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According to the U.S. Bureau of Labor Statistics, the Consumer Price Index for All Urban Consumers saw an increase of 0.6 percent in May – fueling further discussions over rising inflation. This episode, Walter Posiewko, Vice President & Senior Portfolio Manager, Global Fixed Income & Currencies, provides his view on the latest data. Walter also notes how changes in consumer behaviour in response to inflation can feed the frenzy. [9 minutes,41 seconds] (Recorded June 10, 2021)

Transcript

Hello and welcome to The Download. I'm your host, Dave Richardson. Given what's going on in the global economy and certainly how it's been in mainstream media, outside of financial media, and on the consciousness of all consumers, really, is inflation and the direction of interest rates. So I don't think I could get a better person on to talk about that than Walter Posiewko from RBC Global Asset Management. Walter, welcome back.

Thank you, David. Good to be here.

We taped an earlier podcast with Walter. And I really encourage you to go back and listen to that, because it lays out Walter's extensive background. So, if I'm saying I'm bringing on an expert in this area, you go listen to that podcast and you’ll understand exactly what I'm talking about. So, Walter, the inflation report out in the US today, big number when you look at it, but markets have reacted in sort of a surprising way to it. Anything you're taking away from looking at that inflation report this morning and just, I guess, the series of inflation numbers that we've been seeing so far this year?

You correctly point out, Dave, that inflation has been the number one issue on people's minds. Economies are opening up, slowly here in Canada, but much more quickly in the U.S., and to a middle extent in Europe. Everyone's talking about what's inflation going to be? Because we've got these demand shocks with people coming back into real economic life again. People are sitting on a whole bunch of cash and savings accounts. Businesses are sitting on cash and their deposit accounts. So there's an expectation that all of a sudden this is going to blow up in terms of prices. And we are seeing that. I mean, everyone knows groceries are. Filling up your car with gas, prices are certainly going up. But the fact that everything is more expensive in the one-shot environment that we're seeing right now doesn't necessarily mean it's going to continue. That's what inflation is really built on. Inflation is not necessarily higher prices. Inflation is increasing rate of price increases, you see. And so today's releases in the U.S. were not unexpected. People were ranting about all kinds of big numbers. I mean, they are pretty big. The core number in the U.S., I don't think we’ve seen that over 30 years. The Fed all along has been saying, well, don't worry about this. We all know this is going to happen because we're comparing it to a base of last year where everything was shut down. The economy was moribund. And so when you can make a comparison year over year for that, the numbers are obviously much more scary. In the early months of the year, the markets were struggling with is the Fed right or wrong? First, with rates where they were backing up, the markets were making a bet that the Fed is wrong, that they're going to lose control of the situation. And the markets were pricing in, the term premium, whether it’s the risk premium, if you will. But the way the bond markets have been behaving the last month (or month and a half), they started to buy into the Fed's position. Not just the Fed, by the way; Bank of Canada as well, most central banks. They're still sitting on that proposition; they are taking the view that what we're seeing today is going to be temporary. It will be what they call transitory. And then when the base effect moves its way out of the calendar, which will be now because the next number for June is going to be based on a number that last year already saw improvement. So they're saying that things will start getting better. You can argue at this point in time that today's bad numbers are the high watermark of inflation. This is the view, for better or for worse. I subscribe to the view. I never fight the Fed. The Fed has got PhDs coming out of the ying yang studying the stuff. If they think it’s going to be transitional, I don't have any reason to argue with that. So I'm thinking that this may be the high watermark. I think that we're not going to have an abrupt, inverted V-shape response of inflation where it spikes up and then falls again. It's most likely going to stay at elevated levels, as we work our way through supply chain problems and more and more people are coming back into the economy and then consumption switching from goods to services. So expect a higher costs for haircuts and meals and maybe even movies. All this stuff is going to continue feeding into the overall inflation discussion. But I think structurally, the forces that either support inflation or don't, argue that inflation over the long term is going to be coming off again.

