Episode 3: Inflation Nations: What to know about inflation and interest rates
Listen: "During the course of this year, the Fed will not be concerned only with inflation as the months go by; increasingly the pendulum will shift, and they'll be concerned about the employment part of their mandate as well," says Charlie Reinhard, Head of Investment Strategy for North America at Citi Global Wealth Investments.
In the latest episode of Living Beyond Borders, a podcast produced in partnership between GZERO and Citi Global Wealth Investments, Reinhard joins Eurasia Group’s Rob Kahn for a check-in on the lasting, sticky rates of inflation, how the Fed will continue to adjust interest rates, and what kind of recession - if any - investors should prepare themselves for.
Managing Director of Climate and Sustainability, Eurasia Group
Head of Investment Strategy, North America, Citi Global Wealth Investments
Director of Geoeconomics at Eurasia Group
Transcript: Episode 3: Inflation Nations: What to know about inflation and interest rates
Disclosure: The opinions expressed by Eurasia Group analysts in this podcast episode are their own, and may differ from those of Citigroup Inc and its affiliates.
Charlie Reinhard: Even at the end of this year, we don't think the Fed will truly be at its goal of three and half percent, but we do believe that during the course of this year, they will not be concerned only with inflation as the months go by, increasingly the pendulum will shift and they'll be concerned about the employment part of their mandate as well.
Rob Kahn: We know from history that that process of raising rates to bring the economy back in balance is very hard to predict. It can be very uneven and bumpy, and it's very rare that the Fed does that in a way that achieves a perfectly smooth soft, landing.
Shari Friedman: Welcome to Living Beyond Borders, a podcast from Citi Global Wealth Investments and GZERO Media. On this program, we examine global risks and opportunities from the angles of both politics and economics. I'm Shari Friedman, Managing Director of Climate and Sustainability at Eurasia Group.
Today we're looking at a topic we've tackled frequently over the past three years on this podcast: If the economy is so good, why do things seem so bad? Consumer spending is up, hitting a two-year-high earlier this year. The job market continues to surge and unemployment's at its lowest that it's been in 50 years. But we continue to hear the R word: recession.
So why is this, and what is the connection between jobs, interest rates and inflation creating this swirl of uncertainty as we head deeper into 2023? Today we have the perfect duo to answer this question. I'm joined by Charlie Reinhard, Head of Investment Strategy for North America at Citi Global Wealth Investments. Welcome.
Charlie Reinhard: Thank you for having me.
Shari Friedman: And Rob Kahn, Managing Director of Global Macro Geoeconomics at Eurasia Group. Hey Rob.
Rob Kahn: Hey Shari.
Shari Friedman: Let's start by asking the big picture question. Is the U.S. economy good or bad, or both? Charlie, what do you think?
Charlie Reinhard: If we think of the economy as being one part real growth and one part inflation, we actually have different answers. In the case of the real economy itself, we're starting the year out in a position where things are good, but we think that they're going to become bad during the course of time. Leading indicators have turned down negative. The Fed is still raising interest rates. Because interest rates are higher, we see a softening in interest rate sensitive areas of the economy like housing and when we're done constructing homes that were decided back when interest rates were lower, does the order book exist to continue building those homes?
And if we're not building homes, we're not ordering the appliances, the heating systems, the cooling systems. And if we're not ordering them, we're not shipping them. If we're not shipping them, we're not insuring them. There's a ripple effect when it comes to housing.
And of course, we've also seen some layoff announcements in technology also in areas of finance as well. So for a variety of reasons, we think that the economy is going to slow. It's starting the year off strong, but we think that we're going to slip into a mild recession.
In the case of inflation, we're starting off from a bad position, which we think is going to get better during the course of the year. Inflation has already come down. It peaked at 9.1% in June of last year, and we think it'll be at three and a half percent by the end of this year.
We've recently heard from S&P 500 companies in their fourth quarter reporting season. Profits are slightly negative compared to a year ago. And not only are they negative, but seven of the 11 major sectors are in profit recessions versus four sectors just three months ago. So it's spreading.
