November 30—How has the pandemic impacted inflation rates and our inflation forecast as we inch closer to a post-COVID environment? Tony is joined by Wilmington Trust Investment Advisors Chief Economist Luke Tilley for a discussion about the importance of inflation as an economic and market indicator.

Please listen to important disclosures at the end of the podcast.

Wilmington Trust’s Capital Considerations with Tony Roth
Episode 25: Inflation Dynamics
Tony Roth, Chief Investment Officer Wilmington Trust Investment Advisors, Inc.
Luke Tilley, Chief Economist, Wilmington Trust Investment Advisors, Inc.

Tony Roth: Welcome to Capital Consideration, the podcast that takes complex ideas from the investment world and makes them accessible to everyone. I’m your host, Tony Roth, chief investment officer of Wilmington Trust.

Joining us today is our very own Luke Tilley, chief economist at Wilmington Trust.

In addition to generating economic forecasts, Luke manages our tactical asset allocation team and is also a member of the Investment Committee. Luke, great to have you back
Luke Tilley: Happy to be here.

Tony Roth: Inflation is incredibly important for consumers, businesses, and financial markets. For consumers, it affects the amount they can buy with each of their paychecks. For businesses, it affects how much they can charge for their own products and it affects their workers’ demands and expectations for pay and pay increases. For financial markets, inflation has important effects on asset classes. High inflation drives up long-term interest rates and erodes the value of a bond. Lastly, it drives the interest rate decisions made by central banks, in the U.S. case the Federal Reserve.

So, the reason we’re having this conversation is because by understanding inflation we are able to hopefully do a much more accurate job in predicting the future value and direction of stock prices and bond prices.

Luke, we know the recession pushed inflation down as it tends to do in recessions, and we know it has come back a little bit in the second half of the year. Our current expectations are for low inflation in the near-term, but there is risk of some accelerating inflation after we find our way out of this pandemic. Maybe the place to start again, Luke, is to talk about how we arrive at our current view of inflation.

Luke Tilley: Yeah. Tony, we definitely think about it in terms of timing, as you said, sort of in the near term and then the longer term. When I say the near term, we’re thinking about the next 9 to 12 months, which works out to that timing that you’re talking about with the vaccines and when we would expect the vast majority of people to be vaccinated or at least enough that we stop the spread.

And also, so you said there’s a lot of things that affect inflation. It’s the business of inputs. One of those inputs is wages, of course. There’s also the cost of their material goods and we know that that obviously affects inflation.

We see a lot of stories right now about the prices of some goods moving up pretty sharply while others are still low. A lot of that is coming from supply chain problems and those are definitely near-term phenomenon that we would expect to improve. But the overriding factor that we think about is consumer spending and consumer demand. So, this is a little bit of a different picture.

Consumer spending has picked up over the course of the recovery in 2020 and a lot of that has to do with fiscal stimulus and we do expect another round of fiscal stimulus. But when we look a little bit further out and we look over the entire 9- to 12-month period, we do expect that even when we get past the stimulus that there’s still going to be some weakness in terms of jobs, not everybody having returned to work. So, we have had that very encouraging bounce back, but ultimately, I think we’ll get our economy back to a more normal place over that 9- to 12-month period. But to the extent that we have consumers facing a little bit of different decisions about how they spend their money, some of that weakness for jobs, still some uncertainty, that’s where we arrive at our view that consumer demand and spending is really not going to be strong enough to bring about very strong inflation in the near 9oollil.term, Tony.

Tony Roth: So, Luke, I want to make sure that the listeners understand that inflation is like many things where, essentially, the price of a particular good or service is set by supply versus demand. There’s a balance of supply and demand and there’s a price at which, a clearing price at which, a product or service trades hands.

And so, I think what you’re describing is that even as we come out of the pandemic, there’s still not going to be enough demand to push prices up fast enough to be concerned about inflation, inflation of course really just being how fast prices are moving either up or down. did I get it right?

Luke Tilley: Yeah. You do have it right. And I think when people see prices in front of them, right in front of their eyes going up or going down, like oh, bacon costs a lot at the store today or the cost of cars is really moving up, those are supply and demand curves as you describe them. Now not each one of those is inflation. Price of bacon can go up because there’s a shortage of hogs for some reason or cars can change because of regulation or the quality of the car or a shortage, and those are all, if you will and as you described, individual supply and demand curves.

