About this Episode

As the outlook for the economic recovery from the COVID-19 crisis brightens, market participants are closely watching the shape and speed of the rebound. While many are concerned about the risk of rapidly rising inflation as the Treasury yield curve steepens, commodity prices surge worldwide, and stimulus money fills U.S. consumers’ pockets, such fears may be overblown. S&P Global Ratings Global Chief Economist Paul Gruenwald joins the Essential Podcast to discuss the risk of unanchored inflation and benefits of orderly reflation in the wake of the U.S.’s $1.9 trillion fiscal stimulus package and proposed $2 trillion infrastructure package. 

The Essential Podcast from S&P Global is dedicated to sharing essential intelligence with those working in and affected by financial markets. Host Nathan Hunt focuses on those issues of immediate importance to global financial markets – macroeconomic trends, the credit cycle, climate risk, energy transition, and global trade – in interviews with subject matter experts from around the world.

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Show Notes

• As the outlook for the economic recovery coming out of the COVID-19 crisis brightens, market participants are closely watching the shape and speed of the rebound. Get the essential intelligence on Rising Inflation & the Post-Pandemic Recovery.
• The recent rise in U.S. Treasury yields, and its spillover into corporate bond yields, indicates greater confidence in a sustained economic recovery, including a normalization of both market functioning and risk pricing. Read Paul Gruenwald's report on reinflation here.

Transcript

Nathan Hunt: This is The Essential Podcast from S&P Global. My name is Nathan Hunt. Economists are a fractious bunch. Put any two economists in a room and you were likely to get three different opinions and there is nothing that activates the argumentative instinct for economists like the topic of inflation, unless you are paid in Zimbabwean dollars it is unlikely that inflation has been a pressing concern for the last few decades. However, countries around the world have reacted to the economic devastation of the Coronavirus pandemic with unprecedented levels of fiscal stimulus and that has, in turn, revived a furious debate around the risk of inflation. Something I look forward to discussing with my guests today.

Paul Gruenwald: I'm Paul Grunewald. I'm the Global Chief Economist for S&P Global Ratings and I'm based in New York.

Nathan Hunt: Paul, it's a pleasure to welcome you back on The Essential Podcast. 

Paul Gruenwald: Thanks a lot, Nathan. It's great to be back.

Nathan Hunt: There's a lot of money coming into the economy very fast. We have a $1.9 trillion fiscal stimulus signed into law. There's talk about an infrastructure bill of similar or larger size. What is the danger of a return to high inflation? Is it 1978? All over again?

Paul Gruenwald: Well, I would say that, uh, you're right. Inflation is definitely back on the radar screen for economists. I don't think I'm going back to the 1970s, that's probably a bit of a stretch. But $1.9 trillion is a lot of money, it's more than most economists would say it's necessary to bring the economy back to its sustainable full employment levels. So because of that, the risk is that this stimulus plans going to generate some excess demand, and let's remember this stimulus is a demand-side measure, not a supply-side measure and that could potentially push inflation higher. The question is, does it go temporarily higher and the central bank brings it back? Or we have a situation where the central bank gets behind the curve, which is really what happened in the '70s. So far, inflation expectations over the medium term seem to be pretty well anchored, so if we do get a bit of overheating and high inflation, the markets are currently up the view that the fed can handle it.

Nathan Hunt: What would we expect to see if all this fiscal stimulus overheated a recovering economy?

Paul Gruenwald: The economists like to think in terms of the output gap. The output gap is zero when the economy is at its sort of equilibrium position, the labor market is close to full employment and capacity utilization is close to full. If we start to push beyond that with an extra fiscal stimulus that doesn't add to the productive capacity of the economy, then we've got a kind of classic taste of too much money chasing too few goods and that's when the inflation will start to rise. We're forecasting inflation to be above the Fed's 2% target for a couple of quarters. What happens then is really whether the market thinks the Fed can use its tools to reign it back in. Jerome Paul has been pretty clear in his recent speeches that the fed knows how to handle higher inflation. 

Nathan Hunt: So, is it your sense that the fiscal and monetary authorities are well-coordinated and conscious of the potential danger of inflation right now?

