UE-EN Institutional

Inflation: Much discussed but rarely witnessed

Alongside the prospect for a strong economic recovery, a growing debate has sprung up around the path of inflation and whether it could derail growth.
February 2021


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With vaccine rollouts gaining momentum, consumers ready to spend historically high savings and ample fiscal stimulus to start off the year, we remain optimistic that we are set to see high levels of economic growth in 2021. Alongside the prospect for a strong economic recovery, a growing debate has sprung up around the path of inflation and whether it could derail growth.

Some have questioned whether higher inflation could prompt the Federal Reserve (Fed) to withdraw monetary stimulus by tapering asset purchases or even raising interest rates. The higher rates and bond yields that would coincide with a contractionary policy could potentially make equity markets less attractive to investors. This inflation anxiety has begun to creep into markets as rates and measures of inflation expectations have marched higher over the last few months, though it has yet to create a material headwind for equity markets.

In the near term, base effects should mechanically boost measured inflation as prices in March and April 2021 will be compared to the very low price levels of inflation seen in March and April of last year. We anticipate a modest increase in inflation as the economy begins to accelerate and consumers spend more freely.

Though inflation will likely rise, Fed Chairman Jerome Powell recently noted that substantial inflation past the central bank’s 2% target for a sustained period would be required before the Fed will make any adjustments to its accommodative polices. This dovish rhetoric aligns with the framework review released last year, in which the Fed formalized their approach for a symmetrical 2% inflation target and indicated they would be comfortable with >2% inflation given the historically low inflation seen in the past several years. In addition, the Fed expects rates to remain at near-zero through 2023. In reference to suggestions that the Fed may consider trimming down its bond purchasing program, Powell underscored, “Now is not the time to be talking about it,” adding “the economy is far from our goals…and we are strongly committed to using our monetary policy tools until the job is well and truly done.”

Inflation hawks point to rapidly increasing demand

Some argue that inflation will increase more rapidly and settle at a higher level than consensus expectations. First, strong monetary and fiscal policy support means the harm to the private sector has been much less severe than the Great Recession. U.S. household net worth has increased by $5.2 trillion since the end of 2019, and U.S. households currently hold $1.4 trillion in excess savings. These excess savings may cause a rapid rebound in demand as soon as economies reopen more fully. We also expect Congress and the Biden administration to use fiscal policy more actively via another stimulus package and potentially a new infrastructure package. These possibilities have elevated concerns that a sharp bounce in consumer and business demand could cause inflation to pick up faster and sooner than the market expects.

The labor market will remain a disinflationary force

While a spike in consumption provides an inflationary force, we believe the labor market slack should be firmly disinflationary. Levels of unemployment have dramatically declined since spiking in March, but there is still much work to be done before numbers return to the level seen at the start of 2020. Many businesses have closed or restructured, resulting in high levels of permanent job losses. In addition, it is expected that the Fed aims to achieve maximum employment before tightening policy as a result of elevated inflation. While the headline unemployment rate remains a concern, just as worrisome is a slowdown in the labor market healing at the end of 2020. According to the U.S. Bureau of Labor Statistics, the U.S. rate of unemployment declined dramatically from its peak level of 14.8% in March to 6.9% in October. However, it leveled out at 6.7% in the remaining months of 2020, signaling a stall in the decline in unemployment.
Inflation spotlight
Source: U.S. Bureau of Labor Statistics
While the labor market may take years to return to the 3.5% pre-pandemic unemployment rate, recapturing this level may not even translate into meaningful inflation (after all, it didn’t before). The Fed has adjusted its estimate for the non-accelerating inflation rate of unemployment (NAIRU) over the years, lowering it each time the unemployment rate breached their level and inflation did not materialize. This inability to predict inflation based solely upon the unemployment rate either means the economy has never reached NAIRU and/or there are other disinflationary forces at work. We believe both factors are in play and the Fed seems to agree with that conclusion. Therefore, rate hikes are unlikely until the Fed is confident that longer-term inflation dynamics have shifted up and they have confirmation that the economy and labor market have truly reached peak capacity.

Disparity in services versus consumer goods

The restrictions and lockdowns put in place in 2020 delivered unprecedented devastation to levels of output within service sectors, leading to services price inflation falling to a record low. While the consumer goods sector was also hit as a result of the pandemic, global core goods inflation has essentially seen a V-shaped recovery since the spring of 2020. This divergence has highlighted a distinct disparity between the consumer goods and service sectors, with services lagging significantly behind. It will likely be some time until we see the service sectors catch up and we do not expect a rapid rise in inflation until there is improvement in this area. While there may be pockets of near-term inflation from service sectors that have slashed capacity — travel and leisure come to mind — we do not see that materializing into longer-term inflation.

Lingering risks to a full economic recovery

There are risks to the anticipated economic recovery that we have yet to see play out. As of now, business restrictions and lockdowns are still in place across several regions in the U.S. and around the world. The recovery of the U.S. and the global economy in 2021 is in large part dependent on vaccine deployment or herd immunity combating the level of cases, hospitalizations and deaths to a point where restrictions are eased and things are back to normal. Until we see this fully play out, and see the projected economic boom unfold, we do not view inflation as a significant concern in the near term.

Inflation is a risk but not enough to derail markets

Inflation is certainly a factor for investors to keep in mind in 2021 and to follow more closely into 2022. A modest pickup in inflation should not be of great concern for policymakers nor prompt them to remove their accommodative policies. Additionally, inflation hasn’t historically been an issue for equities until it reaches above 3%–3.5%. We ultimately anticipate continued accommodation from policymakers and a modest rise in inflation within central bank tolerances to accompany the expected economic growth and recovery projected for second half of 2021. For these reasons, we remain constructive on equity markets and neutral duration.

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This is not intended to serve as a complete analysis of every material fact regarding any company, industry or security. The opinions expressed here reflect our judgment at this date and are subject to change. Information has been obtained from sources we consider to be reliable, but we cannot guarantee the accuracy. This presentation may contain forward-looking statements. “Forward-looking statements,” can be identified by the use of forward-looking terminology such as “may”, “should”, “expect”, “anticipate”, “outlook”, “project”, “estimate”, “intend”, “continue” or “believe” or the negatives thereof, or variations thereon, or other comparable terminology. Investors are cautioned not to place undue reliance on such statements, as actual results could differ materially due to various risks and uncertainties. This publication is prepared for general information only. This material does not constitute investment, tax or legal advice to any party and is not intended as an endorsement of any specific investment. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investment involves risk. Market conditions and trends will fluctuate. The value of an investment as well as income associated with investments may rise or fall. Accordingly, investors may receive back less than originally invested.

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