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Patrick O’Toole, vice-president, global fixed income, CIBC Asset Management.
We think inflation is a bigger risk for fixed-income investors this year than we’ve seen in years past. So, if you think about, between the great financial crisis and Covid, we were of the view that inflation expectations were overblown. I mean, most investors, I think, and strategists out there thought that inflation had to rise given the amount of stimulus that was in the marketplace that the Fed and other central banks had injected in the economy.
Instead, we thought that the forces of demographics, technological innovation and excessive debt levels would all act to keep inflationary pressures and growth lower than the consensus expected. But today we see some significant differences. Demographics, technology and the excess debt — those factors haven’t gone away, and they will reassert themselves as disinflationary forces again. But, this year, we expect those forces to take a back seat to inflation. That’s particularly in the U.S., not as much in Canada.
Let’s remember that the Fed targets not CPI but the Personal Consumption Expenditure deflator as its preferred inflation gauge, and that measure is more all-encompassing than CPI. For example, it includes health-care costs whereas CPI does not.
Now, the Fed has targeted 2% for that PCE deflator since 2012. However, its inflation measure has only hit that 2% target in a handful of months since then. So in September of last year, the Fed basically admitted defeat, saying that it was moving to average inflation targeting, or AIT as some call it.
Now, that new regime means the Fed would now look for inflation to not just reach 2% in any given year or any given year-over-year basis, but would seek to achieve a 2% average over an undetermined period of time.
Now, what that may mean is this: the deflator had averaged about one-and-a-half per cent in 2012 to 2020. So it undershot the Fed’s target by about a half a per cent. So, some would argue the Fed could potentially allow inflation to average two-and-a-half per cent or half a per cent above the 2% target, allow it to average two-and-a-half per cent for the next eight years to achieve an average of 2% since the target was established.
Now, what that may mean for interest rates is this: in the past, if the Fed saw inflation coming at 2%, it would increase the Fed funds rate to slow the economy and dampen down inflationary pressures so that it wouldn’t overshoot. Now, the Fed has stated that it will not act by raising rates if inflation moves above 2% and the Fed expects that it will hold the Fed funds rate — which is currently zero to 0.25% — it’ll hold it there until 2024.
Now, the Fed can always change its mind if inflation starts to overshoot for too long, but let’s remember the economy wasn’t hitting the Fed’s 2% target for the past eight years, so why would it do it now? Well, it might, and the Fed may finally get its wish.
Let’s look at that PCE deflator, the Fed’s inflation measurement.
And it can be broken down into three components. There’s durable goods, which is 12% of the deflator; non-durable goods is 22%; and services are 66%. Now, the dynamic around durable goods prices has shifted. Between the great financial crisis and Covid, durable goods prices were in deflation, averaging about negative 2% a year. Negative. That was due, of course, to globalization where China and other developing countries were capturing market share in manufacturing and passing those cheaper costs through here to North America, et cetera.
Since Covid, we’ve seen that shift. Durable goods prices are now in the black and rising. We think they’re going to stay there this year — that’s the upside risk to inflation. Non-durable goods prices are different. Those prices swing about three times more than prices for durable goods. That’s because it has energy as a major component of non-durable goods, and it also has the impact of changes in the currency on import prices.
And let’s remember, last year oil prices went to negative $40 a barrel for a while and we saw an energy inflation at negative 20% year over year. We’re now seeing it likely to be about 30% year over year on the plus side. And the U.S. dollar has declined over 10% against a widely followed basket of other currencies, and that means import prices should be rising soon also. So that’s durables and non-durables.
Now, the services side — that’s the largest component of the deflator — and we all know what’s happened to that sector since the pandemic started. It’s the hardest hit sector of the three really, and you’ve seen major declines in activity, like the personal care sector is down 40%, recreational services activity is down 26%, transportation activity down 26%, food services and accommodation negative 17%. So, obviously, the services sector has been very challenged in its pricing, but we think we’re going to get some pricing power back this year and prices in this area will be higher than the two-and-a-quarter average of the last 10 years.
What does that all mean for total inflation? Well, the consensus expects inflation to peak at around two-and-a-half percent in the second quarter of this year as the drop in oil prices last spring falls out of the year-over-year calculation. Then the consensus expects to see inflation fall back below 2% in the second half of ’21. However, we think that inflation will be pushing above 3% in the second quarter and maybe even hit 4% in that period. Then we expect that inflation will stay closer to 3% for the balance of the year.
So, the implication of that is twofold. Longer-term interest rates could drift higher, and they may hit a point that causes the Fed some discomfort that it’s losing control in keeping yields low enough to keep the economy moving forward. Second, the Fed could shift sooner than investors expect to reduce support for markets.
Now, how do investors prepare for this? Well, I don’t think most investors really have to worry much about it. Assuming, of course, that they’re diversified with bonds and stocks already. Should government bond yields move higher because the economy is doing better, investors will likely benefit from their stock and corporate bond holdings, and their government bonds would be the laggard. If yields are rising because inflation is rising more than expected, that would likely lead to a pretty similar result. If inflation isn’t a problem, their stock and bond returns should be relatively stable.
So, inflation is a genuine risk for the first time in decades. The Fed will tell us not to worry about it, at least initially. And, while we may be right that inflation will exceed consensus expectations, the impact from that realization is likely to be short-lived because the long-run secular forces of demographics, technological innovation and excessive debt levels will reassert themselves in coming years to keep inflation and GDP pretty low.