Chat with the CIO: The Strangest Recession in History Creates a Messy Inflation Puzzle




This quarter features a point-counterpoint with Frank Marcoux, CFA, SVP & Portfolio Manager - Sustainable, Responsible and Impact Investing and Chief Investment Officer, Eric P. Leve, CFA.


June 30, 2021


Eric P. Leve, CFA: Frank, thanks for engaging me on this topic, one that has claimed a top spot on many investors’ minds and seems perfect for us. You and I probably represent opposing sides among Bailard’s research team: I perceive today’s inflation to be shorter-term while you have the greatest anxieties about its possible persistence.


Frank Marcoux, CFA: Yes. This one is a head-scratcher. The National Bureau of Economic Research (NBER) still considers the U.S. to be in a recession despite the economy’s sharp bounce back. Over the three quarters ended March 31, 2021, real economic growth has amounted to 10.3%, the highest level for a three-quarter period in more than 70 years. With this, the U.S. economy is likely to be larger than pre-pandemic levels very soon, and that leads to my concern over rising prices. We’re already seeing it; at 5.0%, May’s year-over-year Consumer Price Index (CPI, a measure of the average change over time in the prices paid by urban consumers for a market basket of consumer goods) was the highest since a brief period in 2008. Before that, we hadn’t seen 5% inflation since 1991. And we know there’s a mountain of cash to spend that could add further fuel to price pressures. Usually, personal income falls in a recession; for example, in the Global Financial Crisis of 2008/2009, personal income fell by 7.7%. In contrast, since February of 2020, income has risen 8.8%, largely due to stimulus from state and federal authorities to individuals (and businesses).


Eric: I want to go back to your comments about inflation rates being “highest since.” In both of those cases inflation came down quickly after those peaks. In fact—only with the exception of the supply shock driven inflation of the 1970s—the challenge for central bankers in the U.S., Europe, and Japan in the past 30 years has been to avoid deflation. Even this time, many of the elements driving prices higher can reverse quickly. The items I’m thinking of are the ones getting the headlines: household furnishings were up 0.9% in May as individuals welcomed friends back into their homes, used car prices rose 7.3% on the month as semiconductor supplies limited new car production, plus car and truck rentals were up a shocking 12.1% for the month as people hit the road for vacation but found that rental car companies had sold off much of their fleets during the downturn.

In a nutshell, I see today’s economy like one coming out of war and readjusting factory output to peacetime needs, which naturally leads to some supply dislocations. Of greatest concern to me is the 6.4% increase for domestic services. Here we’re talking about labor and that backdrop is more disconcerting.


Frank: Yes. Wages are notoriously sticky on the downside. They can build into lasting inflation as those higher wages become higher input costs that get passed onto the consumer who then needs higher pay to afford the goods, creating what (in the early 1970s) was called the “wage-price spiral.” We’re already seeing early evidence that the state and federal unemployment benefits have acted as a disincentive to return to the workforce. Fortunately, as state benefit provisions sunset, we’re also seeing unemployment rates come down quickly. With essentially all additional benefits ending by September, we are likely to see the all-time record number of unfilled job openings come down. If this doesn’t release the current upward pressure on wages, I’m concerned that wage inflation could become more entrenched.


From a broader perspective, I’m also concerned that the amount of monetary growth and debt issuance over the past 16 months could pave the way for higher prices. The 10-year U.S. Treasury yield began the year at 0.92% and, by June 30th, it was 1.47%. M2 (a measure of money in circulation in addition to deposits held in checking, savings accounts, and money market funds) has grown by more than one-third, from $15.4 trillion on December 31, 2019 to a recent high of $20.4 trillion on May 31st. And the outsized debt issuance isn’t just a domestic problem, it has global implications.


Specifically, the U.S. dollar strength of late has fueled inflation in some emerging countries and has resulted in interest rate hikes in Mexico, Russia, Turkey, and Brazil (among others) to help moderate it. Can those countries afford the prospects of higher inflation fueled by the U.S.’s post-pandemic consumption? This consumption isn’t simply consumer-led; business investment is also surging in tech, software, industrial goods, and input materials. Non-residential fixed investment rose at an annualized rate of 11.7% in the first quarter, led by growth in software and tech-equipment spending. This measure also logged similar doubledigit increases in the third and fourth quarters of last year.


This stands in contrast to the experience after the financial crisis of 2008/2009 when companies were more cautious on spending, choosing instead to hire employees to drive growth. This time around, with a very challenging hiring environment leading to higher wages, companies are instead spending aggressively on software and other productivity-enhancing tools and technology. This spending, along with higher labor prices, could result in longer-lasting inflation in goods and services.


Eric: At the risk of being a dupe here, I see societal benefits to slightly higher inflation. I think about this from two perspectives. First, often the expectation of the ability to charge more for goods in the future is the incentive entrepreneurs need to make productivity-enhancing investments that you just mentioned. A more productive economy means more wealth overall.


The other element is how that wealth gets distributed. If wages rise faster than the inflation rate of goods, then you are generating real wage growth. The path of the past 20 years seems unbalanced and unsustainable. If we use the annualized growth in earnings for the S&P 500 Index as the “return to capital” measure and growth in real average hourly earnings as the “return to labor” metric, we see that capital grew by 7.6% annually while wages rose at a 0.8% pace, well-below the annual inflation rate for the period of 2.0%. I admit, inflation and especially wage inflation, is a genie one doesn’t want to let out of the bottle. Many times in history, when it has risen, it has done so uncontrollably. And today’s central bankers do seem to have a pretty blasé attitude toward incipient inflation risks, making a policy under-reaction a real threat.


Frank: I’m pretty tired of people calling the current inflation transient. How long is transient and when does even “transient” inflation begin to impair the economy? I find it difficult to believe that the supply chain issues currently plaguing the system will be gone by Labor Day or Christmas. The current supply bottlenecks are a major cause for our current “transitory inflation.” If we can’t eliminate them, we are likely to see “transitory” stretch well into 2022.


Your point about inflation being somewhat of a desirable outcome is a good one. Ultimately, the U.S. may well be better off if we tolerated higher inflation to attempt to inflate our way out of the debt load. However, while the U.S. economy can likely bear higher inflation, my concern about the potential knock-on effects for emerging markets remains. Once the Federal Reserve (the Fed) stops buying the vast majority of Treasury issuance, we’ll see interest rate levels driven primarily by market forces; it could be well above today’s 1.47% rate.


While the Fed has what is called a dual mandate—stable prices and full employment—I think the former responsibility is most critical. The Fed needs to telegraph its actions well, but for me that means preparing for increases in short-term interest rates earlier than most people forecast (currently, 2023).


Eric: What do you think the risks and benefits of such a move would be?


Frank: This is a rare time. Inflation bugs have been pessimistic Cassandras a lot over the past 40 years, but I think most would agree, today’s environment has real potential to lead to 1970s-style inflation. The amount of debt we have is too large to “grow our way out of.” As Western oil companies step back from major new oil projects, the relative power of OPEC (Organization of the Petroleum Exporting Countries) rises, even as we transition our demand away from fossil fuels. This power, plus China’s control over many commodities both represent real inflationary risks. None of us ever want our central bank to slow down an economic recovery, but the current risks seem to demand it. What I would hate to see is investors overreacting to a Fed rate hike, driving short yields higher and pushing the economy back toward recession.


Eric: I know when you think about these outcomes, they are outliers. But you’re right to point them out. At Bailard we’ve always thought in terms of future economic scenarios and today is a time when that spread of outcomes seems wider than any time in the past couple of decades. Thanks for the lively discussion, Frank.