Get perspective on inflation and short-term interest rates

Vanguard Global Chief Economist Joe Davis discusses Vanguard’s expectations for inflation and the Federal Reserve’s actions regarding short-term interest rates.


Jon Cleborne:Joe, I want to go back to something you’ve talked a little bit about earlier. And that was inflation. And inflation expectations and some movement in long-term interest rates today. I’d be interested in your question, or in the question that came in here was, should we be worried about inflation given the projected ‘deficits that might be coming?

Joe Davis: Yes, we went into, I mean just for context, this time last year, and we said two things. One is hey, listen, you know over the next five or ten years the inflation outlook is fairly muted, relative to the ’80s and ’70s, clearly. And central banks have struggled to generate 2% core inflation as is commonly measured, right. We’ve been below the target for the past ten years more than we’ve ever been above it. Now that is context; we also have said, for the first time since 2006, on a modest cyclical basis, at least in the U.S., and perhaps less so in emerging markets and other economies, or Japan, that we would see the likelihood of some domestic inflation pressures, modestly building. And now that was delayed to be fair, right. We had the commodity price, the veracious drop to begin the year. We’ve had some depressants in the healthcare prices. Some of the Affordable Care Act. But when you strip out some of that, ‘I think even the election aside, I think we’re going to have just, with near-full employment in the U.S. economy our long-held view of the economy. You throw a lot of shocks at it, but it’s still fairly resilient, even though growth we would all, I’d like to see a little bit higher. But that leads us to modestly higher inflation. Now what the markets I think are picking up is that regardless of what inflation is, one year, two years, three years, that has a distribution shift so that there’s a material risk of inflation 10 years, 15 years down the line, because of high debt levels and some sort of fiscal motivation that we may see a higher risk premium with markedly higher inflation. I think where it is today feels more appropriate than where we were three or four months ago. We’ve talked about that, right, in our own active strategies team. But I don’t see a meaningful risk of a sharp rise in inflation, at least over the next several years. But that’s also conditional on the Federal Reserve over the next year or two, removing some of the success of an accommodation measure.

Jon Cleborne: And can you talk a little bit about that, what do you think?

Joe Davis: Well, you know they’ve raised rates 25 basis points from a range of between zero to 25 basis points over a year to now we’re modestly above the zero between 25 to 50 basis points. We’ve only held two views. One is we believe the Federal Reserve has a strong case to raise rates to roughly around 1%. We could debate the number after the decimal. And at that point then we would have removed emergency measures in 2008, 2009. The U.S. economy is not in a state of urgency by the board metrics at the Federal Reserve from their mandate. After that, I think it becomes a higher hurdle, global conditions, the state of emerging markets, other developed markets, and there’s still some healing that has to go on at some parts of the economy. So I think if we get any sort of modest fiscal stimulus in the near term, I think it’s only going to give a little bit of cover to the Federal Reserve to actually raise rates. But I think increasingly they acknowledge that they want to be a little bit, have a little bit more, they want to get a little bit further above zero, a cushion, because at some point we may very well have another recession. I mean if the consensus is right, two years from now we will then have had the longest expansion in U.S. history. Now, that doesn’t mean we have to have a recession. But I don’t think the unemployment rate and core inflation says that we should have such trivially low short-term rates either.

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