When we talk about inflation, it’s not those prices of the things, just the ones that you see going up in front of you. It’s the overall price of goods and an increase in the overall price level that consumers face on their, all of their spending. And so, in that way what we’re seeing right now is a lot of switching between some types of goods and others, spending a lot on goods. We’ve seen over the course of this year the demand curves for new dishwashers and backyard swimming pools and treadmills and decking materials all go up significantly because we’re in a pandemic. But the demand curves for a lot of services have gone down for the exact same reason, because we’re in a pandemic. And when you sum those all, together, if you will, if you, you know, add up all the prices of everything what we see is in the aggregate lower demand and basically getting to that lower inflation outlook in the short term, Tony.

Tony Roth: So, Luke, you referenced a distinction that I think is an important one, which is goods versus services. And I know that when we look at retail consumption or retail spending and consumption of goods, it’s been off the charts this year. Whereas, services, whether it be hotels, leisure, travel, have been very, very soft for the reasons that we all know. I would expect, therefore, that you’d see significant inflation in the goods arena and then the negative of that, I don’t know if the word is deflation, but you’d see prices dropping in the services arena. Is that what we’ve seen?

Luke Tilley: Yes, it is what we’ve seen. And it’s a marked difference from what we have seen over time. We have spent many, many years, you know, at least a decade where for the most part goods prices have been in decline, deflation as you suggest, while services were really what was driving inflation and keeping it above zero and keeping it, you know, around the 2% to 2.5% mark. And that has switched in this pandemic where the prices for services are not increasing as much. It’s kind of a silly sounding word, but disinflation is when you have the slower inflation or it’s moving down, but it hasn’t actually moved to decreasing prices, while the cost of goods have seen stronger inflation. So, it’s been a flip, as you suggest, in a way that we haven’t seen for a long time and it’s easily traced back to the contours of the pandemic and its effects.

Tony Roth: So, if I think about, for example, Luke, this coming holiday season, would you expect that there’ll be shortages of many kinds of goods that people are going to want to essentially give as gifts or consume? I’m pretty much a perennial last-minute gift acquirer. Should I be going out now to make sure that I find some things before maybe even prices go up? Or how should I be thinking about that?

Luke Tilley: Well, there are certainly some issues with supply chains and getting a lot of things filled. And yes, I do think that the prices of goods will be higher. You won’t see as many deals relatively there. If you’re the kind of person who gives gift certificates for services at a salon, however, you might get a pretty good price right now.

But, the other part of it is clearly there’s a lot of uncertainty, especially in the near-term, about the very near-term, over the one-, two-, and three-month period about what’s going to happen with jobs and consumer spending and stimulus. So, there are a lot of retailers out there trying to get their sales in right now. So, it’s a bit of a mixed bag and I think at the end of it people close to you would appreciate it if I said, yes, definitely go out and do your shopping now.

Tony Roth: Okay, thanks. So, I’ll try to do that. Let me just dig further though on the idea that with the pandemic hopefully coming to a conclusion in the first half of next year that we wouldn’t see a bigger jump in overall inflation. I think that we’re somewhat representative that we have this big pent up demand to go on trips. And I know that there’s probably going to be an absence of a pickup in business demand compared to personal demand relatively speaking. What makes you so confident that when we get through the pandemic that you wouldn’t continue to see strong consumption for goods but also a big increase in the demand on the services side so that when you put it all together you could have an inflation surprise the second half of next year?

Luke Tilley: There’s a couple of parts of that answer. And first and foremost is that the run-up in goods prices that we’ve seen over the course of this year is not likely to be extended. We did see that ramp-up in some of those things that I named, like backyard swimming pools and decks and treadmills that are fortifying your home for the quarantine environment while we’ve had the weaker spending on services.

If you get a rotation of consumer spending, not the financial market rotation that we often talk about, but the consumer spending rotation from those goods and into the services, then we would expect to see both of those things moderating. You get some slowdown in the prices of goods, a little bit of acceleration in the prices of services, and they would come together to make a more balanced progression for inflation. But then ultimately, our expectation that there’s not going to be as many jobs, that we’ll still be clawing back some of those jobs means weaker demand once fiscal stimulus is done.

But, you know, to the thrust of your question, the risk would be if the vaccines work incredibly well, not just in getting people vaccinated but also in stemming some of the large structural changes and you get a lot of people going back to work and pretty close to normal in mid to late next year, then you would have that higher risk of higher inflation as you suggest. But our baseline is that there—we’ll still be having some weak demand and then inflation will not be running very high next year.

