In this episode of William Blair Thinking Presents, macro analyst Richard de Chazal puts inflation and Fed rates under a microscope, explains the correlation between gold prices and bond yields, and discusses the Fed’s independence when it comes to policy changes during an election year.

Podcast Transcript

Chris Thonis
Welcome back everybody. We are nearing the end of April, which, of course, makes this a perfect time for a check in with macro analyst Richard de Chazal, for another episode of Monthly Macro. Richard, thank you, as always, for joining. To kick things off, I thought we could take a look at where things stand on inflation, which is something that is proven to be even more stubborn than my five-year-old, which is no easy feat. In particular, let's focus on the three hotter than anticipated inflation reports that came out recently. I know we are stalling out on inflation now potentially. Or are we seeing it reaccelerating? What's your take?

Richard de Chazal
Well. First. Great to be back here, Chris. Literally feels like it was yesterday. Saying that, I also think it's crazy how rapidly and probably radically the narrative has changed in just that short space of the last time we spoke four weeks ago, which I think is interesting and somewhat discouraging or disconcerting in a way, in the sense of what it says about the accuracy of our collective understanding of inflation in the economy and how quickly that can change in such a short period of time. So that's not particularly encouraging. But I guess, to get back to your question, maybe somewhat controversial opinion of the day, I’m still, you know, fairly optimistic on the inflation front.

I still think this “Powell’s bumpy ride” analogy is about right in that the destination for inflation, say in Q1 next year, is around 2.5%. This last mile is going to be a little bit bumpy, but we're getting there. So, what we've just seen, hasn't been encouraging, that's for sure. And the annual rate of inflation lifted from a low of, 3.1% in January to 3.5% in the latest March data. And a little bit more worrying is the three-month annualized rate has moved up from December, 1.9% to 4.6% in March.

So clearly the momentum is heading in the wrong direction. And I think with the first two prints in January and February was easier to put these inflation spikes down to quirky things like residual seasonality and sort of new year new prices phenomenon. But with this third consecutively hotter print in March, this one was a little bit more difficult to dismiss so quickly.

I think it's true that even though a good chunk of that March increase was due to a spike in insurance premiums for autos, and remember those, increase by 2.6%, they're now 22% higher annually. They account for 2.9%, almost 3% of the entire CPI basket. But again, that’s not so much a reflection of demand driven inflation. It's still more a reflection of there being a lot more cars on the road these days following the pandemic, particularly secondhand cars. Parts have become more expensive. And the automakers, they were making a lot of money on those premiums when nobody was driving during Covid. But, everyone started to drive and have more accidents. They've been making a loss on those claims. So, they've jacked up the premium. So that's a little bit quirky. Probably more of a tax on consumption, maybe sort of put some pressure on discretionary spending in other areas. But I think more generally, if we still look at the Fed's favorite three buckets of inflation. So, goods prices, core services, less shelter. So that's super core measure, and then shelter prices themselves. We know that goods prices over the last year have had a significantly disinflationary driving force. And we're sort of waiting for that baton disinflation to be handed over to the services and shelter price components of the CPI.

And I think what's concerned the Fed a little bit more recently is if there's some risk that the economy is really accelerating. Maybe those goods prices are going to reaccelerate here before that kind of hand over to the other services and shelter disinflationary component really gets going.

And more recently, we've seen some supply chain issues again, we've seen some commodity prices rising again. And there's a bit of a fear that if the manufacturing sector is starting to reaccelerate (so we saw the ISM move back up into expansion territory in March), maybe we start to get some inventory rebuilds going on and that starts to put pressure on these goods prices before that that handover starts taking place.

But I think the reality is, so far that's not really happening. So, if you look at measures of supply chain disruption. So, the New York Fed has a global supply chain index, that's still pretty low despite what's going on in the Red sea and Panama and Suez Canal, as well as Ukraine< and the Middle East, freight costs have been coming down.

So those peaked there. Now they're now coming down. And as far as an inventory rebuild goes, not really seeing it yet. If you look at surveys of companies and their inventory sentiment, they really still think that inventories are too high and not very comfortable with the current levels. So, I think on that side not really seeing it.

