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Jeff Meli Ajay Rajadhyaksha

Episode 35

Jeff Meli in conversation with Ajay Rajadhyaksha

Is rising inflation here to stay?

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Global financial markets were shocked by the April US inflation numbers, with the Consumer Price Index (CPI) posting its largest monthly rise since 1981, far exceeding forecasts. Equities fell, interest rates rose, and cryptocurrencies and certain high-flying “meme” tech stocks were particularly hard hit. This has left investors wondering whether the spike is a transitory blip or the beginning of a self-sustained rise in inflation.

In episode 35 of The Flip Side, Jeff Meli, Head of Research, and Ajay Rajadhyaksha, Head of Macro Research, provide their views on some of the key factors fueling inflation, whether pressure will ease in the coming months as the recovery continues, and the role that psychological factors may play in all of this.

  • Jeff Meli: Welcome to this episode of The Flip Side. Today, we're going to be discussing perhaps the most central issue driving global financial markets, the recent spike in U.S. inflation and whether it's a transitory blip or here to stay.

    I'm Jeff Meli, the Global Head of Research at Barclays. And I'm joined today by Ajay Rajadhyaksha, our Head of Macro Research. Thanks for joining me, Ajay.

    Ajay Rajadhyaksha: Thank you for having me, Jeff.

    JM: All right. Markets were shocked recently by the April inflation numbers. It was the biggest monthly rise in core CPI, that's the main inflation measure, that the U.S. has experienced since 1981. Some goods experienced particularly big price increases. For example, used car prices jumped 10 percent just in one month.

    Now, we've been hearing for a while that policymakers and economists, including our own U.S. economics team at Barclays, were expecting inflation to rise temporarily as the economy reopened, but this far exceeded any forecast for the temporary blip in inflation.

    AR: Well, look, it did exceed expectations. Markets did react, stocks fell, interest rates rose. And we saw some “meme” investments especially hard hit, like cryptocurrencies and certain high-flying tech stocks.

    All that said, Jeff, I remain convinced that this is a temporary, a transitory issue, one that we should be looking through. You know, the reopening process was always going to be choppy, but nothing suggests that we won't end up pretty much where we were before COVID which is with sustained low inflation.

    JM: Well, Ajay, I realize that what I'm about to say flies in the face of the long history of lower than expected inflation we experienced pre-COVID, but I think you're wrong and that now we have the ingredients for a sustained rise in inflation.

    The pressures we're seeing behind this so-called temporary blip will last for at least four to five months and maybe longer. And that could shift expectations which in turn could make the rise in inflation self-sustaining.

    AR: Well, it sounds like we have a lot to talk about. Now, before we go into that, I think you agree with me, Jeff, about the implications of sustained high inflation. If we are actually at the start of a persistently high inflation cycle, that's a pretty big deal.

    Not only will the Fed have to stop buying assets on a dime, it might even have to sell assets and hike interest rates quickly to get inflation under control. That's not something that either the global economy or global equities markets or bond markets – none of them are prepared for the Fed taking away the punchbowl quickly.

    JM: Yes, I agree. If it turns out not to be transitory, we could be in for a recession and a pretty sharp drop in equity prices. On the other hand, if it is transitory, then all these worries fade, the Fed remains accommodative, and the backdrop remains very positive for risky assets like equities.

    AR: Yes. And so let me start by why I think increased inflation is temporary. Now, the first reason is the recent inflation number was high, but it was because of a number of one-offs related to frictions associated with reopening, not because of a general rise in the level of inflation.

    JM: Now, hold on a second, Ajay. That April CPI print was eight standard deviations above the expectation. You can't just shrug that off as a one-off.

    AR: So, I acknowledge it was an extreme number, but I'm less worried about the magnitude because just a few goods were responsible for the majority of the jump, there were massive rises in airline fares, cars, hotel rooms. You know, you've had a shortage of semiconductor chips that were responsible for part of the price rise because it limited new car supply and pushed up the prices of used cars, but we know that extra capacity for semiconductors is coming online. Autos is historically a very competitive sector and there's no reason to believe that this is a permanent change.

    JM: Sure, but our autos analyst, Brian Johnson, also wrote recently about price pressure from higher metals prices which is yet to be fully reflected in car prices. Commodity prices in some cases are at 10-year highs, notably steel, which is obviously an important input into cars. I'm not sure that the metals prices will fall so quickly.

    AR: OK. So, there I disagree. Now, remember 2009-11, oil went to over $120, far higher than it is right now. And inflation did rise, it went about 2 percent in the United States, but the Fed ignored it. And the reason was because unless commodities kept going up at the same pace, these price rises would eventually not be permanent. They wouldn't repeat year after year. And guess what, the Fed was right.