Tony Roth: One of the ideas I wanted to bring to the conversation is I love the jargon and terminology that you economists use. There are terms, such as cost-push inflation and demand-pull inflation, And I think what we’re talking about right now is a demand-driven inflation, so this idea of demand-pull inflation where, if in fact we have a really dynamic rise out of the pandemic from an economic activity standpoint, that perhaps there’d be too much demand for the amount of goods or services that are available, so it would be a demand pull type of inflation. And how does that compare to the overall inflation environment that we’ve been on over the last decade?

I know that there have been some periods where we’ve had this massive inflation like the ‘70s and then there have been periods where we’ve been—it’s been very hard to generate inflation for the last 10 years or so. And it sort of feels like if that were to occur, it would be a real break from where we’ve been over the last decade. So, I’d love to sort of continue to explore this idea of whether or not the end of the pandemic could be a welcome surprise in creating some more inflation.

Luke Tilley: So, it could be a welcome surprise. And I think the way we need to think about it is exactly as you described. You know, is it demand pull or is it cost push and what are these dynamics that are going on? And I hope you’ll indulge me just for a moment to go back to absolute basics on where does inflation come from?

Tony Roth: Absolutely.

Luke Tilley: If you just think about sort of like a silly example and it’s a simple economy with 100 goods that are produced and consumed every year and you’ve got $100 in that economy and they’re spent on those 100 things. These are identical items. Everybody buys one of them, importantly, there’s no productive growth in the economy. The economy doesn’t grow and there’s no money growth. Well, then you’ve just got a stagnant economy with zero inflation.

And then, where inflation comes from, you know, just silly example is say, let’s say you wake up one morning and there’s twice as much money in the economy because the Fed dumped a bunch of money into people’s hand. Well, they want to go out and they want to buy two of those things instead of one and quickly find out that everybody’s got double the money and that would drive the price level twice as high. You would just have inflation, but you haven’t had a change in the productive capacity of the economy.

and the other way would be to say, well, what if the productive capacity of the economy doubled but the money didn’t change? Well, then you’d actually have deflation.

So, essentially what I’m saying here is inflation comes from the differential and the growth between the productive capacity of the economy and the amount of money in the economy and sort of that spending.

So, to get to the question of cost push versus demand pull, what you really have to be thinking about is have the economy over 2020 and into 2021, have we really changed the productive capacity of the economy? And there are a couple of different views that you could take here. One would be that we had a recession. A lot of people were sent home and everything’s going to come back online, and we’re back to where we were. And there hasn’t been really a change to the productive capacity of the economy, but you have had a lot of dollars sort of dumped into it by the fiscal authorities that have dumped money in. And that would bring about some inflation and a little bit—that would bring in, you know, some inflation and a little bit of a return to normal.

But if we’ve had—if you’re going to go and you get to sort of the end of the pandemic and everybody’s had their vaccines and everybody’s going to sort of return to, quote, normal behavior, if you think that there is some structural damage to the economy in the sense that, well, there’s a change in how often people are going to the office, there’s a change in the number of people who are actually going to go to movie theaters or restaurants and all of those types of things, where you get at the end of that is you’ve changed the productive capacity of the economy in the sense that some capital is not really usable anymore. It’s sort of been taken out of the system and something needs to be done with that. And you also have a lot of these people with dollars and stimulus that has been spent.

So, when we think about getting to the end of next year, if there has been a lot of dollars that have flowed into household spending ability, but you’ve also had a massive change in the way that people spend, then you can have those relative changes going on, but it’s not quite the same thing as a return to normal where you would get that higher inflation. So, there are a lot of moving parts there, but ultimately where we end up with our assessment is that there’s going to be enough structural changes, there’s going to be enough job losses that we do have that risk of high inflation if people go back to spending as normal. But it’s going to be a very different economy and because there’s a lot of people who have lost their jobs and simply don’t have the dollars, you get that overriding impact. So, yes, it’s cost push and it’s demand pull, but there are a significant number of changes there that we’re just not returning to normal, Tony.

Tony Roth: So, let’s move forward and talk about the impact of what I would describe as very benign inflation right now, which is, it enables the Fed to try to help to support the economy during this very challenging economic period by being extremely accommodative. Can you explain how that works and what that means for us, please?

Luke Tilley: So, just through that framework that I was just talking about, what the Fed is really concerned about are a couple of things. One, the productive capacity of the economy. There’s a risk that we have decreased the overall productive abilities of the economy because of what’s going to happen to capital and then also because of job loss, if there’s significant permanent job loss.

