The New Inflation Regime

ZACH BUCHWALD:  Welcome to the BlackRock Future Forum.  I'm Zach Buchwald and it’s my pleasure to serve as your host today.  At the Future Forum, we bring together thought leaders to discuss the biggest topics that influence today’s investment landscape and right now there is no topic more relevant to investors than inflation. 

If 2020 was the year of the pandemic, 2022 is the year that seems destined to be defined by inflation.  One in five Americans sees rising costs as the most pressing issue that affects them right now and our own client research puts inflation as the number one challenge for institutional investors.  And certainly, it will drive our economy for the foreseeable future.

Inflation has been giving us signals for some time.  Costs started to creep up during the course of the pandemic and the big question was whether inflation was transitory or longer lasting.  And then as the restart took hold, major changes to consumer behavior accelerated and between the fiscal stimulus and pent-up consumer demand, a lot more money flooded the economy.  Supply chains struggled to keep up with the click-and-get consumer, workers reshuffled the job market, and new disruptions, like Russia’s invasion of Ukraine, pushed prices even higher. 

The demands of higher prices have brought challenges for institutional investors.  Take universities and hospitals.  Many need a target return of CPI plus 5% just to keep up with operating costs and to deliver their services.  If inflation persists and normalizes at higher levels, those targets rise from about 7% to now north of 10%. 

But today’s toolkit is also more expansive, and the investment universe includes more options to help investors meet the demands of higher prices.  Today, we’re going to have some of BlackRock’s leading investors on to talk about specific opportunities coming out of the inflation challenge, like automation, transportation innovations, and real assets.  And then there are those investments that may actually help drive prices down.  We had Senator Portman on the Future Forum in March and he discussed how the federal infrastructure spending is focused on projects that will improve the ports and waterways and help alleviate supply chain issues, and renewables and other energy sources, which are also part of the legislation, may provide new paths to energy independence and bring costs down.

Today, we’re going to discuss all of these opportunities.  First up, BlackRock’s inflation expert, Gargi Chaudhuri, will speak with former New York Fed President Bill Dudley about the future path for rates now that policy has started to shift.  In our second segment, we have the legendary investor, Rick Rieder, on what he expects from the Fed and how investors can strengthen their portfolios in anticipation.  We’ll get the global perspective on inflation and central banks with Wei Li, Chief Strategist of BlackRock Investment Institute, and we’ll close with a discussion with Chubb’s CIO Tim Burroughs on how he manages a large insurance portfolio amidst rising rates and elevated inflation. 

I’ll also share some footage from today’s session on my LinkedIn page.  Following the conference, you can access replays of all of these sessions. Now, to kick us off, I am delighted to pass the mic over to my colleague and friend, Gargi Chaudhuri.  Over to you, Gargi.

GARGI CHAUDHURI:  Thank you, Zach.  Bill, welcome to the Future Forum.  It is such an honor and a privilege to have you here with us today.  You’ve been so vocal and may I say so correct in your call for the Fed to take a more aggressive path of policy.  Earlier this year, you had stated that we needed Fed funds to get up to about 3 to 4% and at that time the market was only pricing in about 75 bps.  Fast-forward to today.  We obviously know that the market has priced in a lot more, almost getting close to that 3% by mid of next year. 

So, first question, curious about what your estimate for, you know, where policy is going to go from here, where the neutral rate is, and how much past that do you think the Fed will need to push in this cycle to rein in inflation?

WILLIAM DUDLEY:  Well, I think they’re going to have to go further than what’s currently priced into markets.  I also think they’re going to have to go further than the Fed has written down in terms of their own economic forecast.  Chair Powell in his press conference earlier this month was asked about, you know, where neutral was and he said that neutral was in the 2 to 3% range at 2% inflation, and that's an important qualification.

So, if inflation comes down to, say, 3 to 4%, neutral’s not 2.5%.  It’s 3.5 to 4.5%.  So, I think that people have to reevaluate where neutral is given the fact that inflation’s likely to be higher, above 2% for some time into the future.

GARGI CHAUDHURI:  Yeah.  Fair point around that neutral rate’s moving higher.  I do want to follow-up on the May FOMC meeting that you referred to.  So, obviously, you know, one of the things that the market focused on right after that meeting was the idea that they won’t go 75 basis points and the idea that that was off the table for now and they’re more likely just to be able to go 50 basis points for the next couple of meetings.  How would you characterize that shift in tone that we heard from the FOMC in the May meeting?

