Linda Duessel: Hello, and welcome again to the Hear and Now podcast from Federated Hermes. I'm Linda Duessel, Senior Equity Strategist. Today I'm joined via phone by Phil Orlando, our Chief Equity Strategist, and Steve Chiavarone, Portfolio Manager and Equity strategist. We are talking inflation under the comparative lens of classic economy versus new paradigm. Let's start with you, Phil. How is the current environment reminiscent of previous periods when inflation was an eventual problem?
Phil Orlando: So Linda, the core consumer price index, the CPI retail inflation, for the month of May just hit a new 29-year high at 3.8%. But if you go back to the record high in June of 1980, it was 13.6%, much higher. The core PCE, the personal consumption expenditure index, which is the Fed's preferred measure of inflation, in April of this year, just hit a new 29-year high of 3.1%. But if you go back to 1975, we had a record high of 10.2%, November of 1980, 9.8%. So we're nowhere near those horrible levels back in the '70s and the '80s, but my concern is have we let the inflation genie out of the bottle now? And as we look across the proverbial valley, is this a problem that could grow into something bigger and worse a couple years down the road?
Linda: I mean, with the V-shaped recovery and the supply constraints, it's definitely something we haven't felt in quite many years. And Steve, when my husband and I were first married in the 1980s, double digits interest rates started to fall. And so we raced to buy our first house before mortgage rates should eventually rise again. And little did we know that they would keep falling for the next 40 years. So Steve, how is the environment today actually quite different, so that inflation may not be the worry it once was in a strong economy?
Steve Chiavarone: That's a great question, Linda. And I think what it really comes down to is the global economy is much different than it was 40 years ago. And it starts with demographics. After World War II, you had robust population growth throughout the world, particularly with the baby boom generations in many countries. You also had a big move of folks from poverty and the middle class. And that was very much an inflationary environment. In addition, you had economies that were heavily commodity oriented and you were in kind of a lull for technological innovation, when you think through things.
Steve: That's a very different world that we live in today. Today, 50% of the world's economy, and I'm talking specifically about Europe, Japan and China, are in population decline, which is disinflationary. Globalization has been disinflationary. You have the Amazon effect where you create a new product and there's a cheaper version offered by Amazon very shortly. We have the substitution of technology for labor, which is also holding wages down. And you have less unionization than you did. And so I think all of those are downward pressures on inflation that respectful of what's going on right now in this V-shaped recovery and the inflation impulse that's at play, we just think that that creates some lid on that and keeps us from getting back to those '70s, '80s style level.
Linda: Amazon effect. We never had that back decades when we were growing up, did we Phil? So now, with the world reopening, prices have surged, commodities in particular. I just heard that commodities are a more crowded trade than cryptos. But I do remember that oil prices on the rise have historically signaled, I think always, problematic inflation. So Phil, you recently posted a commentary on our website discussing inflation, particularly, and the problem with oil prices. Would you share some thoughts please?
Phil: Certainly. As I mentioned a moment ago, we just had this nominal CPI print for the month of May that came in up 5 percent, 13-year high, very high number. And energy was the single largest contributor to that spike in inflation. Now, as we look at two of the energy commodities that we pay attention to, crude oil, WTI, West Texas Intermediate, was 35 a barrel last November. It's more than doubled sitting at 72 a barrel now. Now, our forecast is 90 a barrel, and we've had that forecast in place since the end of last year. Everyone thought we were lunatics when we put that forecast in place. No one's laughing now. You've got some people now talking about 100 a barrel. Gasoline, which was roughly 2 a gallon last November, is now up 50 percent, or up to 3.08 a gallon. We're just getting into the summer driving season, and the nice folks at AAA are saying, we could be at 4 a gallon before you know it. So if everyone is now saying that crude oil and gasoline prices are going higher, and these were the single most important contributors to this spike in CPI inflation that we just saw the other day, this raises the question of the sustainability of this inflation rather than just being maybe a transitory blip.
Linda: I know it. You're making an excellent point there. But on the other hand, Steve, some suggests the bigger worry is actually deflation. What do you think?