On top of that, the Fed is viewing past periods where, especially over the previous recovery, where they had an operating strategy, a long run goal strategy that said we’re going to try and target 2% inflation over the longer term, which means if inflation fell below 2%, then they would try and keep interest rates low enough and entice enough economic activity that it would start moving back towards 2%. And then, they would start raising interest rates in order to move towards that 2% and then stop there and try and get the economy to stop right at that 2% run rate of inflation.

The change that they made earlier this year, late August, was a fairly substantial change to the way that they say that they approach inflation and it was basically that they’re going to wait longer before the first rate hike and they want inflation to run higher than 2% for some time and then bring it back down to the 2% target. And essentially what that means is they’re trying to tell consumers, they’re trying to tell businesses, they’re trying to tell financial markets when you see the economy improving and inflation heading up, don’t get concerned that we’re going to start hiking rates right away. We’re actually going to wait. And the impact that they’re hoping to have there is multifold.

They want businesses to keep investing, to increase that productive capacity. And they also don’t want financial markets to start pricing in, oh, here comes the Fed. We know that they’re going to start hiking rates and stop what is sort of an early recovery.

So, what their idea is to try and get and they’ve actually stated explicitly, we will not even consider hiking rates until inflation crosses the 2% market. So, it’s it all boils into them waiting a little bit longer, Tony, before they start those rate hikes.

Tony Roth: So, the fact that they’re able to keep rates so low is because inflation is so low, And it’s so important for us as investors because it means that relatively speaking, equities are more attractive than bonds. And it’s one of the fundamental pillars, that has been supporting the equity market, which again is that with very, very low rates bonds are unattractive because they provide very little return from an income standpoint.

As one foresees rates potentially moving up, that would erode the value of bonds that are currently outstanding. And so, there’s an acronym TINA, which stands for there is no alternative. And that essentially denotes the flow of capital into the stock market because bonds, which is other typical destination for capital, are so unattractive right now.

And what you’re describing, Luke, which is the significant reticence of the Fed to raise rates, is so important to us as investors because the stock market continues to benefit, not just from the fact of low rates but the expectation that rates will stay low. When we think about the relationship between interest rates and inflation, we often think about the idea that as inflation moves up, interest rates tend to move up as well given the expectation that the Fed would have to raise rates in order to slow down the economy and keep a lid on prices. But in fact, the market is as concerned around expectations for inflation as it is around inflation itself. So, I was hoping that you could give us a bit of a primer if you will on inflation expectations and how they come into the picture as well.

Luke Tilley: And this is critically important, as you say. And, I’m sorry I’m going to drag you back to my simple example. If you think about, you know, the economy and the productive capacity growing at some percentage each year and the Fed needs to grow the money supply each year so that you can get inflation to hit a certain target, if they wanted to just match the two of them and match money growth to the growth of the economy, that would be shooting for 0% inflation. But the Fed has decided not to do that for various reasons. They think it’s better to have a little bit higher growth rate and they’ve basically said, okay, whatever the economy’s going to grow at, we’re going to add 2% to that and we’re going to grow the money supply 2% faster than the economy can grow and there are some advantages to that.

The expectations component is incredibly important here, as you say, Tony, because that’s the expectation that they want firms and consumers to have is that they can count on roughly 2% inflation. Now, it can also go badly if they don’t manage that. And the 1970s is an excellent example of this where they were putting way too much money into the economy for a decade and consumers and businesses built in those expectations and it was this vicious bad cycle where inflation just kept moving up. Everybody was counting on that to keep happening in the future. And, importantly as you suggest, that drove up long-term interest rates higher until the famous Paul Volcker coming in and breaking the back of inflation.

So, what does that mean for the current environment and going forward? The Fed, as we were just discussing, has said, well, we want some higher inflation in the short term and we’re going to wait until it moves over 2% before we even start hiking and they’re trying to, you know, as we said, keep firms borrowing, get financial markets not to overreact if we start getting close to it. But, importantly, those inflation expectations, if you—if we get into the year 2022 and 2023, whenever it is, that inflation crosses the 2% barrier and the Fed is thinking about hiking, what really matters to them is, okay, we see inflation of 2.5% and markets, consumers, and businesses are expecting long-term inflation to come back down to 2% and we’re going to sort of raise rates and tamp that back down and meet those expectations. That’s a very different situation from current inflation running above 2% and hitting that 2.5%, but then firms and businesses and financial markets think that they’re never going to bring it back down and they start pricing in 4% or 5% or 6% inflation. And that’s the risk.