WILLIAM DUDLEY:  I think that they’re telling us that they want to move in a, you know, orderly but expeditious manner.  So, both expeditious, which Chairman Powell has stressed, but also orderly.  They don’t want to surprise markets.  And they don’t want the markets essentially dictating to them how much they much they have to do at any particular meeting. 

But they’re clearly going to march towards their view of neutral over the next few months.  And, you know, Powell was asked about what happens after that and he was pretty cagey about whether the Federal Reserve would have to actually move to a restrictive monetary policy late this year or early next. 

GARGI CHAUDHURI:  On this point that you made on the march to neutral, obviously that is what the market is pricing in.  And I'm curious what you think the cost of this marching to neutral, you know, tightening in a meaningful manner to rein in inflation is.  What is the cost to labor markets and to growth?

WILLIAM DUDLEY:  Well, I think the Federal Reserve has to slow the economy down sufficiently to push up the unemployment rate.  As Chair Powell has made clear multiple times, the labor market is extraordinarily tight.  For example, there’s 1.9 unfilled jobs for every unemployed person in the United States.  Now that compares to 1.2 unfilled jobs for every unemployed person in February 2020 before the pandemic, when the labor market was also at the time considered very tight.

So, the Fed basically has to tighten policy sufficiently to slow the economy down to push the unemployment rate up to loosen up the labor market.  If it doesn’t loosen up the labor market, wage inflation’s going to continue to rise and that’s going to feed into prices.  You can’t get rid of inflation now just by relying on supply chain disruptions normalizing.  You have to do something about loosening up the labor market.  And I think that Chair Powell has essentially understated what’s going to be required to accomplish that.

GARGI CHAUDHURI:  Do you think 1.2 on that vacancies to unemployment ratio is what the Fed will be targeting towards or do you, like the Fed, think that they don’t really have a target in their mind?

WILLIAM DUDLEY:  I don’t think they have a target in their minds, but I think they know what a too tight labor market looks like compared to a market, a labor market that’s just about right.  And right now, we have a too tight labor market.  And the consequence of that is not just the labor market’s too tight, but wages are running at a pace that’s inconsistent with the Fed’s 2% inflation objective.

If you look at what the wage trend has been, it’s been about in the 5 to 6% range.  That's consistent with 3 to 4% inflation, even if we normalize and get rid of all these transitory factors that have been driving inflation up over the last 18 months.  And as Powell has also noted, the supply chain disruptions are not going away soon.  The war in Ukraine, the shutdowns in China to deal with COVID are sustaining the supply disruptions.  So, that’s another source of upward pressure on inflation.

GARGI CHAUDHURI:  Actually, let’s stick on that topic for just a second.  Obviously, you brought up the war in Russia and Ukraine and the supply-related inflation pressures that we are facing in the US.  But actually, we’re seeing it globally.  Do you think that the Fed policy should differentiate between supply driven inflation and more of the, you know, the usual demand driven inflation?  And, you know, we heard the Fed say in the May meeting that their tools are not made for that supply driven inflation.  So, how do you sort of reconcile that supply driven inflation narrative with a Fed that’s going to tighten past neutral?

WILLIAM DUDLEY:  Well, at the end of the day, the Fed has to achieve a balance between demand and supply.  And right now, demand exceeds supply in a number of areas of housing, autos, and a lot of other things in the United States economy.  So, that’s the problem.

Now, part of that’s due to the strength in demand; part of that’s due to the supply disruptions.  I think the Fed can look through the supply disruptions and feel confident that those supply disruptions are temporary.  But the longer that the supply disruptions last, the more inflation stays high, the more that feeds into wages, and then you get a more persistent impulse, even though the supply chain disruptions ultimately might go away.  So, I think the problem right now is, you know, even if the supply chain disruptions were to magically vanish, you still have a too tight labor market and you still have too high wage inflation to be consistent with the Fed’s 2% objective.