Steve: I think that's what's driving the Fed. We've experienced inflation rates that are below their 2% definition of price stability for the better part of a decade. And there's some concern, I think, in the Fed that the United States is likely to go the way of Japan. I wouldn't agree with that. I think when you think about deflation, and deflation is pernicious because I don't spend today if I think prices are going to be lower tomorrow, which, in fact, makes prices lower tomorrow. But I think prices are a function of population growth and innovation. And the United States still has positive population growth, unlike a country like Japan, we're still the center of innovation. So I think we should avoid that outcome. And it's very interesting because I think it's the Fed's fear of deflation and Japanification that has been pushing so hard in the direction of generating higher levels of inflation than what we've seen over the last 10 years, that are leading to some of the kind of bottlenecks and price spikes that Phil's talking about in terms of the energy cycle.
Steve: And then the last thing I would say is I think one of the issues with the commodities that I think Phil was touching on is if I'm a commodity producer, because I've been head faked so many times over the last seven years on prices, I might be slow to respond in terms of supply. I'm not going to drill the new well or build a new factory. And I think that could make some of the inflation that we're seeing a little bit longer than transitory.
Linda: I'm happy to hear you don't think Japanification will be a problem here in the United States. And I know I've read that highly developed countries that are getting older and then more and more in debt, that's kind of a formula for deflation, but happily the United States is one of the more fertile, actually, developed countries out there. And so I think that's really bullish for the US. I'd like to now move along to the Fed's role in all of this. Phil, the Fed was created to be an independent entity with two objectives, low but positive inflation, and full employment. Will you tell us how Fed Chair Volcker reacted to inflation in the late '70s and the early '80s.
Phil: So this is a Fed history lesson that during that period of time, Arthur Burns gave away the chairmanship of the Federal reserve to William Miller, who was only there for two years, '78 and '79, which coincided with President Carter's four years, '77 through '80. And it was a very dangerous combination because we introduced a new word in our lexicon, stagflation, which we measured through a new misery index. Inflation was going up, unemployment was going up, tough combination. Paul Volcker comes in as the chairman of the Federal Reserve in 1979 and decides that he needs to break the back of inflation.
Phil: So we already talked about the inflation metrics, how high they were at that time. The rate of unemployment, just so you know, we had gotten up to 9% in 1975. We peaked out at 10.8% in 1982. And Volcker had to make a decision that, yes, unemployment's very high. Inflation's even worse. I tell you what I'm going to do. I'm going to invoke a recession, a really deep recession, in order to sort of clear all the excesses out of the marketplace. So we took the Fed funds rate up from 11.2% when he took over in 1979, took it all the way up to 20% in June of 1981. Just in contrast, Chair Powell has interest rates zero bound. So that's-
Linda: Oh Phil, let's let Steve talk about Powell.
Phil: Fair point, fair point. But-
Steve: Thank you Linda.
Phil: But what he did is he invoked the recession in order to bring everything back to zero, and that successfully broke the back on inflation. And we had a 40-year bull market in bonds as a result.
Linda: Exactly. He broke the back of inflation, Steve, by giving us 22 percent Fed funds and two back-to-back recessions. How does the current Fed Chair Powell differ from his predecessor of 40 years ago?
Steve: Significantly. And I think he believes that he's informed by his predecessor. I think in the current Fed's view, the Volcker Fed showed that you could effectively fight inflation, and you do it by raising rates and causing a recession. What he does not have an example of is any central bank effectively fighting deflation. And I also think that there is a philosophical difference between the two Feds. The Fed has a trade-off between unemployment on the one hand and inflation on the other. And the Volcker Fed said that they would accept some higher level of unemployment to avoid inflation. Well, that has consequences to real people. That means that there's people that are out of work. This Fed is making very different value judgment, and it's saying that I will not accept a higher level of unemployment in order to keep inflation low, especially when it looks like it's systematically low anyway. In fact, we're going to push towards full employment. We want as many people to get to work. And if the cost of that is inflation that's slightly higher, then so be it.
Linda: You're speaking of the third mandate there, are you Steve?
