In the past week, we’ve seen a substantial changes in the Federal Reserve, as well as an unraveling of the geopolitical rift in Ukraine. Lisa Abramowicz and John Authers sat down to discuss out the inflation implications of these events in detail on this week’s Risks & Rewards. Here’s a lightly edited version of their conversation.
Lisa Abramowicz: The big question of the week is clear: How hawkish have we gotten? We’ve reached a crossroads where we’re pricing in five rate hikes by the Federal Reserve this year. And we’re also expecting that they will not necessarily break the market or break the economy. Is there a dissonance here? Can the Fed orchestrate a soft landing?
John Authers: It’s true that two-year yields have risen quite fast while longer, 10-year yields have actually fallen, which is unusual. That strongly implies that the market thinks we are going to get five interest rates hikes this year, and maybe one or two more at most. But at that point, somehow or another, we are not going to need to go any further, which would imply that things will have gone wrong. There is a positive take you could make on this, which is the belief that by moving faster while still having a much a lower terminal rate than the Fed itself thinks appropriate, you’re going to deal with inflation nicely and swiftly. And then you can stop hiking rates. I suppose that would be the positive way of making sense of where we are. I still find it very hard to imagine that you’re going to beat inflation with the Fed fund rates still significantly below the rate of inflation.
LA: Well, I guess that people point to the transmission mechanism. If it’s not markets, if it’s not necessarily materially higher borrowing costs in an all-in basis for corporations or individuals, how do we achieve some sort of effect on inflation? We got that University of Michigan survey, which came out and actually showed sentiment falling to the lowest, going back November 2011. People are saying that inflation is a massive problem, in addition to concerns about omicron. But within that, what’s interesting is that the longer-term inflation expectations did not go down. They barely moved. It seems as though people are already perhaps restricting their purchases as a result of this, which is exactly what the Fed doesn’t want to see. How do you tell consumers we’ve got your back without causing a market disruption that has pernicious ramifications?
JA: I’m not sure there is an answer to it. If you get to a situation where you have this amount of money that’s been let loose on the economy and where inflation is high, it’s not realistic to get back to where we’d like to be without something, somewhere along the line, going wrong. Now, there are plenty of very interesting tradeoffs that economists and elected politicians can make. And it’s a fascinating job for the market trying to work out what’s going to be the result. But something has to give, especially given scale of the shock that COVID gave the economy.
LA: I’d like to bring up oil as an area that’s exacerbating some of the inflationary pressures. The Fed usually looks past oil as something that is a passing fad, but given the Ukrainian conflict with Russia, how much does this line up with the inflation that we saw in the 1970s? I’m not comparing the two timeframes, but I’d like to hear your thoughts on the similarities.
JA: There’s very good historical evidence on this. The longer some of those more transitory things — food prices, fuel prices — stay higher, the more expectations across the range of goods will tend to rise. Everything will get stickier. I think when it comes to the Ukraine situation, it’s obviously a fascinating political problem for Biden and the administration to judge because they don’t want to look weak, but they also presumably know that it must make life much harder for them bringing inflation under control if they do [impose sanctions]. When it comes to the Fed, one of the worst monetary policy errors of recent years (which is easy to forget because it came in the middle of 2008) was the ECB actually hiking rates in the summer of 2008 when the credit crisis was already going because oil prices were so high.
There was a (now forgotten) huge oil spike in the summer of 2008 that helped central banks take their eye off the critical problem that was about to burst out. I think the general message is yes, as a central banker, you should not take too much concern about oil in itself.
The only other thing that is important to mention is a lot of the more bullish forecasts. The forecast that inflation does come down in the next few months is based on the idea that the base effects of the oil price rise from 12 months ago will start to turn negative for inflation. And if oil keeps making new highs that cannot happen. So that is, in terms of the optics for the public, a very serious problem in terms of forming expectations.
LA: Okay. Hear me out because this is just a hypothesis and I’m playing through it and thinking out loud. How much do higher oil prices accelerate a global tightening cycle? How much does it not just force the Fed’s hand because it keeps the consumer continuing to worry about inflation, but push the hand of the ECB, push the hand of the bank of the Bank of England? When might we start to see this factoring into that discussion? And then the global tightening has a magnifying effect that feeds into the markets that the Fed is most concerned about — the credit market, namely, which so far has been relatively insulated and has been calm. Yes, you’ve seen yield rise. Yes, they’ve sold off, but it has not been disorderly. Will the momentum of that global tightening cycle lead to an aha moment of “wait a second, have we gone too far?” And then at that point, what happens?