This means that CEOs and CFOs are going to be looking to contain their costs. And of course, for many labor is the big expense. We've seen rents tapering off, supply chain improvements, supplier delivery times have shortened, backlog orders have come down, commodity prices have come down. So when we put all of that together, we think that inflation is going to continue to dissipate. So an economy whereby the growth picture gets worse and the inflation picture gets better is probably the best way to describe how we see events unfolding this year.
Shari Friedman: So kind of both. And on this recession piece, Treasury Secretary Janet Yellen is bucking a bit against the idea that we are entering into a recession. And she had this to say ahead of President Biden's State of the Union speech in February.
Janet Yellen: You don't have a recession when you have 500,000 jobs and the lowest unemployment rate in more than 50 years. So what I see is a path in which inflation is declining significantly and the economy is remaining strong.
Shari Friedman: So Rob, do you agree with this assessment?
Rob Kahn: Not really. Now where you stand depends on where you sit. And as Treasury Secretary, it's her job to make the case for the administration's policies working and her optimism is part of that story. In that sense, I agree with most of what Charlie said. The economy has shown impressive resilience to date. It's growing around two and a half percent now led by the consumer. So we are certainly not in recession now, but it's coming at a high price. Most importantly, high and sticky inflation. The economy is out of balance.
And so as we look ahead - the path forward - I am less optimistic than Secretary Yellen, that inflation is declining significantly and the economy will remain strong. In fact, I would take the Fed at its word when it tells us that they're prepared to raise rates until they have slowed demand, and that likely means a cooling of the labor market. And we know from history that that process of raising rates to bring the economy and back in balance is very hard to predict. It can be very uneven and bumpy. And it's very rare that the Fed does that in a way that achieves a perfectly smooth, soft landing in which growth stays strong and inflation comes back down to where they want it to be, a 2% target.
So that means in my view, that interest rates are going to have to rise quite a bit more from here and highly likely will produce a significant downturn in demand and growth as the year goes on.
Shari Friedman: Rob, what are the principal reasons why inflation has persisted? And to what extent does some of this trace back to the actions taken to shore up the economy during the worst of the pandemic?
Rob Kahn: That's a really tough question, and I should start with a reflection on how economists have done up until now in predicting inflation and an acknowledgement that, as Jay Powell said in a slightly different context, we're trying to feel a way around a dark room without hitting too much of the furniture. It's difficult, it's challenging.
And the reason why we're operating in darkness is because of the extraordinary and unusual nature of the shocks that we have had to deal with in recent years, from pandemic, to war, to all the supply chain disruptions associated with that. This is not typical of the boom/bust cycles of the U.S. economy, and it certainly is something that our experience and our models that are based on our history don't give us much insight to.
As I look back at why inflation is so high now and why we were surprised by that, it is a mix of both supply and demand factors. On the supply side, the disruptions from the pandemic were severe and it's certainly taken us longer than we expected to work through them. They're still with us. We're still seeing many continuing challenges with working through that.
And just as we thought we were kind of at the peak of the disruption and starting to move back to a more normal economy, I think the war between Russia and Ukraine provided an additional set of challenges, particularly in the areas of energy and food which are so critical to so many consumers and households.
Add on to that, that I think these shocks have changed the way people look at their jobs and at their lives and their futures. That has affected labor supply, and the return of people to the markets disappointed, our hopes, and there are a lot of reasons for that. That's the supply side of the economy and tells us something about how much is available to be bought and at what price.
But of course, there's also a demand side too, and it's also interesting to ask ourselves why has demand pressed up so hard against this restricted supply. In that case, part of it is a resilient U.S. economy that has responded well to these challenges.
Part of it also, and this is what differentiates us from so many other countries, was an extraordinary fiscal effort; that the amount of stimulus that was provided by the U.S. government in the early days of the pandemic was really extraordinary. We had the capacity to do that. Many countries did not have what economists would call the fiscal space or the ability to provide that much support, but in the U.S. we certainly did.
There's an active debate about whether we went too far, but be it as it may, in those early days, we felt extraordinarily at risk and along with an extremely expansionary monetary policy, fiscal policy did provide that floor under activity.
