Morgan Stanley economist Ellen Zentner says people are becoming “more convinced that inflation is a real thing.”
The outlook for inflation and interest rates is a hot topic as the US recovery picks up steam. Here’s the view Morgan Stanley recently outlined for bank treasurers at a recent NeuGroup meeting:
- Inflationary pressure will almost certainly continue, but even with upwards of $2 trillion in additional capital from the Biden administration’s Build Back Better initiative likely to arrive early next year, the Federal Reserve will probably not increase rates until third quarter of 2023.
- Ellen Zentner, Morgan Stanley’s chief US economist, told members that her forecast is consistent with the Fed’s new framework that recognizes short-term rates close to zero require waiting longer to raise rates, and then only gradually.
- Morgan Stanley sees the core personal consumption expenditures (PCE) index peaking around 2.6% and longer-term falling to 2.3%, higher than the Fed and Wall Street consensus expectation of 2.0%.
Inflation surge. The bank anticipates a pop in inflation this year, stemming partly from comparing this year’s growth numbers to last year’s deflationary numbers.
- Replenishing inventories and resuming services after the Covid-19 hiatus will also fuel price increases, as well shortages of goods and other distortions stemming from the economy unwinding from the pandemic.
- However, core PCE, which anchors Fed policy, should recede in 2022 but remain elevated, Ms. Zentner said.
- Seeking an average core rate of 2%, the Fed won’t rush to tamp down inflation, which has been stubbornly below that target for some time.
Rising 10-year rates. The 10-year Treasury bond rate fell from 1.9% pre-pandemic to as low as 0.50% during, and this year ramped up to 1.6% from below 1.0% at the start of the year. NeuGroup’s Scott Flieger asked whether that increase represented returning to a pre-pandemic environment or inflation.
- “It’s mostly due to inflation compensation,” Ms. Zentner said, adding that while normalization has played a role, “The difference now is that people are becoming more and more convinced that inflation is a real thing.”
Higher inflation. Longer term core PCE should remain above 2%, Ms. Zentner said, partly because globalization has slowed long-time disinflationary pressure from lower import prices and labor costs.
- Plus, the pandemic is likely to lead to sticky increases in labor costs, and households flush with cash, combined with low mortgage rates, have pushed up housing prices and rents.
- Consumers are also likely to draw upon $2.1 trillion in excess savings.
Fed’s view. The Fed is assuming unemployment can return to as low as pre-Covid, around 3.5%, without becoming inflationary, Ms. Zentner said, although structural changes stemming from the pandemic may change that.
- The Fed has recognized, however, that its old concept of full employment is not an inclusive goal, so it now seeks to achieve ‘maximum employment’ by running a tight labor market, focusing on objectives such as closing employment gaps among demographic groups.
- Combining its inflation framework target with the concept of maximum employment, Ms. Zentner said, is why the Fed will keep rates on hold for so long while “running a high-pressure economy.”
Infrastructure raises productivity. The Biden administration’s infrastructure plan provides the biggest bang for the government buck.
- Morgan Stanley anticipates infrastructure will be passed via reconciliation in October and start to trickle into the economy at the start of 2022.
- Although a massive chunk of change, Ms. Zentner said, the Fed is likely to see it revving up currently depressed productivity levels in the long term. “You can get inflationary pressures at first because you might run into shortages with these big projects,” she said. “But higher productivity ultimately will put a lid on runaway inflation.”
Tax question. A bank treasurer asked whether failure to fund President Biden’s initiatives fully via taxes would prompt the Fed to purchase Treasury bonds to increase the money supply and liquidity in the financial sector.
- If the Fed has to step up purchases, it will be because it has seen pockets of financial conditions tightening that must be offset to support its outlook, Ms. Zentner said. “Keep in mind the Fed may consider higher interest rates from more debt issuance perfectly acceptable given that infrastructure would also be boosting the economy’s prospects for stronger growth.”