Paul Gruenwald: Yeah, I think the answer is yes. I mean, look who the treasury secretary is in the U.S., It's Janet Yellen who used to run the fed. She's been sitting in both chairs, so I think she knows the drill here. Let's remember what was happening after the global financial crisis. The criticism back then was that monetary and fiscal policies were not well coordinated. That's when central banks were seen to be the only game in town with hyper-stimulatory monetary conditions. While at the same time, we saw governments quickly returning to austerity after the worst of the crisis had passed. So, we had kind of one foot on the gas and one foot on the brake at the same time. What's happening now is once again, we've got the monetary authorities of the major countries, including the U.S. at zero, plus some asset purchases, what we call quantitative easing. But this time around it's different because the government is at the same time, adding a lot of stimulus to the economy. The mantra this time around is to "go big." That's been the talking point for the U.S. oFficials around this 1.9 trillion stimulus plan. So I would say compared with exiting the last major crisis, which was the global financial crisis. As we're exiting the COVID crisis, we've got monetary and fiscal policy much better aligned.

Nathan Hunt: Larry Summers and Paul Krugman have spent the last couple of months debating the risk of inflation. Ironically, it has been Krugman who has argued that inflation risk is low and that the greater risk is secular stagnation, which is, of course, an idea popularized by Larry Summers. Summers has argued that we are overcompensating for a relatively slight GDP gap and have a real risk of what he calls and I quote here, "classic wartime, inflation pressure." so let me ask you, do you have a dog in this fight?

Paul Gruenwald: Well, let me go back to your earlier comment, Nathan, you said that when you get two economists in a room, you get three opinions, so now I'll give my two opinions. So you'll have one economist on your podcast with two opinions. I think in a way they're both right. What have we been doing for the last decade-plus since the global financial crisis and we've been trying to generate inflation. Again, central banks have been at, or near zero, when that wasn't enough to stimulate demand in inflation, they began to purchase assets, mostly government bonds and they've been having a heck of a time getting inflation up to their targets. We've been struggling with this notion of secular stagnation, which as you noted in Larry Summers's terms. So, you know, Krugman's right to point that out. We've been arguing at S&P Global Ratings, along with our credit research colleagues, that you know, a little bit of reflation is a good thing. If we get an order of the reflation and the fed eventually goes off of zero and are up to around two and a half percent, which is their long-term neutral estimate, that puts 10-year bond yields in the low threes and that's a good world, as long as we get there smoothly. I think Summer's concern is his number of a 3% gap. You hear that number a lot in the U.S. now. The way to think about that 3% or to unpack it a bit is right now in the middle of 2021, the U.S. is getting back to its end 19 levels of activity. So, we've lost a year and a half of growth, and the U.S. iS a 2% economy, so that gets you to three. But again, As you mentioned earlier, this stimulus plan is something like 9% of GDP. We are almost certainly going to see inflation, get pushed above the Fed's targets. My question is whether that starts a kind of a virulent wage-price cycle, that's going to be difficult to reign in and we may find that out relatively soon because I think with this plan and perhaps the infrastructure plan behind it, we're going to get to a world where inflation is going to be higher than we'd seen it for a while.

Nathan Hunt: Let's talk about how markets are reacting. Bond yields are creeping up. Is this a good thing or a bad thing?

Paul Gruenwald: It depends on why yields are rising. If yields are rising because we have a reasonably robust recovery of growth and employment and earnings coming out of COVID, which means that the real yield is relatively stable. That's this healthy scenario I was talking about a few minutes ago. That's good for growth and it's good for credit. If yields are rising because it's just an inflation scare and nothing's happening on the real side of the economy, then real interest rates are rising and then we're having a tightening of monetary and financial conditions, and that can have bad outcomes in terms of the macro. So far, it looks like we're mostly in the first of those stories. We're seeing a pickup of being growth led by the U.S. Real yields seem to be pretty stable. There's always going to be some volatility as we go from A to B, B being the end state. I talked about it a minute ago. We're not concerned about the yield of tenure at one seven right now. When this was all said and done in the feds off of zero and back to neutral, the 10 years, should probably be in the low to mid-three spend but it's the path of how we get there and really, this issue of the unevenness of their recovery.

Nathan Hunt: Say, I'm a CEO who's been issuing triple C debt to finance operations. Am I happy or sad with the way things are going right now?

Paul Gruenwald: To answer that we would probably go from the macro to the micro-level. Just as we can talk about a macroeconomy. In an Individual firm, if sales are rising and earnings are rising, then that firm able to digest higher interest costs. One of the metrics that our credit research colleagues look at is the interest coverage ratio. Are the earnings enough to cover the interest bill? So, if the interest bills going up and nothing's happening to earnings, then it's going to be more difficult for this firm to services debt. But if it's in one of the parts of the economy that's currently growing and earnings are going to be enough to cover the higher interest costs, then the credit view of that firm would be broadly unchanged and that, again, points to this issue of the unevenness. If you look at the sectors of the U.S. Economy, some sectors have little or no hits from the COVID pandemic, and other sectors such as food and beverage and entertainment, the hardest-hit sectors here because of social distancing, they're still well below pre-COVID level. So it depends on where this particular firm is sitting. If they're sitting in one of the good sectors that's rebounding and earnings are growing, then again, the higher interest costs should be digestible.

