Special Episode, Pt. 1: Two Kinds of Inflation

Inflation has reached levels not seen in years, but there is an important distinction to be made between frictional and cyclical inflation, one that has big implications for central banks this year.

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Andrew Sheets Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross Asset Strategist for Morgan Stanley Research.

Seth Carpenter And I'm Seth Carpenter, Morgan Stanley's Chief Global Economist.

Andrew Sheets And on this episode of Thoughts on the Market, we'll be discussing inflation, central banks and the outlook for rate hikes ahead. It's Friday, February 18th at 1:00 p.m. in London

Seth Carpenter and 8:00 a.m. in New York.

Andrew Sheets So, Seth, it's safe to say there's focus on inflation at the moment in markets because we're seeing some of the highest inflation rates in 30 or 40 years. When we think about inflation, though, it's really two stories. There is inflation being driven by more temporary supply chain and COVID related disruptions. And then there is a different type of inflation, the more permanent stickier type of traditional inflation you get as the economy recovers and there's more demand than supply can meet. How important is this distinction at the moment and how do you see these two sides of inflation playing out?

Seth Carpenter Andrew, I think you've laid out that framework extraordinarily well, and I think the distinction between the two types of inflation is absolutely critical for central banks and for how the global economy is likely to evolve from here. My take is that for the US, for the Euro area, for the UK, most of the excess inflation that we're seeing is in fact, COVID-related and frictional. And so, what we can see in the data is that we have an easing now in supply chain disruptions. Supply chain disruptions are still at a very high level, but they're coming down and they're getting better. Similarly, in the US and to some degree in the UK, there have been some labor market frictions because of COVID that have meant that some of the services inflation has also been higher than it might be otherwise. I don't want to diminish completely the idea that there's some good old fashioned cyclical macroeconomic inflation there, because that's also very important. But I think the majority of it is in the frictional type of COVID-related inflation. The key reason why that matters is what has to get done to bring that inflation back down to central bank targets. If the majority of this excess inflation is standard macro cyclical inflation, central banks are going to have to engage in sufficiently tight policy to slow the economy to create slack and bring down inflation. Now, the estimates are always imprecise, but estimates in the United States for, say, the Phillips curve, and when I say the Phillips curve, I mean either the relationship between the unemployment rate and inflation or more generally, the relationship between where the economy is relative to its potential to produce and how much there's currently aggregate demand in the economy. If we have three percentage points of excess inflation that has to be dealt with by creating slack, you're probably going to have to either cause a recession or wait many, many years to gradually chip away things to bring it down over time. It's just too large of an amount of excess inflation if it is truly that standard macro cyclical inflation.

Andrew Sheets So, Seth, it's been a while since we've had to deal with rate hikes in the market. And as you just laid out, there are estimates of how much the Fed would have to raise interest rates to address inflation, these so-called Phillips Curve models and other models. But there's a lot of uncertainty around these things. How much uncertainty do you think there is around how rate hikes will act with inflation? And how do you think central banks think about that uncertainty?

Seth Carpenter So I would completely agree there's uncertainty right now, and I think there are at least two important chains in that transmission mechanism, the first one that we're just talking about is how much of the inflation is cyclical and as a result, how much is going to respond to a slower economy. But the main part that I think you're getting at is also how do rate hikes - or any sort of monetary policy tightening - how does that affect the real economy? How much does that slow the economy? And I think there, it's a very open question. What we know is that over the past several decades there has been a long run downward trend in real interest rates and nominal interest rates. As a result, there's going to be a real tension for central banks trying to find just that sweet spot. How much do you need to raise interest rates to slow the economy without raising it so much that you actually tip things over into a recession? I think it's going to be difficult. And central bankers justifiably then take things very cautiously. Take the Fed as a particular example, they're tightening with two policy tools right now. They are going to both start raising interest rates and they're going to let their balance sheet runoff. We saw in 2018 that that was a tricky proposition, initially that everything went smoothly but by the time we got into late 2018, risk markets cracked, the economy slowed. Part of that was because of monetary policy tightening, and we saw the Federal Reserve in fact reverse course with those rate hikes. So it's going to be a very delicate proposition for central banks globally.

Andrew Sheets So, Seth, you talked about some of the uncertainty central banks are dealing with, how do they calibrate the level of interest rates with the effect it's going to have on the economy and maybe how that's changed relative to history. And there's another question obviously around timing. If you take a step back and kind of think about those challenges that the Fed or the ECB or the Bank of England are facing. how much into the future are they trying to aim with the monetary policy decisions they make today?

Seth Carpenter We're really talking about at least a year between monetary policy tightening and the effect it's going to have on that fundamental cyclical type of inflation. As a result, central bankers have to do forecasts, central bankers do forecasts all the time. And part of the judgment then will get back to that uncertainty that I mentioned before. How much of this inflation is temporary/frictional, how much of it is underlying, truly cyclical inflation? If all of this inflation that we're seeing is truly underlying cyclical inflation, then not only are they behind the curve, they're not going to be able to have any material effect on inflation until the beginning of next year. That's a really important distinction.

Andrew Sheets Well, and I think, you know, I think your answers there Seth raise such an interesting question and debate that's going on in markets that the market believes that the Federal Reserve won't be able to raise interest rates for very long before they'll have to stop raising rates next year. But then you also mention that the impacts of the rate increases they'll make today may not be felt for some time. These are really interesting kind of pushes and pulls. And I'm wondering if you think back through different monetary policy cycles, do you think there's a good historical precedent to help guide investors as they think about what these central banks are about to start doing?

Seth Carpenter I do, I do. And as you are comparing what central bankers may do to how the market is pricing things, I think there's a very interesting set of observations to make here. First, the last Bank of England report, where they provide their forecasts for inflation predicated on current market pricing. Under those forecasts the bank put out, the market has priced in so many rate hikes that it would cause inflation to be too low and go below their target. That's a reflection of the Bank of England's judgment that maybe the market has too much tightening baked into the outlook. But to your specific question about a previous historical precedent, I would look for the 1990s in the United States. During the 1990s hiking cycle, or should I say, just over the whole of the 1990s because it wasn't just one hiking cycle and that for me is the key historical precedent to look for. We saw hikes start in the early 90s, was not at a consistent pace. There was a time where the hikes were bigger, they were smaller, then the hiking cycle paused for a while. We got a reversal, we got a pause, we got more rate hikes and then we got a pause again and it came back down. That sort of very reactive policy is exactly what I think we're going to be seeing this time around in the United States, in the U.K., in the developed market economies where we have high inflation and central bankers are trying to sort out how much of that inflation is cyclical, how much of it is temporary.

Andrew Sheets Thanks for listening. We’ll be back in your feed soon for part two of my conversation with Seth Carpenter on central banks, inflation, and the outlook for markets. As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show.