Michael, prior to the pandemic we hadn’t seen high inflation rates for decades. What contributed to the higher rate we have seen in the past few years? Also, what signals influence your inflation outlook?
The relatively high inflation of the past few years was largely a result of pandemic-related supply and demand imbalances. This recent inflation episode was distinctive. Fiscal transfers supported aggregate demand and helped maintain incomes, while full or partial lockdowns restricted production (aggregate supply).
We saw these imbalances at the sector level. The inflation indicator preferred by the Federal Reserve (Fed), the Core Personal Consumption Expenditures Index (Core PCE), can be thought of as consisting of three broad sectors: core goods, core non-housing services and housing. In the early days of the pandemic, bottlenecks restricted the supply of goods. As the economy reopened, demand in the non-housing services sector was met with a labor shortfall, which restricted supply. In the housing sector, where inflation is measured by rents or imputed rents, a surge in rental demand sent vacancy rates to 40-year lows and in turn rental rates rose.
In my view, these imbalances have largely normalized. In the goods sector, bottlenecks have eased and demand has moderated. In non-housing services, and more generally labor, supply has grown at a rapid rate. Real-time market rents have softened, vacancy rates have turned up and there is a record number of multi-family housing units set to be available over the next year.
Looking at official housing inflation, the data has multi-quarter lags. I believe this is why it is still running at greater than 7% year over year. However, based on our research various real-time measures of rents on new leases have been roughly flat year over year. I think this could be where the official housing inflation data is heading as it works through the lags.
Today, I like to focus on measures of Core PCE inflation that either exclude rents or substitute current market rents for the official (lagged) inputs. By these measures, the current underlying trend rate on Core PCE inflation is 2.2% to 2.4% annualized over the last six months. Bottom line, I estimate that underlying Core PCE is already running at or near a 2% annualized inflation rate, with progress likely to continue if imbalances continue to normalize.
While it's widely accepted that "real," or inflation-adjusted metrics matter more in the long run than nominal metrics (measured using current prices), recent events have reminded us that nominal trends can matter a great deal. Can you talk more about that and how nominal trends have influenced the credit cycle?
Real rates of growth do matter most in the long run. However, money flows in the economy—revenues, employee incomes, outlays—are all in nominal terms. So, nominal rates of growth can matter in the short term—as recent experience has shown us.
Increases in inflation don’t necessarily lead to increased nominal growth. Generally, higher prices do decrease demand. But, this instance in the credit cycle was a bit different. It seems that fiscal transfers, related excess savings and accumulated wealth during and after the pandemic served to insulate many consumers from the negative impact of higher prices. I believe this contributed to significant growth in nominal terms.
In 2022, when inflation and recession concerns were peaking, nominal growth was expanding by more than 7%—about 3% above the average rate of nominal growth in the 2010s. This in turn supported corporate revenue growth. While most of us were worried about high inflation and low levels of real growth (real GDP grew at <1% in 2022), high levels of nominal growth, fueled by high inflation, became somewhat of a tailwind for corporate revenues and unexpectedly extended the economic expansion.
You made a case that inflation might be less volatile in the future. What does that mean for the equity and bond markets? What are the implications for correlations between assets?
To help simplify things, I consider a world where inflation is low and stable at about 2%. This was generally the case for a couple decades before the pandemic. If we assume no fluctuation in inflation, then it is possible for most of the volatility in nominal GDP to come from the real growth component (see table). If the economy were to experience significant inflation, the relationships depicted in the table would be highly uncertain.
As shown in the table, the economy needs low and stable inflation for investors to have the opportunity to realize potential correlation benefits that can be provided by bonds. If inflation falls and stabilizes below 2.5%, these correlation benefits could possibly enhance multi-asset allocation outcomes. In my opinion, this would remove much of the premium, or additional compensation required by investors to own longer-dated government bonds. In such a scenario, bond prices are likely to appreciate through that process with yields falling—perhaps significantly. Be aware, there would likely be costs associated with waiting to allocate to bonds until these potential correlation benefits become evident and established.
 Haver Analytics, Census Bureau, as of 25 October 2023.
 The New York Fed’s Global Supply Chain Pressure Index suggests that supply chain pressures are lower now than they have been, on average, over the prior 25 years.
 The current labor force is larger than it was projected to be at this time back in 2019, prior to the pandemic.
 Zillow, Haver Analytics, as of 25 October 2023.
 Bureau of Economic Analysis, Haver Analytics, as of 25 October 2023.
 Sources: Bloomberg, Loomis Sayles, as of 25 October 2023.
 Source: St. Louis Federal Reserve.
Past market experience is no guarantee of future results.
Market conditions are extremely fluid and change frequently.
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