But it did put a lot in spending into the system which we are still working through and has contributed to not only resilient demand, but pressure on markets and has led to price increases that in turn has proved very sticky and has remained at much higher levels than we have hoped. And that's why it puts the Fed in a very tough bind.
The rate hikes that we have gotten so far haven't had the effect we had expected it to or had hoped to. And so I think we're seeing a momentum to inflation that I think is very worrisome if your goal is to put inflation down on a firmly downward track. And I don't think we can have great confidence that the policies that have been put in place so far are going to be enough to get us to where we want to go.
Shari Friedman: So there's a lot, Rob, that you kind of packed in there with this interconnection between inflation and interest rates and this move to try to kind of keep the economy in this balance. Charlie, moving over to you - I'm wondering if you could kind of create this linear trajectory and unpack this piece that Rob was talking about given the correlation between inflation and interest rates and why the Fed is implementing these incremental rate hikes.
Charlie Reinhard: Sure. So the Fed has two mandates. The first is full employment and they feel pretty good about achieving that mandate at this particular juncture. The second is stable pricing. They want to average inflation that's not too much beyond 2% over the course of a cycle, and that's where they are concerned. So they are raising interest rates in order to bring that about.
Now the problem is that if you're looking at inflation data and if you're looking at the unemployment rate, you're actually looking at lagging information. The leading indicators are suggesting that the economy is going to weaken. In order to bring about lower levels of inflation, the public needs to believe that it's achievable. And we can look at expected inflation for the next 10 years by comparing a 10-year treasury to a 10-year inflation protected treasury and expected inflation is somewhere between two and two and a half percent. So, so far, it's well anchored.
The Fed of course, needs to keep it anchored in order to bring about their inflation goals. Of course, when you're looking at trailing information or lagging information, you run the risk of making a mistake as you would if you were only looking at your rearview mirror and not looking at what lies directly in front of you.
And so, we think that they are likely to go too far; to make a mistake. And of course, a reduction in demand is the arch enemy of inflation. So if we were to see the unemployment rate move higher during the course of the year, and we think that we will, that should also help bring about lower inflation.
But you know Rob made a really good point earlier about the stickiness of the inflation that we are seeing. And even at the end of this year, we don't think the Fed will truly be at its goal of three and a half percent, but we do believe that during the course of this year, the balance of their concerns, because of that dual mandate, will change. They will not be concerned only with inflation as the months go by. Increasingly, the pendulum will shift, and they'll be concerned about the employment part of their mandate as well.
And so, once we have some negative job growth, we think that the Fed will pause. They'll probably pause for a few meetings and then eventually they'll lower rates by the end of the year.
Shari Friedman: Just in terms of interest rates, I think it's important to note that historically the interest rates are still pretty low. I mean, I remember when I was taking out student loans, they were quite a bit higher than they are right now. So is this a case of us getting spoiled by low and maybe unrealistic rates in recent decades?
Charlie Reinhard: Back in August of 2020, I think we made a generational low in interest rates with a 10-year treasury yield of just half a percent. We think that interest rates, the 10-year treasury, is likely to be lower at the end of the year than it is today. But generally speaking, when we think about where interest rates average in the period following the financial crisis you know, up until recently, we're likely to experience higher rates on average in the future than during that time period. Inflation is likely to run a little bit higher, as a result of that interest rate should be higher as well.
Rob Kahn: As Charlie was saying earlier, people's expectations about inflation do seem anchored so far, although that's not something I feel we can count on persisting forever. And I think that's because the last 30 years or so we have lived in a period of very low inflation.
I think there's a lot of reasons for that, demographics, the influx of a lot of workers from the emerging world into the global marketplace, which put downward pressure on interest rates and on price pressures. Some people have referred to this as secular stagnation or other ways of capturing, but fundamentally these are broad long-term drivers that contributed to a period of low inflation.
