This note is a new experimental format, where we share our thoughts on the macro mechanics at play in the context of the current economic cycle. If well received, we will continue to share these Macro Mechanics. Lets us know in the comments below.
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Inflation remains one of the most important drivers of macro markets today. However, the subject remains well-debated. We offer our thoughts on how we see the picture and what it means for markets.
Previously, we have shared our bottom-up analysis of inflation subcomponents to assess where inflation will land. We will once again share those estimates with our subscribers soon. For the purposes of this post, we will outline our thoughts on the macro drivers of inflation.
Conceptually, inflation is relatively straightforward: it is the price level of goods and services in the economy. These prices are determined by the balance between demand and supply in the economy. This demand is best captured by nominal spending and is best captured by output. When nominal spending outpaces output, we have inflation, and when spending is less than output, we have deflation. Both spending and output are capable of being the marginal movers that determine price.
However, what is extremely important to recognize that spending can move far more quickly than output. This is because spending can come from income, savings, or borrowing, all of which are financial sources that can grow at a much more rapid rate than output.
Explaining further, output can initially grow only as fast as capacity utilization can increase, after which it can only grow as fast as the ability to add new production capacity. This has very real resource constraints.
On the other hand, borrowing, financial assets, and nominal income can scale much faster. To be clear, there are limitations on financial expansion as well, but less so than output. As such, spending tends to expand at a modestly faster rate than output and is largely desirable to entice continued investment and spending.
This modest gap between spending growth and output growth is a state of inflation equilibrium. By and large, society seems to have agreed that this number is around 2%, but you can choose your estimate. The truth is that inflation equilibrium is likely dynamic and unobservable.
While we cannot observe inflation equilibrium, what we do know is that when spending far outstrips production capacity, we get accelerating inflation, which can be damaging to society. Therefore, to assess inflationary conditions we look at measures of demand (nominal spending, employment, production) versus measures of supply (interest expense, labor force, output capacity, productivity) to understand how far we are from equilibrium. The more positive the gap between demand and supply, the more inflationary an environment.
Looking through these measures, the aggregate picture is one of significant cooling of inflationary pressures but not one that is consistent with deflation. Currently, we have seen a cooling in the demand for workers and production relative to labor force supply and output capacity. These are likely to weigh on inflation. At the same time, nominal spending relative to measures of long-term potential is yet to cool. This is largely a function nominal spending remains far in excess of interest expense for the private sector, allowing for ease of debt service. This gap is likely to keep us out of inflation equilibrium if it persists.
Putting these forces together, a balanced perspective is that inflation will slow (as it has) but will unlikely slow to target unless nominal spending deteriorates significantly. This is an important dynamic as it meaningfully impacts the decisions of policymakers who will need to bring conditions to equilibrium.
In markets, this means that until nominal spending is under control, the Federal Reserve will have a very significant deterrent to cutting interest rates. This is particularly important in fixed income markets where pricing continues to move towards pricing in interest rate cuts. Currently, this pricing of interest rate cuts is less extreme than it was over the last month over the next year. However, we think this is going to be an ongoing struggle in markets.
We think what is important is to recognize that until inflation is within range of the Fed’s target on a quarterly basis, these expectations will largely be repriced away, creating a degree of chop in Treasury markets. For passive investors, this will likely be a headwind, and we would seek alternative exposures. But for active investors, these are likely to be opportunities. Overall, inflationary conditions remain in disequilibrium, and market pricing contrary to this remains price action to fade. We will continue to track the evolution of these dynamics carefully to see how these forces evolve.
You can follow along with our Month in Macro or by subscribing to our various publications. We hope this helps better contextualize the current inflation environment.