Nathan Hunt: Speaking of unevenness, let's say the United States rides this out with economic growth, moderate inflation around or slightly above the 2% range. How will that affect the rest of the world? Will they be along for the ride or will they lose out?

Paul Gruenwald: Yeah. Well, that's, again, something that we've been looking at in our research, the U.S. is the largest economy in the world, still, that may not be driving the growth equation. I think that baton has been passed to China, but clearly, the path of the U.S. recovery is going to matter in the scenario. You just described Nathan, where the U.S. is growing at 2% and approaching full employment. It would depend on where the rest of the world is and it would depend on where our interest rates are relative to the rest of the world because we can think of growth differentials and interest rate differentials, kind of driving capital flows, which is driving investment in growth. If the U.S. gets too far ahead of the rest of the world and I'll leave too far, a bit fuzzy in this discussion and let's say the fiscal stimulus plan, the 1.9 trillion American Recovery Act leads to take-off on the economy, followed by an infrastructure boom, if the U.S. gets too far ahead, growth-wise, and that requires the fed to raise rates aggressively, we could have U.S. growth and interest rates higher than the rest of the world and that might put some pressure on emerging markets that are financing in dollars. Some of those rates might spill over to other economies, which has been happening in Europe a bit recently, and forced those central banks to do more easing or quantitative asset purchases. So the U.S. recovery given its size is going to lead to a more balanced global recovery if the U.S. doesn't get too far ahead of the rest of the world. Well, the U.S. doesn't control all of that. It depends on the markets and firms and policy actions elsewhere. But this good, that balance order, the reflation scenario we've been talking about really has an implicit assumption that the U.S. has a strong recovery. But again, it doesn't get too far ahead of the rest of the month.

Nathan Hunt: Let's talk about the punchbowl. Historically, the joke has been that the job of the fed is to remove the punchbowl just as the economic party is getting started to avoid the risk of inflation. Let's stretch that analogy. What is the fed doing with the punchbowl right now?

Paul Gruenwald: I would argue over the last dozen years or so the fence probably has been spiking the punchbowl. You know, the way we're all trained, my vintage of an economist, those of us who were in grad school in the 80s and 90s is kind of a one-sided view of inflation, you would ask someone of my vintage Ph.D. of what central banks do and you would say central banks fight inflation. You know, the risk is always that governments tend to spend too much money, they try to juice up the economy a bit too much given electoral considerations, so there's always a tendency for inflation to be too high. The adults in the room are the monetary authorities who will need to take away the punchbowl, meaning raise rates to keep the economy on an even keel. Now we've got the, uh, we had the opposite problem for a while where we've been spiking the punchbowl. Again, you know, maybe this is something that's going to come back into the lexicon, and let me just wrap up Nathan, by saying that would not necessarily be a bad thing. If we get a moderate rise of inflation, and if we get a moderate wage-price, spike spiral, and if we get true rate risk of inflation, inflation is just as likely to be above 2% as it is to be below 2%, but that's not a bad world to be in. We're coming out of a long period where again, growth has been sluggish, we had secular stagnation, and inflation has been too low, monetary authorities are doing everything to try to get the inflation rate up to their targets. So, if we come out of this with more balanced inflation risk, and the economy is close to its steady-state and we have to drag out the punchbowl every once in a while, or even threatened to drag out the punchbowl. You know, I think that's a better world than the one we've been in since the global financial crisis. So I would say that's not all necessarily bad.

Nathan Hunt: Paul, it's always a pleasure to gather around the punchbowl with you and have a conversation.

Paul Gruenwald: Happy to have a punchbowl drink with you anytime, Nathan. It's been a pleasure to be on your show.

Nathan Hunt: The Essential Podcast is produced by Molly Mintz with assistance from Kurt Burger and Lundon Lafci at S&P Global. We accelerate progress in the world by providing intelligence that is essential for companies, governments, and individuals to make decisions with conviction. From my home studio, high above Manhattan's Greenwich Village, I'm Nathan Hunt. Thank you for listening.

The Essential Podcast is edited and produced by Molly Mintz.