The common expectation that inflation will be structurally higher in a post-COVID economy is effectively an admission that the economy’s self- correcting mechanisms are damaged and that the time-tested methods by which central bankers have influenced the real economy are no longer effective. We are not so sure. Certainly, the excesses of the COVID era have set a difficult course over the next few years for both the economy and policymakers, but we think a return to low inflation is more likely than not. Many of the inflationary impulses seen in this cycle will eventually respond to traditional monetary policy; others are seemingly “one-off” and unlikely to be repeated.
Supply-side inflation is fading
First, we consider the economic fixes to structurally higher inflation. The obvious solution to the demographic problem of a shrinking working age population in the developed world is increasing migration. The challenge is that the workers are located in the developing world, and politics have led to restrictions on the immigration of skilled and unskilled workers to regions where there is high demand for both types of labor. But businesses have been made acutely aware of the impact that high wages have on profit margins, and the arguments for expanded migration are emerging.
Should these arguments fall on deaf ears, the obvious alternative to bringing labor to capital is bringing capital to labor. If immigration policies are not loosened, then companies will continue moving production to lower cost locations in the developing world. Such investments are increasingly targeting countries and regions that are geographically convenient (i.e., near-shoring). Along with lower costs for producers, such investments and the jobs they bring may also reduce the size of migrant populations originating in these same regions.
This broad rewiring of the supply chain is often cited as a likely cause of future inflation, but we think the case may be overstated, at least on a forward-looking basis. Many of the costs associated with supply failures and expensive short-term workarounds have been priced in during the three years of the pandemic. Put simply, items like critical infrastructure, communication technology, defense, pharmaceuticals, energy and food have already experienced a price increase that is the inevitable consequence of moving from the cheapest producer to a more secure supply chain. Those price increases certainly don’t need to happen again, and over time companies may find opportunities to reduce supply chain costs while preserving critical resiliency.
In contrast, for the vast majority of consumer and industrial goods there is no national security or public policy focus pushing to move production back on shore. But there remains a persistent profit-maximizing incentive to produce at the lowest cost, perhaps while also diversifying production and building a more resilient supply chain. This will result in real shifts in manufacturing but not necessarily to higher cost locations. Non-China Asia, Latin America and Eastern Europe offer low cost and geographic convenience in varying measure.
Policy responses lead to recession and disinflation
Even if demographics and deglobalization together put some upward pressure on consumer prices in the years to come, economic forces do not act in a vacuum; rather, they must contend with the response from policymakers and central bankers. We know that the Federal Reserve (Fed), European Central Bank (ECB) and other central banks are focused on reining in current inflation and restoring a measure of lost credibility. It seems unlikely that they would suddenly choose to accept a higher long-term inflation target rather than endure a period of short-term subpar growth.
We should not have been surprised that inflation rose sharply after years of negative real rates and quantitative easing, followed by a massive surge in fiscal spending. Nor should we be surprised when inflation peaks and then falls as these policies are rapidly reversed (Exhibit 1). Higher interest rates and a declining money supply have proven their effectiveness in the past and will likely do so again.
The Fed is currently pursuing a double-barrelled policy of monetary tightening: raising short-term interest rates to slow the economy and using quantitative tightening (QT) to reduce the money supply. Real rates are now positive across the curve, and QT had removed approximately 16% of the money supply prior to the recent banking crisis. Fiscal policy remains broadly supportive but nowhere near the “surge” levels associated with the pandemic response. As a result, we believe the Fed’s long-term inflation target of 2% is reachable over time.
Potential growth and a potential recession
Against a backdrop of elevated inflationary pressures, the task facing central banks will be more challenging, but not impossible. The question therefore is not whether central banks can return the economy to pre-pandemic target inflation rates but, rather, how much economic pain is necessary to get there. The Fed understands that it lost precious credibility in letting inflation flare up, and it is now implicitly allowing for a recession as part of the solution. The Fed seems biased to overtighten or at least is willing to keep rates elevated for an extended period rather than pivoting quickly at the first sign of soft data. The eventual outcome should be a decline in inflation back toward the 2% target – accompanied by a period of negative real growth.
