Markets are currently betting too heavily on inflation bouncing back this year despite long-term secular trends that suggest the road to the Fed’s 2% goal will take a lot longer.
With economies emerging from the worst of the coronavirus pandemic, all eyes are on central banks and their next steps. With stoking inflation their goal, many market participants have backed a rushing return to higher inflation levels in the next 12 months.
But for this to happen, one would have to ignore the long-term secular trends of inflation in the last decade, according to Ken Leech, manager of the $13.6bn Legg Mason Western Asset Macro Opportunities Bond Fund and CIO of Western Asset Management, part of Franklin Templeton Group.
“The secular challenges of debt and demographics that were abundant in restraining global growth and global inflation before Covid are not only still in place, in many respects they’ve actually gotten stronger. These headwinds are going to have to be faced again at the tail end of the pandemic,” says Leech.
“The Fed expects that it will take a long time before they’ll be able to move interest rates up, that they need to be very supportive of this economy. There’s been a deep difficulty economically, and this is going to take a long time to heal. Inflation will rise but it will be very slow in doing so.
“In order for the Fed to pull back on its monetary commitments as they stand now, you’d have to see an extraordinary turnaround in economic fortunes, even if a big fiscal thrust from the US government is coming.
“Looking at the unemployment rate as a marker, we’re close to where it was at the bottom of the Global Financial Crisis with around 10 million unemployed. On that basis the Fed is very far away from their goal of a two percent run rate of average inflation and full employment. It has an awful long way to go.”
Leech believes that despite this outlook, the market has swung back and forth on its inflation expectations during the crisis – first that deflation suddenly became the expectation, and now the pendulum has swung completely the other way to it exceeding central bank targets.
“The market has obviously moved its expectations around pretty sharply. At the moment the base case seems to be implying that not only is the Fed going to succeed in reaching their target, but that we’re going to have much higher inflation than you would have expected even last year before the deepest economic contraction we’ve had in 50 years,” Leech said.
Leech believes that the market’s embrace of the speed and optimism for a return of inflation may be misplaced.
“Our base case is that the Fed’s commitment to getting inflation higher along with the improvement in the global economy suggest that inflation should be rising over time. We just think this is going to be a difficult task and one that will take some time,” says Leech.
“If you think about the US as part of the global ecosystem, inflation rates all over the world are arguably still falling, or maybe at best finally at a floor. This really reflects the enormity of global slack.