Quick Thoughts: The Inflation Debate
Disagreements about the outlook for inflation in the new year and beyond continue. Stephen Dover, Head of the Franklin Templeton Investment Institute, recently led a lively debate on the topic with Western Asset’s John Bellows and Franklin Templeton Fixed Income’s Sonal Desai.
As the late German Economist Karl Otto Pöhl once said, “inflation is like toothpaste, once it’s out, you can hardly get it back in again.” Ironically, consumers’ and business’ expectations of higher future inflation can lead to…. higher future inflation.
At this time last year, the markets were more concerned about slowing economic growth than inflation. The prevailing view was that inflation was a “transitory” consequence of post-lockdown reopening. To the surprise of even the Federal Reserve (Fed), elevated inflation has had staying power, whether caused by pandemic-driven supply-chain issues, or expansive monetary and fiscal policies. Whether inflation will continue at above-trend levels or be more transitory is still hotly debated by economists, including across Franklin Templeton’s independent investment groups.
I recently spoke with Franklin Templeton Fixed Income Chief Investment Officer Sonal Desai, who last year predicted that inflation would be higher than consensus, and Western Asset Portfolio Manager John Bellows, who is more in the transitory inflation camp, about their views on inflation. Here are some highlights.
- Sonal thinks the market is still being somewhat sanguine about the second half of this year and that inflation may remain elevated above consensus expectations. Market expectations are quite distinct from broader survey-based expectations, with households and businesses being far more concerned about high inflation than the market (or the Fed). The futures market has priced in that inflation will drop very sharply in the second half of 2022, but Sonal thinks that may be too optimistic as several factors driving higher inflation remain, and the magnitude of the Fed’s intervention may be distorting markets. While she does not foresee the 7%+ inflation year-on-year levels of this past month, she does think that some of the supply-and-demand issues may take longer to mitigate.
- John has a different view. He thinks inflation will moderate in the next six to 12 months and may even end up below consensus expectations over the next three to five years. Supply constraints may be more significant than most expected, but historically, supply shocks have led to supply increases that allow inflation to subside quickly. Demand for goods has been higher than pre-COVID levels and may wane as the effects of the pandemic recede. John points out that business and consumers may have overordered due to concerns of lack of supply, and this will likely be resolved as more supply comes on board. He also thinks that monetary and fiscal policies in the United States going forward are likely to reduce inflation levels. In particular, after being very stimulative in 2021, fiscal policy will likely turn into a headwind in 2022 and beyond. As for the Fed, removing accommodation in response to higher inflation will help to anchor expectations.
- Sonal believes that the massive monetary overhang from the dramatic expansion of central bank balance sheets and explosion of government debt will continue to put pressure on inflation dynamics. If the Fed were to move in the direction of tightening policy sooner and more aggressively than priced into the market, then inflation may be less of an issue five years down the road. However, if the Fed takes a gradualist approach as it has for most of the last 10 years, this creates the potential for longer-term inflation because inflation expectations of consumers and producers—which have already become unanchored—will rise even further and influence both wage-setting and price-setting behavior. Overall, Sonal thinks the Fed finds itself in a very different situation than it has in the past: when inflation was stable below 2%, the Fed could prioritize supporting asset prices and financial markets; with inflation now at 7% the political pressure to get it under control is much stronger.
- John’s thought is that the Fed’s response has demonstrated it takes inflation seriously, which could prevent that spiral of inflation expectations from feeding more inflation. Pre-pandemic secular trends—like technology and demographics—that had constrained inflation will likely reassert themselves. Both John and Sonal agree US interest rates will rise, but there’s uncertainty around the pace and whether the increases are already priced into the market.
- Of particular note are their perspectives on two key issues: what happens to the excess savings that have built up during the pandemic, and how demographics plays into long-term inflation expectations.
- John’s thought, based on one economic theory, is that historically when people are given one-time windfalls, they have saved them. Considering personal savings were already at low levels, he does not think this money would be spent, but would give consumers an opportunity to catch up on their longer-term savings goals. Sonal’s take is that we are already seeing consumers draw down excess savings, which remain largely liquid and available for households to spend, and this continued unwinding would be a tailwind for demand for at least the next several quarters.
- John also points out that an aging US population would likely keep inflation muted over the long term, as has been seen in Japan. However, Sonal points out the case is not so clear-cut and that the experience in China and recent academic studies have shown that inflation actually increases as a population gets older and the workforce becomes smaller; the aging of the population stimulates demand more than supply.
- With all this in mind, Sonal is continuing to position toward shorter duration and sectors that stand to benefit from the rate environment within portfolios, while John is focused on a bottom-up approach and diversification across the credit spectrum.