But there are arguments that some of that may be in the process of reversal. And I think to some extent how much you worry about those reversals depends not only on how you see the world evolving, but what you've experienced. And I am struck that I grew up at a time of high inflation and volatile expectations prior to the Great Moderation. And when I talk to colleagues who are much younger than I am, they don't have that same experience. And I think that probably contributes to a little more concern on my part that we could be shifting in coming years to a higher rate environment with greater and higher inflationary expectations.
And so that idea of being spoiled, what that's capturing, it partly relies on your view on the fundamentals, right? Is the world changing in some material ways, that maybe we're a little less globalized, a little less reliant on cheap global labor in a way that may contribute to higher base inflation? That's part of the debate, but also simply what we're used to, which feeds into our expectations and then in turn can feed into these inflation dynamics.
Shari Friedman: So people may have gotten spoiled, but the interest rates nonetheless are likely to rise. Rob, the former Treasury Secretary and economist Larry Summers took a lot of heat for his assertion that higher unemployment is needed to beat inflation and to stave off recession. Is there any truth to this idea? And kind of going back to this interconnectivity, what's the connection now between wages and employment and inflation?
Rob Kahn: He's right, although it's shorthand and as the Fed often emphasizes, they don't desire higher unemployment, nor do they feel it's essential. They hope they could cool down the labor market, take pressure off prices without a significant increase in unemployment, but they'd be prepared to tolerate it. I think what Larry's getting at is simply that this high inflation has to be addressed through some reduction in demand. Fed's tools, primary tools, which are higher cost of money, will work eventually through reducing demand, and that will reduce, in addition demand for products, the demand for labor.
And that means, of course, in the first instance, the number of vacancies go down, firms will be a little more cautious in advertising for new employees or to hire new employees. And that should lead to some increase in unemployment, as I say, is the natural price of getting back to balance.
Obviously, that causes distress and particularly for sectors of the economy that are in lower skilled professions are more vulnerable to cyclical downturns and the like. Those people, many of them had seen a lot of gains in years prior to the pandemic. We saw real wages of a lot of low-income groups rise significantly. It would be a shame to lose that, but you can't get yourself into a policy position where you kind of say that any increase in unemployment is bad simply because policy should never allow that to happen. That's the situation if you get into that where you're chasing higher and higher levels of inflation in an effort to keep unemployment low.
The goal here is to find some sort of level of activity and resultant level of employment that is sustainable over time in a regime of price stability - because we ultimately believe that stable prices is supportive of higher activity and higher employment.
Shari Friedman: Mmhm. And Charlie, moving back over to you. We've talked a lot about kind of the U.S. policy tools, but are there other factors contributing to the inflation rate and just generally overall uncertainty? Like for example, continuing supply chain issues and the energy price hikes that really were exacerbated by the ongoing war in Ukraine?
Charlie Reinhard: Yeah, so certainly the supply chain disruption that we had during COVID, the war in Ukraine, have complicated matters, and also we had a very big policy response fiscally to also contend with. You know, in normal times, I think technology is actually an advantage. The little barcodes that we see on the back of our packages when we have robust and well-working resilient supply chains do a wonderful job of communicating up and down the supply chain when we need the next shipment and we can better match supply with demand.
When supply and demand are growing at the same pace, things can remain in balance. And I think the technology has contributed to the longer business cycles that we've experienced since the 1980s. That being said, we have been through some unusual times.
Now, in the U.S., inflation did peak back in June and it's come down and I think supply chain pressures have lessened to a large degree. When we look at freight rates, delivery times, backlog orders, I think it's come down quite a bit. In Europe, the situation was a bit different because of the closeness to the events that have had been taking place in Ukraine. Europe has done a wonderful job, I think, in diversifying away from Russian gas and benefited from a mild winter. That mild winter has allowed Europe to reach a very good place with respect to natural gas storage right now.
Of course, the war is still ongoing, so we can't say that it's going to remain that place, but for right now it does -. that aspect does look pretty good. Now that being said, in Europe overall inflation is coming down, but core inflation when we remove food and energy, that hasn't really turned down yet.