JA: One big difference with the Seventies is oil, you’re right. A high oil price is ultimately deflationary. It acts like an extra tax on people. It is a weight on the economy. Compared to the Seventies, we are a much less oil-intensive economy in the world in general. And particularly in the West, you need to burn much less oil. There’s arguments that we should reduce it still further, but the economy is much less oil dependent. And so that is the key reason where we are different from the 1970s. We are not quite so utterly beholden to a big rise in the oil price. We can hope and assume that we are not going to the Seventies again because oil just isn’t as important as it once was anymore.
Other than that, I agree with absolutely everything you said about where we are with oil at the moment. If the situation in Ukraine pans out towards the worst scenario then yes, you would get a baby Seventies that that will have a very sharp effect on the world. It’s a childhood memory for me, but the dynamic of needing to get ration books and having to stock up on candles in case there were power cuts, that really does have an immense effect on confidence generally. If that happens it’s plainly not good for the economy. Very long-winded answer, short, I completely agree with you, but I would at least like to get it off my chest that at least it’s not going as bad in the Seventies because oil is significantly less important than it used to be.
LA: Sure. There are a lot of other dynamics, too. I mean, in the 1970s, real wages were actually increasing. There are a whole host of other things and that are now not increasing, which is not particularly great. George Saravelos over at Deutsche Bank talked about how the people’s rate hike expectations — where the rate would be in 10 years —is now a hundred basis points lower than it was two years ago.
JA: Yes. I saw that. That’s terrifying.
LA: Basically, this is not healthy. This isn’t great. We’re not saying that everything is so amazing. We’re just saying that we took all the inflation and parked it in one year and brought it forward. And then we’re going to go back to that slow grind. And how do we get out of this and the idea of the Fed? Do you just hike aggressively into that? Is it too late to really even be an influence on that? I was really struggling with that note. What did you make of it?
JA: There’s a range of views. What George is plumbing there is the sheer difficulty of reconciling the different strands we have at the moment. The other thing that’s fascinating is market expectations. They are so much lower than the Fed’s own expectations for the terminal rate. Again, this is more of an optimistic take than anything. If you think there’s more inflation, you actually might also think there’s more activity in the economy. The Fed thinks we’re heading for 2.5- 3%, and the market still thinks we stop at 1.75%, which implies barely doing anything more after this year.LA: What do you think is the likely risk or reward right now, the sort of trade that is a bit contrarian, but that feels more likely than not?
JA: It’s not really contrarian at the moment be pro value. But I think the value trade probably has an extremely long way to go. I do broadly believe that we do have inflation returning, and we are entering a higher inflationary regime. I would say emerging markets become an interesting possibility which I can scarcely believe myself saying! But if you look at emerging markets, they’ve actually held up quite well in the last month. Many of them benefit from higher resource prices. And so we might actually have finally got to the point where there really is value there. One other thing that just occurred to me is gold. On a day when the Fed terrified everybody, gold went down a lot. There is an asymmetry between the potential upside and downside of buying some gold when inflation is high and people aren’t buying gold yet. Maybe that’s a sensible thing to have at the side of a portfolio.
LA: That makes a lot of sense. If it goes back to correlation, I’ll just say that the one thing that keeps standing out to me is a number of investors keep saying they’re going into two year bonds. How much more hawkish can the expectations get? Worst case scenario, you have the flexibility to go and cash out since it’s short and use that cash to buy something if there’s a huge disruption that you see that you can take advantage of. And I understand the thinking of the lack of predictability and the desire to get yields that are not that far away from long duration bonds right now. I mean, honestly though, this is a confusing economy and a confusing market.
JA: I’m going to grab one last word. What that reminds me of is the number of people early this week who were saying we’ve now absolutely set ourselves up for Powell to give us a nice little dovish olive branch to walk us back. A lot of people truly believed that. So maybe there’s something similar to the idea of the people piling into two-years. It’s just, people have done their reverse psychology a bit too many times and might have out-thought themselves.
Bloomberg Opinion’s “Risks & Rewards” delves into the biggest market risks and opportunities of the week. Featuring Lisa Abramowicz and John Authers, the series airs on Fridays at 11:30 a.m. Eastern on Twitter and YouTube.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
John Authers is a senior editor for markets. Before Bloomberg, he spent 29 years with the Financial Times, where he was head of the Lex Column and chief markets commentator. He is the author of “The Fearful Rise of Markets” and other books.
Lisa Abramowicz is a co-host of “Bloomberg Surveillance” on Bloomberg TV.