That’s their real fear is that if they let those expectations of inflation start to run higher, that’s where you get the very unhealthy rise in long-term interest rates.

Tony Roth: It seems somewhat counterintuitive, this recent change that they’ve made in August, because by them saying that they’re going to allow inflation to run higher than 2% for longer in order to make up for the period of time in which they allowed it to run lower than 2%, I would think that would have to increase expectations for inflation, because it means rates are going to stay lower for longer. And it seems to be accomplishing in a sense the exact opposite of what they want to do, which is manage inflation lower so they can keep rates down.

So, it seems to be a little of a chicken and the egg situation or a vicious circle if you will from the Fed’s perspective that on the one hand they want to message to the market that they’re going to keep rates as low as possible for as long as possible to support the recovery, but the very fact of them doing that is going to push expectations for inflation up higher because rates will be lower.

Luke Tilley: It’s a tough little dance to achieve here. And if you just think about the previous recovery and what was so challenging, inflation never really moved very significantly higher and that’s because the Fed had built in an expectation over decades that they would never let inflation really run significantly above 2%. The challenge that that presented for them was low long-term rates. The U.S. Treasury 10-year yield, it basically kept trending lower, never really moved up that significantly higher. And it gave them very little room to operate monetary policy.

So, exactly as you suggest, they want to convince markets that they’ll let inflation run a little higher. They’re hoping for the long-term Treasury rate, not next year or the year after—they don’t want long-term rates to move significantly higher. But they want their new equilibrium to be somewhat higher long-term interest rates and a little bit of a steeper curve. However, like you say, they cannot let those expectations run away from them because that would be damaging for everybody, the economy, markets, the Fed, everybody. And that’s a tough tightrope to walk.

Tony Roth: Yeah. It really is, indeed. And it has such an important impact on investments for the – due to the relationship that we just discussed between interest rates and bonds and then bonds and stocks. And, unfortunately, we’re probably going to have to leave it at that for today, Luke. But it’s been a great conversation and thank you so much for helping to provide some of those nuts and bolts to make us better investors.

Let me summarize, as I always do, what I think some of the key takeaways are for today. First is that inflation really is one of the most important economic drivers in understanding the performance of the economy and investments. It affects consumers, businesses, and financial markets in different ways and especially when actual inflation deviates from what the markets expect inflation to be, the impact on interest rates, both directly and vis à vie the Fed and the decisions that the Fed is required to make in order to manage the economy and the consequent change in prices of bonds and equities can be pretty stark and generate large impacts on portfolios. And for that reason, we spend a lot of time thinking about inflation and we’re particularly focused on inflation right now to understand what the trajectory may be as we come out of this horrible pandemic and recession that we’ve been in. So, that’s the first takeaway.

The second is that at this moment there’s really two reasons that interest rates are so low. One is the monetary stimulus that the Fed has engaged in keeping rates, the policy rate very, very low, directly therefore keeping the far end of the yield curve very low, but also inflation itself. And inflation itself being as low as it has been is what enables the Fed to keep its policy rate so low and this, in fact, has been one of the main pillars, as I’ve said, in helping the equity market and we continue to expect the Fed to be very accommodative and to continue to help the equity market in this way over coming calendar quarters.

Thirdly though we would say that we maintain somewhat circumspect around the outlook for inflation and inflation expectations and we are keeping a very close eye on this balance of consumption of goods and services, this idea of pull inflation if you will, as we get out of the pandemic and move into a healthier, more vibrant economic environment and see whether or not that stronger consumption on the services side is counteracted by the continuing overhang from the crisis in the form of permanent job losses and other headwinds, if you will, to consumption and ultimately prices or whether, in fact, those issues in the economy right themselves faster than expected, which would lead to higher inflation than inflation expectations and would cause the Fed to have to raise rates faster than we currently do expect now and would have a negative impact potentially on stocks, reversing some of the tailwind, if you will, that’s been created over the last number of calendar quarters since the pandemic set in.

So, those are the key takeaways for today and we will continue to watch all of this for you, for our clients here at Wilmington Trust. Luke, thank you. You’ve been a terrific copilot as always in these conversations.

Luke Tilley: Happy to be here.

Tony Roth: I want to thank our listeners for joining us and I encourage you to visit for a roundup of our investment and planning content. You can subscribe to Capital Considerations on Apple Podcasts, Spotify, Stitcher or your favorite podcast channel to ensure you get updates on future episodes. Thank you again for listening.

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