Listen: When the COVID-19 pandemic hit in full force in the US, the government had to act quickly to keep the economy afloat. One major thing that the Federal Reserve did was lower interest rates to zero. That helped money keep flowing and borrowing rates low on things like mortgages, cars, and other things Americans needed. The danger in juicing the economy this way, however, is that inflation could go up, and higher consumer prices could end up hurting our wallets. How does the government strike the right balance? In this episode, we'll hear more about the US recovery, the international picture, and what could come next.
The latest episode of Living Beyond Borders, a special podcast series from GZERO brought to you by Citi Private Bank, explores those themes in detail with some top experts in finance and geopolitics. Moderated by Caitlin Dean, Head of the Geostrategy Practice at Eurasia Group, this episode features Robert Kahn, Director, Global Strategy and Global Macro at Eurasia Group; David Bailin, Chief Investment Officer and Global Head of Investments, Citi Global Wealth; and Steven Wieting, Chief Investment Strategist and Chief Economist, Citi Global Wealth.
David Bailin
Chief Investment Officer and Global Head of Investments, Citi Global Wealth
Steven Wieting
Chief Investment Strategist and Chief Economist, Citi Global Wealth
Robert Kahn
Director, Global Strategy and Global Macro, Eurasia Group
Caitlin Dean
Practice Head, Geostrategy, Eurasia Group
Transcript: Season 2 Episode 2: Inflation, interest rates, and economic recovery
Steven Wieting : So it was a very interesting situation to really call that out, that inflation was a problem for Congress now for really the most profound way that we've seen in 40 years.
David Bailin: And the problem of course is that in order to control inflation, one would typically raise rates, and in order to keep the economy running at a very hot speed, you would want to keep rates low. And that's the inherent contradiction.”
Caitlin Dean:Welcome to Living Beyond Borders, the podcast from Citi Private Bank and GZERO Media that examines the risks and opportunities in our rapidly changing world—from global politics to economics—and what it all means for you.
I’m Caitlin Dean, Head of the Geostrategy Practice at Eurasia Group.
It seems like not that long ago when there were hundreds of thousands people in the U.S. -a and other countries - combing through supermarket and drugstore aisles, desperately in search of something we all need – that had suddenly become scarce.
[NEWS CLIP: With shelves stripped bare as Australians prepare for a pandemic take a look at this we went out to take a look for ourselves yesterday and there wasn’t a toilet paper roll in sight.
NEWS CLIP: With toilet paper sales up more than 100 percent from this time last year.
NEWS CLIP: As coronavirus spreads, people across the country are stocking up on essentials. And one essential in particular: toilet paper. It’s sold out in stores around the world and has become the ultimate symbol of panic buying.]
The shortage of toilet paper in spring 2020 was big news, but it was just one small way that the global Covid-19 pandemic upended our daily lives. More than 22 million jobs were lost in the U.S. in the first two months of the Covid-19 crisis – and the unemployment rate at one point hit a post-war peak of nearly 15 percent.
The government needed to act...quickly. And one of the biggest tools that the Federal Reserve had in its toolkit is adjusting interest rates. They announced on March 15th 2020 that they had cut their target interest rate to zero.
Now, much of that so-called “Easy Money” has done its job – keeping cash and credit circulating through the economy while jobs recovered. And though the pandemic is not over – the easy money could be.
To talk more about what that means for the U.S., the world, and for investors, we’re joined now by three leading experts.
David Bailin, Chief Investment Officer and Global Head of Investments at Citi Global Wealth – great to have you back, David.
David Bailin:Hey, Caitlin. Thank you.
Caitlin Dean: Steven Wieting, Chief Investment Strategist and Chief Economist at Citi Global Wealth. Hello Steven.
Steven Wieting:Hi. Thank you, Caitlin.
Caitlin Dean: And we also have Rob Kahn, practice head of Geoeconomics at Eurasia Group – welcome Rob.
Rob Kahn:Hi, Caitlin. It's great to be here.
Caitlin Dean:All right, so let's just level set to start, David. What do we mean when we say a period of free money?
David Bailin:Well, it's not actually free, it's just extremely inexpensive. And what's going on right now really began in the response to the pandemic in 2020, when the Federal Reserve took the actual cost of capital down to zero, created a series of programs to allow access to the capital markets to ensure that they were functioning, and then subsequently the government took monetary actions to actually support the economy actively by actually printing money. And so the combination of policies to create incentives for people to borrow sufficient capital to get over the crisis, and of course dropping interest rates to zero, are all designed to flush the system with liquidity so that we could survive through the pandemic period.