Also, we are actually, even though no one's really talking about it, we are actually seeing some pretty good productivity data so that could be quite helpful on that front as well.

And then on that second bucket, those super core prices of services, less shelter, the Fed tells us they're mainly driven by wages. And I think we can see here that wage growth is clearly decelerating as well. So, if we look at, quit rates, those have a pretty good correlation with wages, job openings. Similarly, we listen to company surveys, you know, the Beige Book, all these kinds of things, they're all sort of saying, you know, wage pressures are clearly easing and we're definitely not seeing any kind of wage price spiral, which was another big factor which drove those high and sticky rates of inflation in the 1970s and 80s.

And then on that last component, shelter, again, we also know that the BLS’ measure of shelter in the CPI kind of is a bit quirky as well. And that kind of lags reality by about 12 months. So if we look at other measures of rental prices, which kind of guide those shelter prices, those have been coming down for the last year and decelerating.

So, I think there's still a lot of disinflation in the pipeline there. And I guess lastly, which is encouraging as well, is if you look at measures of dispersion in the CPI or the PCE, so that's measures that say, you know, how many, within those baskets of inflation, how many of those components are rising versus the percent that are falling.

And the San Francisco Fed do a pretty good measure of this. And you can see that the latest data shows that you've got 21% rising versus falling. So that's historically pretty low.

If you look at the data back in the 1970s and 1980s, you were seeing readings consistently above 50%. And then the entire average from 1960 to 1990 was 77%.

So, we're way below those levels. And I guess my point is, you're not seeing the sort of wage price spiral that you had back then, and you're not seeing the dispersion of price increases across the board like you had back then as well. There's sort of these more idiosyncratic increases rather than, something much more systemic. But it's not something the Fed can ignore at the moment.

Right. Which brings us to the Fed's message recently, which was pretty clear that the rate cuts are probably being pushed further into the future. And the likelihood of them being lowered, in June is not very low. But from your perspective, what should we expect from the Fed moving forward?

The Fed, you know, has kind of done a pivot on their December pivot. So, I think the clear message over the last couple of weeks and, and as we get into, the FOMC meeting, is that rate cuts in June are off the table. Maybe they're still sort of leaving the door open for July or September or November. But clearly June, they're telling us is not going to happen.

I think they're in a bit of a tight spot. You know, I think they lost a lot of credibility with the whole transitory thing. And maybe it's a little bit controversial to say…do we shy away from controversy on this, podcast, Chris?

Yeah. I mean, I'm all for it.

So, I think at the end of the day that, to a large extent, the Fed was kind of correct in that assessment of transitory inflation in the sense that the increases in prices was actually, at the end of the day, related to a lot of supply chain disruptions. And I think what we saw as those disruptions cleared, inflation came down pretty quickly.

So, from 9.1% to 3.5%. And now we’re in this stickier last mile, but regardless, I think the Fed still lost some credibility. and that's important because it's really an essential ingredient for any successful policymaker. And what it does is it gives you cushion; it gives you a little bit more margin for error.

And that's helpful when it comes to assuaging the market, and it also helps to contain inflationary expectations. And I think what that means for the Fed today is that it has a little bit less room to get it wrong. So, if they ease too soon and get it wrong and inflation flares up again, they have to backtrack and start raising rates again, that's far more damaging than staying higher for a little bit longer.

But then also risking the economy slows a little bit more than they like, or maybe missing out on that soft landing. But in the process, they're making sure that inflation really is contained. And what we can see today is that the Fed has nailed the maximum employment part of their mandate, so that does give them a little bit of room. But they're still off on the inflation part of that.

And I think the Fed is definitely cognizant of that, cognizant of looking back at history and seeing that history rewards those central bankers who have really contained inflation, even at the cost of a bit of a slowdown, and not the ones who kind of pussyfooted around trying to perfectly calibrate a soft landing and kind of trading lower unemployment for slightly higher inflation.

So, I think from that perspective and after these inflation prints, the Fed really sees no option but to tilt more hawkish again. And I think they don't really want to raise rates again. And I think the bar for actually doing that is really high.