    JMi: I also think the characterization of these pressures as one-offs is a bit misleading. So, for example, the housing numbers last week were weaker amid talks of lumber shortages. I've heard that there are wait lists that are months long for basic household durables like refrigerators, toilets, and furniture probably because of the housing boom that we've seen alongside COVID.

    Airline fares which you mentioned increased by a lot, they're still 20 percent below where they were in February of 2020. Who's to say they're not going to jump again? At some point, if every good in the economy experiences a so-called one-off price increase, isn't that just the same thing as generalized inflation?

    AR: But Jeff, many of these descriptions will ease over the next few months. As economies reopen, we knew that there would pent-up demand. We knew there would be favorable year-over-year comparisons, some supply chain hurdles, and all of these were expected to conspire to push inflation above 2 percent in 2021. That's not a surprise.

    The same underlying force is responsible: excess demand before supply chains are up and running again. But the fact remains that over eight million fewer people are employed now than in Feb 2020. The labor market is far from healed. You know, as Chair Powell said recently, it's very hard to get sustained wage inflation when so many people are still jobless. Heck, we were at a 3-1/2 percent unemployment rate in Feb 2020 and we still didn't have above average inflation.

    JM: Well, Ajay, I think you're right to raise the labor market, but I'm not sure that the pre-COVID experience is really that relevant. So, look at the latest jobs numbers, they were distinctively underwhelming. The U.S. economy created only 260,000 jobs last month, that was versus an expectation of over one million.

    This is despite record levels of job openings and every business trying to hire. I think that expanded unemployment benefits are clearly allowing at least some people to stay out of the job market for longer.

    AR: That may be true, but I don't think it's in the only factor. I think the labor market is also being held back by fears of COVID infection, hesitation in taking public transit, childcare issues, all of these are coming together at the same time.

    JM: Yes, I agree. Those things matter, too. Although, some recent work suggests that childcare may be less of a drag on labor markets than we thought indicating that those unemployment benefits are playing a role, but regardless of the source of the issues, companies can't find workers and we hear this everywhere.

    Several big companies like Amazon and McDonald's have already announced wage increases. Now, in general – obviously, we want people to get raises. Working – workers getting paid more is supposed to be a good thing, but big short-term raises in response to labor shortages are different from steadily increasing pay in response to improved productivity and economic growth. And the version that we're seeing right now is more likely to result in companies raising prices which translates into inflation regardless of the supposed slack in the labor market.

    AR: You are right. Federal jobless benefits might be allowing people to weigh other factors more, but remember that they will end in September and then this factor should also ease.

    JM: Yes, but September is four months away, Ajay. Who's to say that wages don't keep rising until then and create a spiral upwards? Once wages start rising, expectations can get embedded, it pushes wages up for years. That cycle never started pre-COVID. Like you just said, we had great labor market and no inflation, but it's already started now.

    AR: It has, but I think the offset here, the dampening factor will be that every month, more and more people are likely to enter the workforce. And keep in mind, at least 20 states at this point have already announced that they will not accept the expanded federal jobless benefits, so I think that effect is exaggerated, is fleeting. We are in the eye of the storm right now, but by the end of this year all these pressures fade and we are closer to where we were pre-COVID.

    JM: Well, Ajay, I see two big differences between the current situation and the economy pre-COVID. Now the first is the monetary and fiscal stimulus being applied. So, not only are interest rates at rock bottom, but the Federal Reserve continues to buy $120 billion worth of financial assets every month despite the recovery being well underway.

    They're already super easy. And it's one thing to tolerate high inflation because you believe it's temporary, it's another thing to add fuel to the fire by increasing accommodation every single month which is what they're doing right now.

    AR: I think the way the Fed looks at it is pre-COVID for 12 years, they bought an extra four trillion dollars in assets. They pushed the U.S. jobless rate down from over 10 percent to 3-1/2 and they still averaged less than 2 percent inflation.

    That is why they remain far more worried about downside risks after this near-term pop in growth ends. Having said that, I do think they will announce later this year that they will taper asset purchases, but that will be because they see the labor market healing, not because of worries about runaway inflation.

    JM: Well, like you have said several times here, pre-COVID, the U.S. economy had record low unemployment rates but no inflation. And so the Fed could remain easy, in fact, they cut rates – I believe it was towards the end of 2018, right, despite the strength in the economy.