Caitlin Dean:And at a basic level, remind our listeners what low interest rates mean for average people. How does it affect their daily lives?
David Bailin:Well, let's look back. Over the course of the last 30 years, interest rates have come down almost that entire time, with a few peaks and troughs, and now interest rates are at the all-time low. So how it affects people is in several ways. In terms of the use of capital, it's how they go about borrowing money, for example, to buy a house or to actually buy a car, for an individual person. So it lowers their cost of capital for the things that they want to do. For the economy, it actually lowers the cost of capital for companies that want to invest, and it certainly makes it more attractive for companies to buy other companies, to actually finance corporate financing activities. So all of that has an enormous impact on the individual consumer and the experience that they have.
Caitlin Dean:Steven, what's the motivation for the Fed to start raising interest rates after they've been so low for so long? why does this money party have to come to an end?
Steven Wieting:Well, they're not exactly looking forward to harming anything or anyone, but monetary policy has been set in emergency mode during 2020/21. And now that the economy is recovering and generating on the order probably of forward-looking 300,000 jobs per month, backward looking, twice that. Just setting monetary policy this way and financing most new credit creation in the economy of $120 billion per month of newly printed money to finance all of the borrowing in the economy, or most of it, this is not consistent with long run financial stability or price stability.
Now, during a period when employment is still probably 6 million people short of where we would be if the economy were really normal, this is not an immediate threat. I think markets have toyed with that idea a little bit but come around to the view that this is all about the distortions of covid, but this is time for the Federal Reserve to be thinking about where the ends will meet in a couple of years. And at that point, will we not be intentionally overstimulating the economy?
Caitlin Dean:Rob, what about the political pressure? Is there political pressure to keep rates low or to raise them?
Rob Kahn:There is always political pressure. I think along with death and taxes, you can take as a always true statement that central banks will spar with governments and with legislatures over the setting of policy and will feel often intense pressure to keep rates low or take other measures to stimulate the economy, even when they feel they should not.
But I think if you look at the long kind of path of this, what you come away with is that through a series of recessions and recoveries, through economic crises, electoral changes, it certainly has led to an environment where the Fed in particular, looking at the US experience, has become more strong or independent and also transparent in a way that has given them the tools to withstand the pressures they have faced and continue to face now to keep the economy going, even when they believe that it's right to begin the process of normalization.
Steven Wieting:Yeah, when you take a look at the Fed's monetary policy report and testimony to Congress in July, we probably saw the most profound amount of concern about inflation from members of Congress in roughly 40 years. It was quite interesting how they asked the Fed Chair to restore the economy, strengthen the economy, and simultaneously fight inflation. So it was a very interesting situation to really call that out, that inflation was a problem for Congress now for really the most profound way that we've seen in 40 years.
Caitlin Dean:So I think the political pressure to keep rates low is pretty clear. Is there also pressure from another side maybe to start raising rates?
David Bailin:Well, what Steven was talking about, which is the idea that inflation is a major concern of politicians, is because as you initially asked, Caitlin, it's a pocketbook issue. If people are experiencing extraordinary amounts of cost increases in food or in housing costs or in gas prices, those are the types of concerns that directly affect the politicians' constituents, and so they want to see that controlled. And the problem of course is that in order to control inflation, one would typically raise rates, and in order to keep the economy running at a very hot speed, you would want to keep rates low. And that's the inherent contradiction of, I think, what took place in congressional testimony.
I think, there's an enormous debate about whether or not we have temporary inflation, for example, in used car prices or in things that are in short supply because of the ability not to get those due the shipping issues, versus long-term inflation where demand outstrips supply for an extended period of time. And that is a debate that's going on between banks and between governments right now. We happen to think that it is more temporary than it is long-term troubling, but the intention of the Fed in any case is to run a hotter economy, a growthier economy, going forward, coming out of the pandemic. And that has an attendant cost, which is slightly higher inflation than we've had over the last 10 years.
Rob Kahn:The other point I would make, and maybe it reflects the gray hair I have, is that you are always influenced by what you grew up with and what you lived through. And I think for people of my generation who grew up through the last period of very high inflation in the '60s and '70s, and lived through also the very difficult adjustment costs of the disinflation that followed, I think maybe there is a little more anxiety about the upside inflationary risks that David and Steven have identified.
Caitlin Dean:So Rob, how does the COVID pandemic and the current period we're in compared to previous times when there were also moves to lower interest rates, especially during the great recession?
