Wednesday, February 23, 2011

Inflation:What lies ahead - PIMCO

Inflation: What Lies Ahead
  • We expect popular measures of inflation to show modest increases in price levels this year from last year.
  • Masked behind these seemingly benign near-term increases in inflation are a number of longer-term factors that we believe could actually result in undesirably high rates of inflation in the not-too-distant future.
  • Higher rates of increases in food, energy and other commodity prices are leading to a divergence between the core rate of inflation that the Fed focuses on and the headline rate that includes food and energy prices and actually affects consumers.
Mihir P. Worah
For 2011, we expect the measure of inflation of most interest to the Federal Reserve, core Consumer Price Index (CPI, not including food and energy), to average 1.0% to 1.5%, up from 0.8% in 2010. More importantly, we expect headline CPI, which includes food and energy, to average 1.7% to 2.2%, up from 1.5% in 2010.
Masked behind these seemingly benign near-term increases in inflation from what many deem as undesirably low rates to more “reasonable” rates are a number of longer-term factors that we believe could actually result in undesirably high rates of inflation in the not-too-distant future. Persistently higher rates of increases in food, energy and other commodity prices are leading to a divergence between the core rate of inflation that the Fed focuses on and the headline rate that includes food and energy prices and actually affects consumers (Figure 1).
Models used to forecast U.S. inflation can fall short, because they are generally not designed to incorporate fundamental changes occurring in the U.S. economy. Our expectation of higher headline inflation in the foreseeable future is based on our judgment as well as use of models while knowing and understanding their limitations. One of the key issues to consider going forward is that the emerging countries are transitioning from being exporters of disinflation to the developed countries to being exporters of inflation.
All things considered, investors may wish to consider adding assets typically associated with inflation-hedging strategies to their portfolios.

Near-Term Outlook
First, let’s touch upon our near-term or one-year outlook. We model core inflation using both a “top-down” Phillips curve–based model as well as a “bottom-up” one that explicitly models and predicts the individual components of CPI, like car prices, apartment rents, groceries etc. (The Phillips curve represents a historical relationship between the rate of inflation and the unemployment rate.) Both of these approaches come up with a number near 1.2% for core CPI in 2011. Much of this expected rise from last year’s 0.8% core CPI number comes from a steadying in the cost of shelter, which is 40% of core CPI and which had plummeted amid the housing crisis. The primary inputs into the cost of shelter are rents or imputed rents (since the Bureau of Labor Statistics only wants to capture the utility part of shelter and not the investment aspect of owning a home). Rents stopped going down in the middle of last year and both our model (Figure 2) and anecdotal evidence support a firming in rental prices this year.

Notwithstanding the firming in rents, the 1.2% central prediction for core CPI in 2011 is still benign, and perhaps the Fed will continue to view core CPI as too low and too close to zero or deflation.
However, it is possible that these models are underestimating future inflation. For example, we already know what these models would predict for core inflation in 2012 if the unemployment rate were still hovering around 9.0%, as PIMCO currently expects. The models would predict another year of nonexistent wage pressure, significant slack in resource utilization and hence a below trend inflation number (provided inflation expectations remained anchored). 

These models cannot incorporate what we believe are structural changes in the U.S. economy, like a higher Non-Accelerating Inflation Rate of Unemployment (NAIRU, a level of unemployment below which inflation rises) and concurrently a lower than historic trend growth rate for the U.S. economy accompanied by an unprecedented expansion of the Fed’s balance sheet. As each year goes by, the near term moves ever closer to the long term and one has to augment these cyclical models with longer-term models and secular thinking to try and catch the shifts that models just cannot catch. More important and immediate, these closed economy models for domestic inflation do not pick up the inflationary impact, both direct and indirect, of higher commodity prices resulting from strong emerging market growth.
To be sure, there could always be a downside surprise in price levels, for example if growth in the emerging economies unexpectedly falters. But that is not our expectation at this time.

Longer-Term Outlook
A common argument for ignoring commodity prices when calculating or predicting longer-term measures for inflation is that these prices “mean revert,” meaning large rises in prices are followed by equally large drops. We think this is true to the extent that we do not expect continued 80% increases in grain prices like we saw in 2010 or the 50% rise in oil prices we saw in the first half of 2008. Both those rapid increases in prices were due to special weather-related factors that exacerbated the fundamental long-term tightening in natural resources that we are living through (although they do underline the points that supply lines are generally stretched and weather patterns are becoming more volatile). We feel that although commodity prices may show tendencies to revert to a “mean,” the mean itself is not static, but rather a moving and, in our opinion, a rising target.

It is not difficult to understand the reason for our expectations of generally rising commodity prices. It is simply a result of several billion people living in emerging economies that are gaining economic clout and improving their standards of living, often in an extremely commodity-intensive way. This generational shift in global consumption patterns leading to a secular rise in commodity prices was temporarily thrown off course by the Great Recession of 2008, but the longer-term direction is clear.

Hence, as far as “mean reversion” in commodity prices goes, we would say that “history does not repeat, it rhymes.” Rapid rises are likely to be followed by modest pullbacks; however, five years from today prices are likely to be higher on average than they are today.

The inflationary impulse from emerging economies is not limited to higher longer-term commodity prices. A combination of too-loose monetary policy (imported from the U.S. via pegged or semi-pegged currencies) and significant rises in food prices (which are a large part of the consumption baskets) has led to an inflation problem in many emerging market countries already. This is likely to result in some combination of higher wages for workers and an appreciating currency, both of which could result in higher import prices in the U.S. and hence higher inflation for U.S. consumers.

Adding to these concerns for imported inflation are the impacts of U.S. monetary and fiscal policy. By now it is well known that the unprecedented expansion in the Fed’s balance sheet is not inflationary if it does not result in increases in broader money aggregates like M2 or M3, which measure money actually circulating in the economy. (M2 includes the narrower M1 as well as certain deposits and money market funds. M1 includes cash and checking account deposits. M3 includes M2 and certain large, long-term items.) Our models of the relationship between money supply and inflation show that a policy error where the Fed does not shrink its balance sheet in the face of the money multiplier returning to its pre-crisis level may result in double-digit inflation with a lag of three years (conversely, shrinking their balance sheet too soon may send us back into deflation). The fact that the emerging economies are no longer a source of disinflation like they were over the past 20 years (in fact quite the opposite) severely complicates the Fed’s job. They now have to make an explicit decision to slow down job growth if they want to fight inflation. In our opinion it is no longer possible to have robust job growth AND low inflation simultaneously.

Finally, we get to our fiscal situation. Our budget deficit is around 10% of GDP and given the current trajectory and in the absence of a surprise economic expansion or political compromise, we estimate our debt-to-GDP ratio will reach around 100% in a few years. There are three ways to solve our debt problem: Growth, Inflation or Default. The choice is clear to us; which one seems most likely to you?

Conclusion Although current inflation numbers and the near-term inflation outlook appear benign, there are a number of factors, including higher commodity prices, that lead us to expect higher inflation longer term. Assets typically associated with “real return,” such as commodities, real estate, equities (as long as inflation remains moderate), bonds from countries that offer high real yields, and even Treasury Inflation-Protected Securities (as long as the duration aspect is managed; see previous Viewpoints for suggestions) can serve as inflation hedges.

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