But what it seems to be doing at the moment is kind of pivoting again, letting financial condition just do the sort of heavy lifting here and tightening.

So, I guess the point is, I suspect at this latest May FOMC meeting, they'll probably start to ease by tapering on QT, pulling back on how much they shrink their balance sheet each month. But now probably don't start to actually lower interest rates until Q3 and that's, maybe September. And that's despite, you know, the elections coming up in November.

Well, let's touch on that. How independent is the Fed really when it comes to policy changes in an election year? Is that going to influence their decision making, especially later in the year at all?

That's clearly a hot and touchy subject. It always comes up every election year. Can the Fed maintain its independence. Is the Fed really independent? Remember that, given its mandate and its power by Congress, which Congress can take away, I think what's difficult about pushing out any rate cut for June, is that obviously you're pushing that out maybe to the next meeting, July, but probably September. If you look at the probabilities there, that's now around 50/50 for a September cut. And of course, that's very close to November. So, all sorts of accusations start to mount, particularly these days when the left and the right are really miles apart.

But I think what Powell and most central banks will tell you is that monetary policy independence is the bedrock of central banking, and they don't want to do anything to shake that.

And I think if you look back in the past, there’s actually very little evidence to suggest the Fed hasn't been independent during election years. I think really the only episode where there was some legitimate doubt about that, was the Arthur Burns Nixon years, and actually, there's a very good research paper written, I think, in 2006, that sort of goes into that in some detail, but if you look at some of the evidence in that paper back in 1971, ahead of the 1972 election, Nixon was definitely putting a lot of pressure on Burns at the Fed to be accommodative and lower interest rates into that election year. And the evidence kind of suggests that Burns kind of conceded to that in the December 1971 FOMC meeting when the Fed did lower rates.

And many of the FOMC members at the time kind of went along with that, but sort of remarked that they were distinctly uncomfortable in doing so. But I think if you actually look back at policy changes in election years, say, up until November, so through to October, which I have looked at those, in 13 of those election years, since 1972, the Fed increased rates six times. It lowered them five times and kept them stable in two. And the last time they actually raised rates in an election year was 2004, which was when George W Bush was up against John Kerry. Bush won that election.

And then also, I think the other kind of controversial one in the other direction was, if you remember, that George H.W. Bush, back when he was trying to get reelected in 1992, he blamed Greenspan for losing that second term election to Clinton. Remember, it was the economy, stupid.

Yeah. Yeah, I do remember that.

And back then, there had been a recession in 1991 sort of spanning those years. And the economy was still pretty sluggish coming out of that. And Bush blames Greenspan for not cutting rates by enough. So, Greenspan was actually cutting rates, but he was kind of dragging his heels, in doing so, remember that sort of opportunistic disinflation strategy he was following. In Bush's mind, he didn't cut by enough to secure his, election victory.

And I think Powell today, you know, he's been raising rates through ‘22 and into ’23 very aggressively, very much at a risk of unleashing a recession that we've all been talking about potentially happening for years now. And he clearly wants to get inflation down more than necessarily getting Biden reelected.

And as much as Powell, in his heart probably, doesn't want to see Trump win because he knows he's probably out of a job if Trump gets elected. I don't think there's really much basis at the moment for calling into question, the Fed's independence today.

So I think, you know, maybe go back to 1971, maybe some questions there. But I think it's not something there's really a lot of evidence of in more recent years.

Got it. Changing tracks a bit. Let's talk a bit about the recent movements in gold prices and bond yields. Thus far this year, and particularly since the start of March, the price of gold has been hitting new highs simultaneously with bond yields rising. In your recent Economics Weekly, you mentioned that this relatively synchronized rise is curious because it has not been the norm for the last quarter century. In fact, since 2000, there's been a negative correlation between the direction of bond yields and the price of gold, or a positive correlation between Treasury total returns and gold's returns. So, what should investors be making of these moves?

Yeah. I think gold always brings out the conspiracy theorists. And maybe they’ve been swallowed into the digital gold world at the moment. That sort of crypto. Who knows? But, you know, gold is a great asset. It's an important asset. You know, Warren Buffett doesn't really care for it at all. But anytime you do see big moves in it, you know, there's information or a signal there.