Rob Kahn:Well, I think part of it is that we've had this very long period of extraordinarily low rates and risk to financial imbalances are obviously a concern at that point. Steven talked earlier about the asset purchase piece of what the Fed is doing, the direct buying of assets. In a context of a pandemic, which has caused huge supply disruptions, I think it's legitimate to ask the question of are those purchases even having the kind of power that we hope they would have? And I think that that will also conversantly affect questions of how a higher interest rates and how the reduction of those purchases feed through to the economy.
Caitlin Dean:David, what are some of the other broader economic impacts that the economy and that individuals see when interest rates are low?
David Bailin:Well, we've talked a lot about their ability to actually finance their lives. But let's think about what happened in the pandemic. First of all, in creating the liquidity, people were able to borrow at lower costs and that drove up the cost of homes. They were able to borrow and buy goods. We saw an incredible surge in consumer purchases. And now when we take a look at what's happening in the economy, we see a strengthening wage market that is in part a response to the stimulus that's been applied. In other words, people are making more money and that's true pretty much everywhere because there isn't enough labor right now due to a lot of the dislocations in the marketplace. So it's a combination of factors that are creating that. The other thing is that savers in America have an enormous amount of money because of the programs that the government passed in order to enable them to sort of tolerate the dislocations of the pandemic. So these are some of the dislocations that are there.
David Bailin:With rates being this low. It enables a lot of people to lower their cost of living, and the question then is does that cost rise because prices rise. And that really is the tension that we're talking about. But in general, I would say that rates being where they are, that's very attractive to the economy right now and ultimately is going to have to be tapered by virtue of the fact that these rates are probably unsustainable, as all of us have talked about today.
Caitlin Dean:So Steven, beyond interest rates what other support is being withdrawn from consumers?
Steven Wieting:So it's all about perhaps less tailwind. If we take a look at fiscal policy, we had 6% of households lose a job, we had an 85% of households get some sort of direct income support, these checks that were paid out as stimulus. Macro economic policy was very broadly supportive, not just in the United States, but especially in developed markets around the world. And yet the COVID shock was incredibly deep and severe in particular sectors, social close sectors. We've recovered 80% of the hospitality and leisure jobs lost where literally at a single month half of the people who work in restaurants lost their jobs, never seen before in history. And after we recovered 80%, it still actually had the largest net decline in history. And yet unfilled job openings are at a record high, the economy overall is expanded and macro policy the way we formulate it is really not meant to be focused on very, very specific individual needs. The needs of a particular restaurant where people wouldn't be able to come in because they don't feel safe from COVID for example.
So when you think about what was used in the last couple years, we had fiscal stimulus of 13% of GDP, unheard of. Going forward there will be more government spending if the administration's plans pass, they'll also be some more taxes. So it's a diminished positive, luckily being offset by quite a strong rebound in ordinary wage income. But we just have to remember, this is a highly distorted economy and everything that we're seeing about inflation now, a little bit of this is monetary, a lot of it is about distortions in what we spent on. Things that no producer could ever predict.
Steven Wieting:For example, if you take a look at the year through April car and truck demand went up 43%, we couldn't possibly keep pace with that. And during that time, or at least for now we still have public transportation spending down 35%. now, no one's cutting the cost of anyone's subway fare. So the distortions that have happened in the economy, these strange shifts that we've had in demand in the economy that we couldn't possibly cope with in real time. And coming out of this, a lot of these things will diminish. And I think a lot of people are quite worried about inflation and spending, but in reality, things that we did to adjust our lives to COVID are quite discreet. If we needed a vehicle, we have a new or used one. If we needed a flat panel TV to take our Zoom meetings, we've already got it. So going forward, it's a lot like a really a big bounce back that's coming to rest. That's what we should be expecting in the next couple of years. Fortunately enough, we'll be growing quite normally through using technology and applying how we've learned to adjust to COVID all of these things our normal sources of growth that will still be there on the other side.
Caitlin Dean:And looking abroad, how does low interest rates help the US economy have more power than other economies? How does this compare to Japan, for example, or to the EU? Rob?
Rob Kahn:Well, I suppose the answer depends on the reason for the low rates. In the US context, low interest rates as part of a package of measures that we've been talking about provided an important safety net under activity during the pandemic. And certainly a strong economy does help project American soft power abroad, our economic success underpins our diplomacy. But that goes hand in hand with the idea that you need to have your house in order and that means sound economic policy, strong institutions and smart decision-making all supports that. Now I support much of the pandemic response to the government is necessarily inappropriate, but at the same time and looking forward, I think our divided politics, our large fiscal deficit, and are often dysfunctional debates, doesn't provide me with as much optimism for the future. So I think there's certainly reason to believe that while American diplomatic power will persist, it remains the world's most economy, that these economic factors do matter importantly for the international power of the U.S.