Steve: I am. I'm speaking of the Fed's goal to not only get to full employment, but for that employment to be more inclusive, to lower rates of unemployment for folks that have been historically disadvantaged, whether that's based on gender or ethnicity or education level. And that's a philosophically different Fed that should lead to some higher levels of inflation that we've seen over the last 10, but certainly also lower levels of unemployment. And we just have to see can they get that balance right? Or in doing so, do they, as Phil say, let this inflation genie out of a bottle, even with those big long-term downward pressures? We don't know. We've never had a Fed do this before.
Linda: Yes. We don't know, and it's uncharted territory, and our colleague, RJ Gallo, calls this regime change a big deal. I think we have just a brief moment or two to talk about monetary policy and specifically money supply. Volcker was appointed in '79. At that point, the internet hadn't been born yet. The first Bloomberg wasn't even released yet. And though the actual ticker tape stopped being used by traders in 1970, well, the Quotron was what we relied upon as witness, the 1987 film, Wall Street. Phil, can you remind listeners about the most important weekly data as market participants gathered around the Quotron 40 years ago?
Phil: Well, Linda, as you pointed out in the brilliant market commentary you wrote last week, the single most important data point that we looked at back in the late '70s and early '80s, or Quotron's, was the money supply each week, the M1 and the M2. And markets lived and died on that data. But now, you pointed out quite correctly that that data now is reported monthly, not weekly, and it's two months old rather than contemporaneous. And why is that? What do they have to hide? It's almost reminiscent of another metric that we look at now, which is public debt versus total debt. Federal Reserve says, well, we have 20 trillion in debt, 20 trillion in GDP. It's really 100 percent. But the reality is that we have 28 trillion in debt and the Fed, the treasury, have monetized 8 trillion, seemingly made it disappear. We, however, know it's there. You wonder what's going on with the numbers in terms of the relationship between Washington and the market.
Linda: Yes, an 8 trillion balance sheet. We used to find out every single week and now the data's almost two months old. Finally, Phil, times surely have changed from classic economics to a new paradigm today. Google searches for inflation are at a record high, and yet the bond market has really just shrugged. Is the inflation we're witnessing, in our booming economy, transitory or structural? And where does Federated Hermes stand? And what will we be watching to answer the inflation debate?
Phil: Our view at Federated Hermes is that inflation is more sustainable than the Fed is letting on right now. But I think we're likely to see some information coming from the Fed in coming months that will suggest a change in their approach in order to begin the tapering process, begin to lift off interest rates, and get their hands around this potentially growing inflation problem. One of the things that we're going to be watching very closely, my colleague, Steve Chiavarone, has created an inflation dashboard to measure the key metrics that we need to look at to gauge exactly where we are in this process.
Steve: And if I may, Linda, just to put a little bit of a finer point on that. We think just looking at the headline metrics is insufficient. Core PCE, core CPO, that's part of the story. But we think you need to have a deeper, more comprehensive look. So we look down into inflation between goods and services, and in sticky prices, those more permanent areas of inflation versus flexible prices, which tend to be more transitory. We're looking at things like employment costs and inflation expectations. And not just where they are now, but the underlying trend line that we're seeing and what that's likely to produce as we go forward this year and the next. And so we think that that comprehensive view that we're going to watch very closely will give us an idea on where we're headed and whether or not we're moderating, or we're seeing more troublesome inflationary trends. So that's something that we'll be making available publicly as well in the coming weeks.
Linda: Great. Thank you, Phil and Steve, and thank you to our listeners. We look forward to you joining us again on the Federated Hermes Hear and Now podcast. If you enjoy this podcast, we invite you to subscribe to the Federated Hermes channel to get every Here and Now episode, plus our other series, Amplified in Fundamentals, for a global perspective on the issues, challenges, and trends shaping the investment landscape. I also encourage you to subscribe to Insights updates from our website, and to follow us on LinkedIn and Twitter.
Disclosure: Views are as of June 15th, 2021, and are subject to change based on market conditions and other factors. This should not be considered a recommendation for any specific security or sector. Federated Advisory Services Company. 21-10088 (7/21)