It's always a little bit difficult to parse that signal from the noise, but I think what you were saying earlier that we have, from around the year 2000, seen a negative correlation emerge between bond yields and the price of gold. Or maybe I should say, a positive correlation between the price of bonds and the price of gold.

Because remember, bond yields and prices move inversely. So, it gets a little bit confusing there when we're talking about correlations with bonds. What's interesting is looking at these two assets together because I think both are sort of viewed as safe haven assets. That is, you know, they typically do well when investors become more risk averse.

And what we've seen from about the year 2000 onwards is that the returns on the prices, for these two assets did become strongly correlated. But before 2000, there was actually a strong and sustained, negative correlation in the return of those assets. So, the point being is that there isn't a permanent, stable relationship between the two assets over the longer term. There does seem to be over the shorter term and shorter term, I'm, I'm using kind of loosely here, meaning a couple of decades rather than 50 or 100 years.

But again, I think in more recent years, when these bond yields have been rising, gold prices have been falling and that's because if they're both safe havens and there's a tradeoff there or an opportunity cost of holding gold, if the return you can get on what you might view as the equivalent safe asset is increasing.

And what's important is that why we had this relationship since 2000 is that the markets seemed to sense all the way back then, that the world had kind of flipped, that the tilt on inflation for the global economy had shifted, and the risks on inflation going forward were now more tilted towards disinflation or deflation rather than inflation and hyperinflation, if you will, as was the case in 1970s to 1990s.

And I think what the market was thinking is that as long as inflation wasn't going to be the major problem, you could pretty much trade these assets off each other. Conversely, in the high and sticky 1970s and 80s inflation, when the bias was towards higher inflation or a higher inflation regime, so you had a negative correlation between the prices of these two assets. So, if bond yields were falling, the price of gold was rising because bond yields weren't rising because the economy was improving and the risks of deflation were diminishing, as was, you know, the case more recently, they were rising because there was a real fear that inflation was, again, getting out of control. And you really wanted that protection from gold.

Similarly, when bond yields fell, gold prices were falling, too, because it was a sign that inflation was actually getting back under control. And you didn't need to be holding so much gold if that was the case. So now if we're seeing gold prices increasing and bond yields increasing again, like we just have over the last month say, the immediate thought is we're going back into the 1970s again.

And that makes some sense because inflation has definitely been hotter, as we just talked about. But I think if you actually dig a little below the surface and look at what's driving those yields and what's driving gold doesn't seem to be, that message doesn't seem to be exactly the one that we're seeing. So, if you look at what's driving bond yields higher, it seems to be more the real yield and a rising term premium rather than sort of that third component, which is the inflation premium. So, bond investors are pricing in faster economic growth, perhaps higher risks around a greater debt burden, but not so much higher sustained inflation going forward. And then if you look at gold, I think what we can see here is really who's buying it. And it's not domestic US households fearing higher inflation. It's to a large extent the Chinese, and they're actually flirting still with deflation. So, they're not particularly worried about inflation. You had some Middle East countries buying it. They’re probably concerned about conflict, which is emerging there.

And also, over the last few years, you've had plenty of Eastern European countries, they've been aggressive buyers or their central banks have because of the ongoing conflict which is taking place there. So, again, these are purchases for geopolitical reasons rather than necessarily buying gold because they're really overtly worried about inflation soaring and becoming unstuck.

So, I think this is really about foreign central banks which are making geopolitical decisions that they kind of want to move away from the dollar.

Maybe they're increasingly unhappy with this sort of US hegemonic control the US has over the world's reserve currency and they're trying to diversify into other assets, and gold being one of the most attractive, hoping that gives them a bit more freedom.

So, I guess, sadly, I'd say, that's a little bit concerning from a geopolitical standpoint, but less concerning with the messages from an inflation standpoint.

All right. Well, Richard, appreciate your time, as always. That's pretty much all the time we have for today. Unless you have anything else you wanted to touch on before we go.

No, I think we probably covered enough and look forward to next month.

Yeah. See you in what feels like a couple days. All right. Thanks, Richard. Appreciate it.

Great. Thanks, Chris.