Thanks for that, Walter. Because I know people who have been listening to this podcast know that looking at me on a screen— and we're actually taping this via video—my hair triggers people to think about haircuts. I clearly need one. This has been an ongoing theme in the podcast. I'm glad you're playing along. So, as you said, you've been on the side of the central bankers and what they've been thinking for quite some time. There's nothing that you've seen thus far that really changes your perspective on how this plays out over the next year or two?

Well, there are risks there, obviously. I mean, we can't say with 100% certainty that the central bankers view is correct, because one thing they can't control is what people expect of inflation. And I think that's what's keeping central bankers up at night. You can look at all the numbers and you can explain them one way or another. But if the expectational component of inflation— kind of a buzzword which really means people's perception of prices— starts changing, or when people start believing that prices are going to start going up and up and up, their behavior will adjust in such a way to make it a self-fulfilling prophecy. That's where the risk is. If that happens, if enough active parts in the economy start believing that inflation is going to keep going higher and that the Fed will lose control, it almost becomes a self-fulfilling prophecy then. Because obviously the rates are going up, prices are going up, they jump in earlier. That's just going to feed the frenzy that we're seeing already now, that's only so far caused by people returning to the pre-pandemic economy. So that's the risk. That being said, when you look at the big picture, when you look at the structural forces at work, let's say pre-pandemic, no one is talking about inflation. Demographics were working against this. You had technology working against, you had globalization, and a whole bunch of long-term structural forces at work working against inflation. Then we have this pandemic where everybody shut down; that all came back, spiked everything up in prices. So the question now is, OK, you said one or two years from now, will it continue? My guess is no. I mean, right now you can't buy a car because there are pieces missing because there are chip shortages. So you can buy a car, but all of a sudden they won't have anti-lock brakes or won't have rearview mirror cameras or something like that. So used car prices are going through the roof because people can't get their hands on new cars. All these things happening now are connected not to real fundamentals, but supply chain problems. That probably will correct itself within that time frame that you mentioned of one or two years. So until I see evidence of the contrary, I don't see any reason to fight the Fed here, or fight the banks, if they say that this is going to be transitional. There’s probably going to be a period of elevated inflation numbers and then some small decline again as the normal forces reassert themselves in the economy and we put this whole pandemic nightmare behind us.

Wow, Walter, that was about as good an explanation of all that as I've ever heard. I was just trying to explain all of this to my mom on the phone who’s concerned about meat prices at the grocery store. And I wish I'd had you on the phone with me to do that. So I'll get her to listen to the podcast so she'll actually understand it.

But it probably won’t make her feel any better. Because the fact of the matter is that things are still going up in price and it's real. Everything that's not regulated is going up in price. And that's going to be with us for a while. There’s always something with meat, to use the recent hack of the large meat producer, and who knows what's going to happen next? There's so many things happening at the same time. If it's not a supply chain problem, somebody’s getting hacked or having a blackmail incident taking place. At the Colonial Pipeline for gas prices. There always seems to be something coming down the pike. But, when you look at the big picture of inflation and unions negotiating COLA into their contracts, I don't think that is an immediate problem just yet. And I reserve the right to say I was wrong on that. But certainly, I think that right now. I still do believe the position that structurally the forces just aren't there to feed inflation the way we saw, for example, in the 70s. That was a whole different time where the forces underpinning inflation were real and they were growing. That's not the case today, and I think demographics is one of the biggest one there to argue that.

Well, Walter, I would hang my hat on your track record around things like this again. Thanks for the great explanation, putting a historical context around it as well. And we always appreciate your expertise. So thanks for stopping by.

My pleasure. Thanks, Dave. Good to see you again.

Great to see you.

Disclosure

Recorded: June 10, 2021

RBC Global Asset Management is the asset management division of Royal Bank of Canada (RBC) which includes RBC Global Asset Management Inc., RBC Global Asset Management (U.S.) Inc., RBC Global Asset Management (UK) Limited, RBC Global Asset Management (Asia) Limited, and BlueBay Asset Management LLP, which are separate, but affiliated subsidiaries of RBC.

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