Caitlin Dean:So taking a look at what we might be facing once interest rates rise, Steven, we know that there are many people who think that the inflation we're seeing is a really serious problem. In your opinion, to what extent do you think that's true?
Steven Wieting:Well, we're thinking that the bulk of what we've seen, just looking back at this past year of US inflation above 5%, that this is a reflection of the distorted economy that I just showed, that I just discussed. So you think about what happened to used car prices. Again, we're going to talk so much about this but it almost sounds silly, but the reality is this single tiny item, three and a half percent of spending, gave us as big a contribution to inflation as the entire energy sector, which we're used to having these big swings in. So literally about half of the rise in core inflation has occurred because the auto industry couldn't keep up with demand, with people not taking trips abroad and finding that they needed to drive to the office instead of taking the train.
So what Chair Powell has been talking about showing that an industry like autos is not the industry of the future and that for most of the last 25 years prices for durable goods have been generally falling. And seeing that the remainder of what really depends on domestic compensation, for example, in pricing has been much more stable. I think that that's heartening news that inflation won't be on this permanent rise. There are other things that are not changing. Information, we can now look at data as our ability to fill demand. We can shop around with information the way that we couldn't in decades past. International competition. Well, we might've gotten the benefits of that. It may be globalization slowing. But we're not necessarily receding away from very competitive markets. And then finally, consumers are behaving as if inflation expectations really do matter.
So they're not expecting their compensation to be wildly higher because their cost of living is going up. Now, that's important because when prices go up, maybe they'll buy it, but they cut back on other things. They discipline the economy. And when prices fall, they're happy to act on that and see increased demand.
So I think from the Fed's perspective, all of this is great. Looking backwards, it really tells us that this is not an inflation with a life of its own that's going to take up forever.
Caitlin Dean: If we see interest raised and then we see the economy correct itself as in the used car example that you mentioned, do we think that there could be an overcorrection there?
Steven Wieting:So the one thing to just say about that is let's remember with nine rate hikes in the last cycle and the Fed significantly reducing, I think it's $700 billion of its outstanding credit, it took all the way from 2013's warnings all the way to the end of 2018 before the Fed had over done it.
Caitlin Dean:So how much do we expect rates to actually rise? And at what point would it really become a problem for the economy?
Steven Wieting:So Caitlyn, markets are expecting short-term policy rates to rise about one and a half percent over the next three years. And in context, that's a relatively small tightening. There were past increases in the fed funds rate that were five and a half percentage points, but it would come a little bit earlier, of course, in an economic recovery then when the federal reserve raised rates in the last cycle where they were at a zero rate for seven years. And that again reflects the strength of the recovery.
Steven Wieting:I would look at it this way. If rates rise for the right reasons, that income and output is rising and the federal reserve needs to make sure that the economy isn't overheating, that demand is truly outstripping supply in a way that is destabilizing for the economy, that's not a problem. Now, if we think about financial markets, we're embedding in an inflation adjusted U.S. treasury yield of -1%. So if you think about what would be disturbing for financial markets if that were to rise, let's say three percentage points and if that were to happen quickly, that is the move that would really reprice a lot of financial assets and then be an impact, probably something that's quite significant on the economy. But no one is expecting that the federal reserve here is going to do what Paul Volcker had to do in 1980. And that is to knock the economy down purposely into recession to try to cure it of a severe inflation problem that had built up over a long period of time.
Caitlin Dean:And David, what do rates mean for investors?
David Bailin:Well, this is actually an interesting time to be an investor, Caitlin. First of all, our investors in general have too much cash and they're not earning enough money that cash. So if Steven is right and let's say inflation runs at two and a half percent and they earn 25 basis points, it means that their cash loses 2% of its value every single year or more than 20% over the course of the decade. That's lost purchasing power by doing nothing.
When you look at the bond market, interest rates there are very low. And if they stay low, that's also not necessarily an attractive place to be. So investors now in this environment have to be thinking about the nature of the type of portfolio they have to have. And in our view, they have to have high-quality stocks that actually pay dividends, potentially increasing dividends that have a high probability of having earnings go up and then they can actually earn good risk adjusted returns.
Investors will also have to think about what else they can do with their money. And obviously owning other assets, right? Is useful. We're investing in companies that do investments, meaning that companies that buy real estate, that buy other companies, that use the low interest rate environment to their advantage or attractive investments. Looking overseas where valuations for stocks are far less than they are in the United States, all of that is what investors need to do. What we're most fearful about is complacency. Because in the environment we've described the bond holder, the cash holder are penalized, the equity holder or the asset holder are benefited. And of course, most clients, most investors do not actually appreciate that enough. Our biggest fear actually isn't that rates rise by one half of 1%. Our biggest fear is actually that investors take no action and don’t modify their portfolios to the environment we’ve been talking about today.