While there could be a temptation to raise the inflation target and shorten the period of economic contraction, the benefit would be limited. A 3% inflation target vs. a 2% inflation target might require a smaller economic contraction, but it would not change the medium- to long-term amount of economic restraint necessary to keep the rate of inflation stable. Growth must be restrained at potential in either case.
Potential growth is effectively the speed limit on sustainable growth at full employment that is neither inflationary nor deflationary. Potential growth was slow before the pandemic (Exhibit 2), but it is probably even slower now if the secular forces of demographics and deglobalization are real. The current level of growth is too high relative to potential; to reduce inflation pressures, growth must be reduced. While central banks rarely describe policy in these terms, this is effectively what they are seeking to achieve.
Are high real rates sustainable, or survivable?
It follows that if potential growth must be slower, then the neutral policy rate (r-star) may need to be higher post-pandemic to ensure that economies do not exceed their (now slower) growth speed limit. Debates around the level of neutral policy rates in a post-pandemic economy may seem academic, but they can have a significant real-world impact on bond markets and asset prices broadly. Policy rates may be a creation of central bankers, but they greatly influence the supply and demand for capital and the productive capacity of capital previously deployed. Central bankers may see a justifiable need for higher neutral rates … and the real economy may feel some pain as a result.
Most productive assets in the global economy, whether real or financial, have some kind of capital structure, which in practice means that debt financing is used to purchase the asset or enhance its returns. During the extended period of low nominal and real interest rates that prevailed up to and into the pandemic, a lot of debt was added at very low interest rates to assets with any sort of income stream or expectation of price appreciation.
Now, post-COVID, the cost of refinancing that debt has gone up while the potential income generation and price appreciation have gone down. It follows that the next step is likely to be a drop in price. But downward price adjustments often leave asset owners with little or no equity, facing the unpleasant decision of recapitalizing the asset or defaulting on the debt. The principle is the same whether it’s a margin call on a stock portfolio, refinancing an office building or a deposit run on a bank.
If there is sufficient capital available, the process of recapitalization stands a chance of succeeding. Often, equity holders may be diluted or even wiped out, but the senior debt remains largely unharmed. Voluntary debt restructuring may play out in the event of a more serious loss in asset value without causing broader damage. Outright defaults and foreclosures would be more concerning, of course: Given that they are deflationary, the central bank might initially tolerate them as being consistent with a restrictive monetary policy stance, but if they metastasized through the economy, central banks would be forced to lower rates before too much damage was done.
This is the crux of the matter. Central banks have responded appropriately to the surge in inflation by raising short-term interest rates and restricting the money supply. But the capital structure of the modern, debt-financed economy will face significant challenges as a result, and it’s not yet clear if a sharply higher neutral policy rate is sustainable for long. In the best case, the outcome may be a slow write-down of capital that was invested too aggressively. In the worst case, a decade of low cost debt may come to ruin if the write- down accelerates and insufficient capital is available to recapitalize leveraged assets.
Implications
The move higher in interest rates that occurred in 2022 has restored yield and defensive diversification to bonds, and it has significance for asset allocation broadly and for portfolio construction in fixed income. As a result, investors should be repositioning fixed income allocations to reflect this important function.
For U.S. investors who have been tilting defensively toward cash, the time to return to more traditional bond allocations may be at hand. For European (and Japanese) investors who had been looking offshore to escape negative yields, the opportunity to return capital to local bond markets is appealing. Over the secular horizon, we expect policy rates to decline, providing positive returns to duration and leading us to favor moving out the yield curve to longer maturities.
We also see long-term value in high quality corporates and securitized products, where “safe spread” offers fair compensation for credit risk and all-in yields have risen dramatically. These sectors also happen to reward disciplined active management, where fundamental research helps to protect portfolios from concentrations of credit risk. Riskier credit sectors like high yield or loans should be approached cautiously but opportunistically.