    Now, we have a different situation. It's actually the exact opposite situation. We have high unemployment and high inflation. We used to call that stagflation, right? That's like a term that got thrown around from the ‘70s. Now that's a big difference. This time, we've actually seen prices rise.

    And then let's not forget fiscal stimulus. We passed almost $3 trillion in stimulus between last December and this March which is on top of the multiple trillions earlier in 2020, all for COVID relief. And the administration is still pursuing lots more.

    Now, sure, in the last cycle many people forecast inflation that never came. Here, we've already started to get some inflation and we're spending several trillion dollars a year with plans to add up to as much as another four trillion.

    AR: So, I'm skeptical that these new spending plans will come to fruition, especially on anywhere near the scale you mentioned. In fact, Jeff, our economic forecasts for 2021 as you know, don't assume new fiscal stimulus beyond what was already passed. Now, if a relatively small infrastructure package passes that is spread out over a decade which is perhaps possible, I don't really see that as having an effect whatsoever on near-term inflation.

    JM: My second issue, Ajay, is that inflation is partly psychological. We've been focusing on the economics of it, but the fact is if we all expect prices to rise, then that's what happens. That's because we demand raises from our employers who then have to pass that higher wage cost through to the prices of the goods and services that they sell.

    And so the expectation of becomes self-fulfilling, but in order for those expectations to change, you need a spark. And I think you could argue that that spark was what was missing pre-COVID so we never saw expectations shift, but four to five months of wage pressure and supply disruptions could provide that spark and change the paradigm.

    AR: True, but we have measures of inflation expectations. We can look at 5 year 5year CPI swaps, for example, they look at the market's expectation of average inflation in the second half of the decade and it's watched closely by the Fed. And you know what, that level, that is very close to where we were at the start of the year even though current inflation is elevated. So, what markets are saying is, near-term over the next few years, inflation will rise a lot, but that they still very much trust that medium-term inflation will stay in check.

    JM: Well, you know, that's interesting you're pointing out market expectations. I would have pointed to the expectations of the U.S. consumer which gets measured in the University of Michigan survey of consumer confidence. And last week's read showed that consumers are getting far more worried about medium-term inflation than in the past even if financial markets are not.

    AR: That part is true and it bears watching. But in the past, Jeff, consumers' expectations, even if they are asked about the long term, seem to react much more to near-term gas prices which have risen lately.

    And that I think is also why policymakers do look at the market-based measures that I mentioned which are far less worrying. But even if you are right, I don't think the Fed has any choice right now. They have communicated over and over that they will be patient with near-term inflation. Reacting to the first high print would destroy that credibility. Either way, we are going to have to see this play out.

    JM: Yes, I do agree with you on that front, Ajay. I think the Fed benefits in the long run from clear communication and following through on commitments and so that seems locked in. The bigger question to me is what to make of the spending proposals being floated by the new administration.

    So, we haven't even finished spending the money from the last two COVID relief bills, we're already seeing demand outpace supply. At very least, I think we should wait to see if you are right and this inflation surge sort of burns itself out, because if you're not, spending another $4 trillion will seriously supercharge inflation.

    AR: Well, I said this before, I'll say it again, I doubt spending of that magnitude will pass. I suspect the process will take a long time to play out and by then, we will have a stronger sense of longer run inflation risks and also this is supposed to be infrastructure spending. It is spread out over a decade. The stimulus so far spends trillions of dollars over 2021 and 2022. It's much more near-term impactful, but I do agree that the more inflation builds, the less likely new spending proposals are to pass.

    JM: Well, Ajay, we'll obviously have to watch the incoming inflation data very closely. Clients of Barclays can read our latest take on the trade-offs facing policymakers over the next several years in the Great Unwind, a chapter in our latest equity gilt study available on Barclays Life.
     

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About the analysts

Jeff Meli is Head of Research within the Investment Bank at Barclays. Jeff joined Barclays in 2005 as Head of US Credit Strategy Research. He later became Head of Credit Research. He was most recently Co-Head of FICC Research and Co-Head of Research before being named Head of Research globally. Previously, he worked at Deutsche Bank and JP Morgan, with a focus on structured credit. Jeff has a PhD in Finance from the University of Chicago and an AB in Mathematics from Princeton.

Ajay Rajadhyaksha is Head of Macro Research at Barclays, based in New York. He oversees the global research and strategy efforts of the economics, rates, FX, commodities, emerging markets, securitised, and asset allocation teams. Since joining Barclays in 2005, Ajay has held various positions, including Co-Head of FICC Research and before that, Head of US Fixed Income Research and US and European Securitised Research.

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