GARGI CHAUDHURI:  Fair point on that supply disruption vanishing.  Obviously, you know, that’s magical thinking and we don’t think it’ll go away immediately.  But, you know, the topic of this conference is around inflation, and I'd love to deep dive into that just a little bit more if I can.  And we talked about supply chain.  We talked about wages.  And there’s a huge narrative in the market around peak inflation, right, and the view that many economists have is that we’re reaching peak inflation and after that we’re probably going to settle down. 

I don’t know if you agree with that view.  I'd love to hear your view around the path of inflation from here, but also if that changes the Fed’s reaction function somewhat once they see that the peak is past us.

WILLIAM DUDLEY:  Well, obviously, they’re going to be more comfortable with inflation falling, the rate of inflation falling than it continuing to rise.  And I think it is going to fall.  I think that the supply chain disruptions will gradually lessen and the comparisons versus inflation a year ago start to get a lot easier.  We had very high inflation a year ago, April/May/June.  Those high readings are going to drop out of the number. 

So, the year-over-year inflation rate is probably peaking right about now.  But that doesn’t really solve the bigger problem.  Where is it going to fall to?  If it falls to 3, 4, 5%, that’s still not enough for the Fed to feel comfortable.

Chair Powell in his recent press conference was very clear.  The Fed’s target is 2% inflation.  So, yes, 4% inflation’s a lot better than 8.5, which is what we’ve seen on the CPI on a year-over-year basis.  But 4% is still well above the Fed’s long-term objectives.  And if we were to sit at 4% inflation, what would happen?  Inflation expectations, which are pretty well-anchored up to now, would become unanchored and that would just make the Fed’s inflation problem worse over time.

GARGI CHAUDHURI:  No.  That's a fair point around the inflation problem and the un-anchoring, because obviously we haven’t seen that in the inflation-linked bond market yet.  But a lot of fears around that that I, you know, that investors are definitely expressing. 

If we can sort of shift gears just a little bit to talk about the dreaded R word.  I was listening to one of your Bloomberg interviews and you obviously talked about the recession as being a likely outcome.  And then, I listened to the FOMC and they’re obviously trying to talk up the soft-landing approach and they do believe that that is possible. 

So, discuss that with our listeners a little bit.  Do you think that a recession is a likely outcome given the Fed’s policy pop as of now?

WILLIAM DUDLEY:  I think it’s going to be very, very difficult for the Fed to avoid a recession over the next few years.  But a recession is not imminent.  I mean the US economy has considerable momentum.  Financial conditions are still very accommodative.  The Fed hasn’t even gotten to a neutral monetary policy.  Supply is inadequate relative to meet demand.

So, I would be shocked if the US economy fell into a recession this year.  I think the only way it could happen is if something really bad happens from abroad, for example Ukraine war becomes even worse or the China COVID shutdown turns out to be even more disruptive to global economic activity.  But, you know, a homegrown recession happening here in the US because of what’s happening in the United States in 2022, I think it’s extraordinarily unlikely.

But looking out beyond 2022 to ’23-’24, I think the probability of a recession goes up dramatically.  And the reason for that is if you start with the premise that the Federal Reserve is going to have to tighten monetary policy enough to push up the unemployment rate, the Fed’s track record in achieving soft landings in those type of situations is abysmal.  The three episodes that Powell has cited in the past of episodes where the Fed has tightened a lot and the Fed has not generated a recession, those don’t really apply to the current situation. 

The three episodes were ’65-’66, 1984-’85, and 1994-’95.  All those episodes the Fed tightened, the economy did not go into recession.  But the unemployment in all those tightening cycles declined.  It didn’t rise. 

So, if you believe that the Federal Reserve is going to actually have to push up the unemployment rate, the chances of them pulling that off without generating a recession are extremely low.  This is really well understood I think by economists.  There’s a economist, Claudia Sahm, who used to be at the Federal Reserve Board.  She has a rule called the Sahm Rule, which basically says every time the unemployment rate rises by more than 0.5%, US economy since World War II has entered recession.  So, that just gives you a sense of how strong the recession likelihood is when the Federal Reserve has to push the unemployment rate up, even modestly.

GARGI CHAUDHURI:  And do you think that applies even when it’s moving up from these near about 70-year lows, from 3.5 to 4, versus is it different when it moves from a 4.5 to 5?

