Morgan Stanley: Five reasons inflation is back!

Morgan Stanley thinks so:

1. Limited scarring due to a sharper but shorter cycle

Private sector risk appetite is largely intact, and public sector support is robust: A key difference in this cycle is that it resulted from an exogenous shock. This distinction matters because of how it has shaped both policy and private sector responses. Policymakers did not hesitate to provide significant support as moral hazard concerns were limited (in sharp contrast to an endogenous business cycle, where misallocation could have occurred). In turn, the damage to private sector risk appetite has been less severe than most feared and continue to assume.

a) The government and central bank has underwritten household and corporate income losses in an unprecedented manner: Household incomes increased even as output declined:

b) Limited signs of stress in corporate and household balance sheets: Heading into the recession, the US private sector (i.e. both corporates and households) was less indebted compared to previous recessions.Private sector debt-to-GDP had been stable and there were no clear signs of excessive leverage or undue risk-seeking behaviors, such as over investment by the corporate sector in aggregate. As a consequence,we believe that the impact to private sector risk appetite is much more limited than commonly thought. Typical measures of stress such as corporate credit spreads or household delinquencies have either normalized very quickly or have not been notably impaired.

2)The unemployment rate overstates the economic loss

Sharper decline in unemployment: Our 2021 GDP growth forecasts are more bullish than the consensus by 2 percentage points and consistent with that constructive view, we are projecting a sharper decline in the unemployment rate than the consensus. We expect unemployment to end the year at 5.1%, vs consensus expectations of 5.5%. Job losses have been concentrated in low-income segments: Moreover,we believe that the unemployment rate overstates the economic loss.While USGDP is rapidly making up lost ground and approaching pre-Covid levels, unemployment remains substantially above its prior lows. This divergence reflects the fact this recession has been a distinctly low-income recession. At the peak of the pandemic, 68% of all lost jobs were in low-wage industries. In contrast, the global financial crisis was effectively a middle-class recession, with middle income jobs accounting for 50% of all job losses. About 77% of the job losses to date a real so concentrated in sectors which are covid-sensitive and hence they should see a rebound in labor market activity as economies reopen.Wage income has almost fully recovered: Given that the GCR unemployed skew largelylow-income, the impact of an elevated unemployment rate on output and wage income is significantly weaker than past relationships would have predicted.Nominal personal income from wage compensation has already reached 99.7% of pre-Covid levels in November, while it took 27 months to return to pre-crisis levels after the GFC.

3) Accelerated restructuring would mean higher NAIRU in the near term

Labor market may tighten earlier due to accelerated restructuring: To be sure, our unemployment rate forecast, bullish as it is, still indicates that it will end the year above pre-Covid levels. At the same time, the recession has also led to an accelerated restructuring of businesses (the most prominent being the shift from offline retail to online). If some share of currently unemployed workers are not able to return to their original industries as the recovery progresses, this would require time-intensive upskilling and reallocation processes. More fundamentally, the need for structural reallocation across sectors may raise frictional unemployment in the near and intermediate term. As research by the Brookings Institution shows, workers in sectors with the largest job losses also tend to have the lowest likelihood of moving to industries that are currently growing.

Labor markets may therefore tighten earlier than implied by the headline unemployment rate. In other words, we expect a higher natural rate of unemployment. Some would argue that this restructuring also took place on a greater scale during the global financial crisis, yet inflationary pressures did not result. Our counter-argument would be that deleveraging headwinds held back the pace of recovery, and the gradual recovery gave businesses and the labor market more than ample time to adjust. The issue is of particular importance in this cycle, especially if policymakers attempt to run the economy hot. At the same time, higher unemployment due to the need for reallocation would make continued support for the unemployed necessary for longer, adding fiscal support to analready strong recovery. In either case, the end result is likely to be a further build up of inflationary pressures.

4) Continued policy action to address inequality

Policy impetus to address inequality: As we argued in our original report, we laid out the case that political and economic triggers were already in place prior to the recession to address the lower wages hare in GDP and rising inequality. The Covid-19 shock has exacerbated the impact on lower income households, creating even greater urgency for policymakers to act to provide relief for affected households. We see two implications from this policy push: First, policymakers will use fiscal policy more actively. A second round of fiscal stimulus is being disbursed at the time of writing that will lift household incomes even further above pre-Covid levels. Further policy actions like the raising of minimum wages are being discussed and if enacted, will impart an inflationary impulse. Second, policymakers are also increasingly focused on the role of tech, trade and titans. Since the 1990s, the steady interplay between this trio had a favourable impact on productivity and corporate profitability. Since capital goods are more tradeable in nature, stronger tech spending boosts trade directly, while technological advances have made transport and communications more efficient, fostering increased trade activity. For developed markets,global integration and competition have given corporate titans more incentive to innovate, increasing the potential for further productivity gains. Trade also aids technology transfer and diffusion, an additional avenue for productivity gains.

Scrutiny over these factors have already risen (witness the moves to check globalization in the form of US/China trade tensions and the likely emergence of a multi-polar world and have continued even in the midst of the pandemic and are likely to intensify. However, disrupting this trio of trade, tech and titans will also mean upsetting the driving forces behind the disinflationary trends over the last 30 years.

5) Monetary policy to accommodate initial rises in inflation

Monetary policy will also remain accommodative. In 2020, the Federal Reserve had conducted are view of its monetary policy strategies and has committed to its 2% average inflation goal, thereby aiming for a moderate overshoot of inflation. Unlike the previous cycle, when the Fed had tightened monetary policy well before inflation has moved above 2% sustainably, they are not likely to hike pre-emptively at the first uptick in inflation.

These are not stupid arguments but the astute among you will have noticed that nearly all rely upon ongoing policy implementation of what I define as the shift to MMT styles of macro-management.

In the short run, I agree that that remains on track, most recently boosted by the US “blue wave”. But longer-term I worry that the MMT argument has been only half made and won with the consequent risk of policy error.

As well, the MMT impulse is going to need to be large. As China resumes its structural slowing deeper into this year, its global deflationary impulse will return as CNY starts to fall. US inflation outperformance will also lift the DXY as recovery expands and EUR will fall with CNY. These are the macro deflationary trend of the past cycle years returning,

Anyways, for now, reflation and value rotation remain the play. If MS is right then it will stay that way into 2022.

David Llewellyn-Smith
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