And as a result of that, they're probably a bit behind in terms of the inflation cycle than we are in the U.S. Some of that reflects the terms of trade between the U.S. and Europe. The dollar was strong in 2021 in the first three quarters of last year. Ultimately that'll turn itself around, but it's not just the Fed, but the European Central Bank President, Christine Lagarde, that has taken a very hawkish stance lately as well to try to bring about better levels of inflation in Europe.
We actually think inflation in Europe will also be around three and a half percent at the end of the year like in the United States, but it's going to take some policy tightening in order to bring that about.
Shari Friedman: So Rob, Charlie had just noted several geopolitical factors that are having an impact on the global economy, and I wanted to turn over to China. As it lifts its zero COVID policy and starts to reboot its own economy, is this going to have a global impact and specifically toward the U.S., is it going to have a mitigating factor in a pending recession?
Rob Kahn: Well, geopolitics, it's hard to imagine a time when it played a bigger role in the performance of the global economy than now. So many of these factors you can mention, most notably the war, but also factors like rising U.S.-China tensions and the like are potential negatives to global growth. Probably the one possible upside risk here comes from China's recovery. From my perspective, the decision last year to rapidly exit its zero COVID policy and accept the high health costs of doing so was really shocking. And it reflects, I suppose, the president's own desire to change the narrative politically and economically in China.
But for whatever reasons, the path by which China rebounds and returns to growth is a major factor for the global economy and for the U.S. economy as well. I think China matters more for the U.S. now than certainly a decade ago, but probably more than in any other time for the U.S. economy because of the way in which we are integrated in trade and in finance.
Now that said, while a China recovery - and does provide an upside to global growth: we expect China to grow about 5% this year. It will not be smooth, and I suspect, will not pack the punch that past Chinese booms have. Let me explain why that is.
It does seem that this recovery's going to be more focused on the Chinese household and the Chinese consumer than past recoveries, which were very much driven by infrastructure and housing. And as a result, put significant upward support for and pressure on commodity prices, key resources that are such an important part of global trade and finance. I think this may be a recovery that is more homegrown and home focused and doesn't drive Chinese imports of critical goods in the same way.
Also, we could see some surges of new variants as the year goes along. I think also Chinese monetary and fiscal policy will be a little more cautious than it has in past cycles, because of some of the legacy they're dealing with in terms of COVID and in terms of strains on their economy that are persisting from their past real estate challenges in particular.
All of this suggests to me that stimulus will be tempered, and also that the growth may be more gradual and more stop/start than maybe some of the storytelling suggests. So I do think that it's still going to be a positive factor for growth. It probably is the biggest upside risk to a story of moderating and soft global growth this year, but it's certainly a lot of uncertainty about how that plays out.
Shari Friedman: And then the idea of the variance also kind of throw a wrench into the possibility of growth - and globally as well. Bringing it back over to U.S. tools. I want to touch on this congressional battle over the U.S. debt ceiling that we'll probably see coming up this summer. Rob, can you explain how that is going to affect all these different pieces that we've been talking about today?
Rob Kahn: Well, let me start with the good news here on this one because so much of what we're talking about here is how things can go wrong and what the risks are. I am highly confident that the U.S. government will not miss a payment on its treasury bonds and bills. It will find a resolution to this debt limit battle in time. But I do worry that this could be messier and more down to the wire than we've ever witnessed before. Now I know many of you will at this point say, “well, haven't we been through this before? It seems like every other year we have a debt limit showdown. We talk about the risks and in the end, they get to a deal and they move on.”
And indeed, there's a tremendous political incentive to do it, but I would highlight a few things. First and foremost is the divisive nature of our politics today, which of course, in some ways has never been worse. And certainly, a desire on the part of the Republican caucus in the house to use the debt limit aggressively to try and change the trajectory of spending, with both sides very far apart in their visions of what U.S. fiscal policy should look like. And it just seems very hard to trace out a path by which those two sides get to a solution other than the fear of a default.
Furthermore, there is a perception and it's not without some merit that we are better prepared now to navigate a close call on the debt limit than before, both because the Fed is prepared to manage any dislocations to money markets and also because arguably the U.S. government understands better than maybe in the past how it might be able to prioritize payments if it has to and pay some suppliers late, delay some bills while at the same time paying on the treasury.