WILLIAM DUDLEY:  Well, it could be different.  We don’t have that many experiences to go by.  But let’s put it this way.  There’s never been an example where the unemployment rate has risen just 0.5%, just 1%, just 1.5%.  It’s either trivial or the next stop is a full-blown recession and that’s going back all the way to World War II. 

So, it’s also important to recognize, you know, top speed in the US economy isn’t really that fast once you’re at full employment.  The prime age working population’s only growing at about 0.5% a year.  If we add, you know, 1.5% productivity growth to that, we’re talking about top speed of the economy of only about 2% a year. 

So, that’s assuming a stable unemployment rate.  Start pushing the unemployment rate up, top speed for the economy falls.  So, you can sort of see how you can get to stall speed pretty easily as the Federal Reserve pushes monetary policy past neutral to tight.

GARGI CHAUDHURI:  Right.  But you’re still sort of viewing this as a 2023 outcome more likely.

WILLIAM DUDLEY:  Yes.  The Fed has some discretion about when this occurs, right?  If the Fed decides to respond very aggressively in ’23, then the risk of the hard landing in ’23 goes up.  Or if the Fed looks at inflation and says, gee, we’re – we’ve made a lot of progress.  Inflation’s no longer 8.5% for the Consumer Price Index.  It’s now running, you know, at 4%.  Maybe we can just take a pause in terms of hiking interest rates. 

Well, if they do that, they can avoid the recession in ’23.  But what that means is they’ll have even a bigger inflation problem in ’24 and they’ll just have to hit the brakes even harder then.

So, my view is it’s coming.  The Fed can affect the timing by whether they procrastinate or not.  But procrastination is not a good option, because if they procrastinate there’s more risk that inflation expectations become unanchored and that means they actually have a bigger inflation mess to clean up.

GARGI CHAUDHURI:  The one thing that we didn’t speak about at all is obviously the balance sheet and the tightening that’s, that was announced and is going to start taking place in June.  How do you think that impacts financial conditions? 

WILLIAM DUDLEY:  Well, I think it’s obviously going to weigh on financial markets a bit.  I mean just like the quantitative easing obviously provided a lot of lift to the stock market and the bond market.  What we don’t have is good sense of how powerful this unwinding process is going to be.  And I think the important thing about the balance sheet is that, you know, the Fed is basically starting the switch at the beginning of June.  They’ll phase in the balance sheet runoff over a three-month period.  And then, once that happens, it’s just going to run in the background.

The Fed’s not going to adjust the balance sheet runoff unless the economic outlook changes dramatically.  The Fed wants to use the federal funds rate as a primary tool of monetary policy.  That means that the balance sheet tool is not going to be used actively.  This will just run on the background.

It’ll take probably three years or so for the Federal Reserve to get the balance sheet down to the level that they think that they’re comfortable with.  And until that time, I wouldn’t expect much change in terms of what the Fed’s doing in terms of balance sheet runoff.  So, it’s going to be a pretty boring story once it starts.  Where it’s not so boring is we just don’t know what the magnitude of the consequences are going to be going forward.

GARGI CHAUDHURI:  You talked about a couple of risks earlier.  Obviously the war in Russia and Ukraine and that becoming even more exacerbated is one.  Are there any other risks that are top-of-mind for you, which makes you believe that the Fed could either ease interest rates or stop on their balance sheet progress?  What are you watching for?

WILLIAM DUDLEY:  Well, I think the Ukraine war is the big, biggest risk, because you can imagine that if it goes particularly badly leading to huge consequences for European economic growth, if let’s say, for example, the supply of natural gas to Europe is – were cutoff or if the war were to broaden out in some unanticipated way.  China’s also another risk because they’re trying to keep the COVID pandemic in check by shutting down economic activity by keeping people in their homes or at the – and keeping them at their businesses, in fact.  And that’s obviously going to exacerbate the supply chain disruptions back to the US.  But it’s also going to weaken global growth a bit, because China is a huge engine of global growth.  So, the Chinese response to COVID has two effects.  It weakens global growth, but it also exacerbates supply chain disruptions.

GARGI CHAUDHURI:  Bill, it has been so great having you here with us today.  Thank you so much for your comments.  And, you know, I hope that we can have an opportunity to chat with you again.

WILLIAM DUDLEY:  Thank you so much.