Thursday, April 22, 2021

BlackRock: "The Enigma and Intangibility of Inflation"

 The co-authors  

  • Rick Rieder, Managing Director, is BlackRock’s Chief Investment Officer of Global Fixed Income and is Head of the Global Allocation Investment Team. 
  • Russell J Brownback is Head of Global Macro positioning for Fixed Income 
From BlackRock:

In Edwin A. Abbott’s book Flatland, a square, living on a plane called Flatland, attempts to grapple with the entrance of a three-dimensional sphere into its two-dimensional world (the square can only see an ever-changing slice of the sphere). The two-dimensional world simply does not allow – indeed, cannot allow - the square to appreciate the full structure of the three-dimensional sphere; it being able to only see from the perspective of two axes at any point. Thus, the square cannot even comprehend the existence of a sphere until it is taken to “Lineland” (a world within a line) and “Pointland” (a world within a single point), where it witnesses how the one-dimensional inhabitants of those worlds cannot comprehend the existence of a two-dimensional square.

From a Study of Space, to One of Time and Prices

In some respects, the Consumer Price Index (CPI) is a marvelous construct, giving us additional dimensions with which to observe the phenomenon of “prices.” A single price at one point in time would be of little use in forming conclusions without some context and perspective about how that price came to be. The CPI is almost like being able to reach into a price point and pull out a line - a time series no less, with which to make historical comparisons. The visibility we have into the basket of goods and services making up that time series is like having the perspective of yet another dimension - the composition of consumption over time. But occasionally, as useful as these data sets are, they still come one dimension short of being able to show a complete picture of prices in a multi-dimensional world. Inflation - the trajectory of prices - is one area where it has become increasingly important to recognize the merits and shortcomings of our measurement tools, so as to make more accurate conclusions about the state of the economy.

The second quarter of 2021, the months of April through June, will mark the one-year anniversary of the economic trough of the Covid crisis. The resulting “peak base effects” (distortions in prior periods that influence period-to-period comparisons) will likely give inflation doomsayers their strongest ammunition yet in calling for runaway inflation. In fact, year-over-year changes in prices will spike to new local highs this spring and summer, probably even exceeding 3%, or well above the Federal Reserve’s (Fed) 2% inflation target (although Core measures of inflation will likely be lower).

But as quickly as they arrive, those same base effects will start working in the opposite direction, allowing the Fed to describe the inflation spike as “transitory.” More interestingly will be how policymakers approach the future path of monetary policy in light of almost-certain high inflation prints this summer, followed by almost-certain declines over the 12 months that follow, back toward 2%, or below. Under an Average Inflation Targeting (AIT) framework, should this trajectory in the general price levels play out, we would not have observed the sustained price increases necessary for the Fed to remove emergency accommodation.

But are prices really languishing in the state of emergency that the posture of monetary policy suggests? Perhaps not, if dimensions beyond the CPI are a consideration.

What Financial Assets and Real Estate Tell Us About Inflation

Financial asset prices, which (rightly) do not have a home in the inflation consumption basket, are certainly not indicating deflation. This year corporate earnings are expected to exceed 2019 levels, and equity prices, which are up about 50% over the last year (using the S&P 500 Index as a gauge), are suggesting that corporate pricing power has emerged from the pandemic largely unscathed (if not stronger). The bond market concurs: 5-year U.S. inflation breakevens, one way of measuring the market’s expectation of forward inflation, currently reside at 2.6%, well above both their 2018 high and the Fed’s 2% inflation target. Financial assets are not consumed, in the traditional sense of the word, by the majority of the population, and can be quite volatile, hence are by no means the embodiment of the inflation to the consumer that traditional consumption baskets attempt to capture; nonetheless their signal value about the state of the economy should not be ignored.

The housing sector is a far more influential force on the economy than are financial assets (home ownership rates are triple that of equity ownership), and yet in aggregate homes are also enjoying similarly robust price appreciation. A majority of the population are homeowners, and we have written about consumer preference having shifted, as a result of the pandemic, toward non-urban ownership rather than urban rentals (see our recent piece In Unprecedented Times, Don’t Rely on (Obvious) Precedent). National house prices are up 17% over the last year, according to Bloomberg data (as of April 12, 2021), even as rents in large urban centers like New York are down (but clawing their way back as vaccination rates rise). So, while urban rental markets are important, they should not dictate monetary policy at the aggregate level, especially since the causes of price weakness in the markets in question have been extremely well telegraphed: social distance.....


If interested see also:
"Rent inflation is going to drive shelter inflation higher by the end of the summer."