the end of the year, the Fed funds rate will be 2.5 to 3%, giving the Fed time to decide how much further to go.
“The Fed will do what it takes,” he said. “If that means going higher, it will.”
In the best-case scenario, the Fed will raise rates a bit, the economy will slow a bit, labor markets will loosen, inflation will come down rapidly and the economy will take off from there. But Rajan said that “soft landing” scenario has less than a 50% probability.
More likely, he said, there will be more tightening and slower growth.
Typically, the Fed raises rates about 1% above inflation and stays there for a while, he said, and there is an economic contraction. “But this is not a typical situation.”
When the Fed wins its fight against inflation, he hopes that growth will be driven by productivity. But over the last 20 years, productivity growth has not been strong by conventional measures, and it is unlikely to improve post-pandemic. Our population is aging, he said, and more people are retiring, shrinking the population – except for immigration.
That foretells slower growth, which means lower real and nominal interest rates.
The real rate for the 10-year is about zero, he said, which is consistent with his long-term forecast of slower growth.
The long-term outlook
Rajan explored three areas that will be key to longer term growth: de-globalization, technological change and climate change.
De-globalization drove growth prior to the pandemic, he said, but will this continue? Rajan fears that certain countries will become uninvestable, because they have the wrong ideology (like Russia) or are located too remotely.
De-globalization is a concern primarily with respect to China. Once COVID was under control, China tried to reform its economy. The problem is that they are too dependent on the global economy and focused on increasing domestic consumption. But changing that is easier said than done, according to Rajan.
China has kept wages low to support industries. Reversing that will inhibit competitiveness. It is switching its strategy to leverage intellectual capital, but the sectors China wanted to push (e.g., drones, chips and artificial intelligence) have consumer and military uses. The U.S. reacted by cutting off China’s access to our technology out of fears that China would benefit militarily.
China also grew though its property sector, but it now has excess supply. It also acted against the private sector, targeting individuals like Jack Ma. The result is that there is growing uncertainty over which industries or sectors will thrive.
“Friend-shoring” – outsourcing manufacturing to friendly countries – may grow, Rajan said, and the tensions between the U.S. and China need to be reversed. But given the rivalry between the two countries, problems “will go on longer than we think,” he said.
Technological change can be good or bad. In industrial economies, the bad side has been the loss of middle-class jobs. For example, accountants are replaced by high-school graduates who are proficient with TurboTax. As a result, communities in manufacturing cities have high unemployment, social breakdowns and crime. Those communities deteriorate and lose population, he said, which causes political fracture. The issues in the recent presidential election in France were driven by this trend, Rajan said.
But technology can spread jobs, as it did in the work-from-home economy during the pandemic. One study found that hybrid workers, especially women, will sacrifice 5% of their salary to work from home, he said. That spreads good jobs to disadvantaged communities. It has contributed to home values shooting up in the “ex-burbs,” he said.
There is a concern about company culture eroding, and whether remote workers will be responsible enough to work independently on a permanent basis.
Technology can create new industries, like reducing transaction costs and increasing inclusion. This is the hope for cryptocurrencies, he said, although they are still “speculative assets,” and most will disappear over time.
Climate catastrophes are multiplying and are all tied to climate change, Rajan said. Governments agree on what needs to be done, but not on how to act. Some countries will be severely stressed, particularly near the Equator. There will be big waves of immigration, he said, as there have been in the past in times of regional famines.
Regulators and shareholders will want action. Advisors will need to ask whether there are industries or geographies that are more immune to climate change, and how they can invest and “do good.”
ESG was a good idea, he said, but eventually the premium disappeared as prices were driven up. “It will be harder and harder to do well through investments,” he said. “Simply investing in companies that claim they do ESG well will not be enough. The easy money has already been made.”
Robert Huebscher is the founder and CEO of Advisor Perspectives.