Now that idea that you can prioritize payments is a double edge sword because on the one hand, to the extent it is true, it does provide some additional time for negotiation. On the other hand, of course, the perception that these deadlines aren't real and that you can navigate around it by just simply paying some bills and not others, is not only a – you know, can become an excuse for non-action, it also could be very destructive to our credit rating. Indeed, at least one of the major credit rating agencies has already said that even if you're paying on the treasuries, if you're defaulting on other obligations, it does undermine your credit worthiness.
I think ultimately, we will get a deal, it will probably maintain spending around current levels.There may be some promises of future cuts. We've, in the past, had certain kinds of rules for constraining spending. They haven't proved very effective, but we could use that again. And there may also be agreements on other non-fiscal issues that each side care about, like immigration or some public programs like Medicare or food stamps and the like that could contribute to a deal.
So I think ultimately I could see a deal taking shape, but it may well not happen until September or October in line with the budget. It may ultimately mean that we actually need some period of market turbulence, some period of actual kind of anxiety about getting this done to actually bring both sides to yes.
Shari Friedman: Right, right. A little bit of heat. It sounds like it's going to be a very exciting summer here in the United States. So Charlie, we've been talking a lot in this broad economics speak, and people are probably wondering, how does this translate down to my own investments? How do I proceed in this environment - and what would you tell them?
Charlie Reinhard: Well, each person is different. That being said, you know, we think that we're in the late part of an economic cycle, so we're proceeding in a manner where we're a little on the cautious side, but we think that events are going to change during the course of the year; that opportunities for being less cautious will open up during the course of the year.
One thing I should mention, though, is that if we were to summarize all of the economic research and financial research that has ever been done on investing, it would really come down to having a diversified portfolio with a pro equity bias, not meaning having equities all the time, being a hundred percent of your portfolio, but rather investing with an eye towards the notion that the economy is going to grow eight or nine years out of 10, and when the economy grows, profits grow, and when profits grow, that takes securities along with them.
Shari Friedman: Yeah. So I mean, what you're saying is this idea of: it's cyclical and here's where we are in the cycle. And so you just have to understand that it's never in one direction. It's up and down, and here's where we are. So, we’ve been dancing around and kind of connecting this issue of whether we’re going to have a recession or not. And just to kind of have a final conclusion and to put this into black and white, are we heading into a recession?
Rob Kahn: In a word, yes, I expect a recession kicks in later this year or early 2024. I put around a 75% probability on that. As Fed interest rate hikes do slow the economy, as sentiment shifts, financial conditions tighten, and as that spreads through the economy, we will see a slowdown that will ultimately take us into recession. I don’t think it needs to be as deep as 2008 or 2020, but it could take a while for the recovery, given that monetary and fiscal policy will be kind of on hold for now and won’t provide support for the early stage of recovery.
Shari Friedman: And Charlie, what do you think?
Charlie Reinhard: We think that we're going to enter a recession. It'll be somewhat mild by historical standards, and it won't necessarily be very long by historical standards. And we're looking for a recovery next year. And in terms of profits, we would expect S&P 500 profits to contract by about 10% this year and then begin to rebound next year.
Shari Friedman: Charlie Reinhard, Head of Investment Strategy for North America at Citi Global Wealth Investments, and Rob Kahn, Managing Director of Global Macro Geoeconomics at Eurasia Group. Thanks to you both.
Charlie Reinhard: Thank you.
Rob Kahn: Thank you, Shari.
Shari Friedman: And that's it for this episode of Living Beyond Borders. Also this season, we'll discuss a wide range of topics like the economic benefits of more women in the workforce, the current state of the US-China relationship and energy transitions at this critical moment for climate policy.
Listen to all of this season’s episodes by heading to gzeromedia.com, and click on the Living Beyond Borders tab. Or you can find episodes in the GZERO World Podcast feed wherever you get your podcasts. For GZERO, I'm Shari Friedman. Thanks for listening.