Caitlin Dean:So let's get some closing thoughts. Steven, in your view, should consumers and or investors fear higher interest rates?
Steven Wieting:I wouldn't fear higher interest rates, I'd consider how they're generated. If a deeper broadening recovery, let's imagine a truly post COVID world, generates higher credit demand and a higher cost of money, it's a higher return. It has historically not been an issue. And if there are some vulnerable parts in the world, we think that they're a lot smaller, right? If we think about the taper tantrum period of 2013 and 2014, the belief that QE to infinity was a little bit of the problem then. We subsequently had a massive energy cost bust with a booming industry producing in the United States and there were consequences for suppliers. There were worries that China went from an economy where it could do no wrong to worries about massive savings outflows. I think the worry that we have now is health worry. So in that regard, I think that the world can hold it together, but it really, really is going to be a different economy post COVID.
Thinking that we're going to go exactly back to where we were before just doesn't make a lot of sense. For example, the demand in production of single family housing and urban office space at the same time just doesn't both work together, right? At the level that we have. We have come a long way, particularly in asset prices since the trough of this cycle. We've already done a lot to adjust away from this idea that where we can just bounce back forever and really start thinking about where the sustainable sources of growth and portfolio returns are from. I'm sure they're not 30% returns per year, but they still can be very attractive. And I think we can have some solace in the fact that the US economy has grown in 86% of months since World War II. If we think about fully global contractions like COVID or like the global financial crisis, they've been rare and far between.
Caitlin Dean:And David, what hidden problems do you think investors are going to face?
David Bailin:I've already touched upon a couple of them, which is the need to reallocate portfolios pretty considerably right now, focusing more on dividends, focusing more on quality stocks, focusing on diversification, focusing on technology. I think this is a pretty brilliant time, though, for the US economy. We've seen competitive advantages in venture capital companies across virtually every industry get accelerated by what's taking place in the economy right now. And the low cost of capital is part of that. The low cost of capital supports continued investment in technology broadly. So for us, we want investors to be wary of just looking at value stocks for old industries and saying, well, they look cheap or growth stocks that just simply look expensive.
It's actually application of technologies in companies, how they go about changing the way they produce goods, the way that they deliver goods, the efficiencies that they drive, the customer service experience that they give. These are going to differentiate companies in the future. And while many of them understand that, there are many that do not. And so for an investor, they need to basically have the researcher, have access to the research and advice that allows them to build portfolios of those companies. Because as everyone's talked about today, we really are in a new economy that's truly been accelerated and advanced by the events of the pandemic and the way that humans have adapted to it.
Caitlin Dean:Hmm. And Rob, do you have any other final thoughts for us?
Rob Kahn:I think this new economy that we've all talked about and agree on does raise some really interesting questions about how central banks should think about the economy. For many years now, we've had it as a presumed fact that inflation should be 2% and nearly all central banks, certainly all industrial world, set their inflation rates around that level. And I think coming out of this, we'll probably again ask ourselves, "Is that the right number? Is that the right way to think about not only inflation, but then how the trade-off between inflation and ease in monetary policy and other elements of the economy such as the labor market?"
And I think all of those are healthy and warranted. And we may end up with an interesting and new set of understandings and frameworks for how to operate monetary policy to have more flexibility when the next shock occurs. Obviously, hopefully it will be very much different from what we have faced this time as well, but we always want our central banks to have the toolkit and the political flexibility to respond aggressively as needed. And so I think going back to something we talked about a little bit earlier; accountability, transparency, and well accepted objectives in the broader community, I think are all going to continue to be critical for central banks to maintain that capacity to act when the next crisis hits.
Caitlin Dean:Well, thanks very much to all three of our guests for your time and your insights. Rob Kahn, director of geoeconomics at Eurasia group, Steven Wieting, chief investment strategist and chief economist at Citi Global Wealth, and David Bailin, global head of investments and chief investment officer at City Global Wealth. Thanks so much to all three of you.
Steven Wieting: Thanks so much, Caitlin.
David Bailin: Thanks for having me.
Rob Kahn: Thanks Caitlin.
Caitlin Dean: That’s it for this episode of Living Beyond Borders. Stay tuned throughout the fall as we look at the biggest issues impacting your world - and your money. Next time, the future of healthcare.
I’m Caitlin Dean. Thanks for listening.