2022 Outlook: Inflation in Context

Text on screen: PIMCO

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Text on screen: Tiffany Wilding, Economist

Tiffany Wilding: The elevated inflation prints that we're seeing just raises the risk that inflation remains more persistently elevated, so we would still characterize what we're seeing as a price level adjustment that's happening and it's happening over a multi month, multi quarter period which should mean that inflation should moderate eventually.

FULL SCREEN GRAPHIC: Title – Risk: Inflation expectations rise; Chart shows PIMCO’s Index of Common Inflation Expectations from January 1999 through January 2021, which shows that inflation had been lower historically before spiking in 2021.

But of course, the fact that we're seeing these headline inflation prints, which are so elevated, it just has the potential to start to change consumer and business behaviors.

One other way that we can start to monitor this, of course, is just by looking at surveys of longer term inflation expectations. The University of Michigan survey, for example, is one that many people like to look at and its longer term inflation expectation measure suggests that we're kind of in the middle of the historical range.

So I would say overall, this is a risk to the baseline still and something that we're highly monitoring and of course something central banks will really want to try to mitigate and avoid.

Tina Adatia: Tiffany, Marc, you both have talked about some very interesting points on inflation, and I just want to follow up on one particular point, I think is quite interesting in the market that there seems to be some fundamental concerns on upside risks of inflation, and while we've seen yield levels rise, yield levels are still fairly low and don't seem to necessarily be fully pricing in those risks. Can you maybe first, Tiffany, to start off with you, can you shed some light on why yields levels remain low despite some of these inflation concerns?

Tiffany Wilding: Yeah, so I think that the market has the tough job of not only pricing in potential upside inflation risks, but also trying to understand what the central bank's reaction to those dynamics will be. And I think that the combination of those two factors is really producing the market pricing that you're seeing. In the past, if you look historically, the Federal Reserve has not had a very good track record, quite frankly, of producing what many people call a "soft landing," so something where inflation moderates back down to target without more dire economic outcomes. So historically we've seen the Fed needing to engineer an actual outright recession to bring down inflationary prints.

FULL SCREEN GRAPHIC: Title – Risk: Financial conditions tighten more abruptly than expected; Two line charts, the first plots the PIMCO U.S. Financial Conditions Index from January 1999 through January 2021, which shows that financial conditions have remained relatively easy even with some recent tightening; the second chart shows the Fed Funds Futures: December 2024 contract from January 2021 to December 2021 and shows that the markets have already priced in rates hike, but a more aggressive Fed remains a risk. 

So I think that's also a risk. So higher inflation dynamics, a more aggressive policy from the Fed which raises the risk in the future of a recession is also having to be grappled with by bond markets and bond investors.

So I think that's just a symptomatic of the fact that the bond market believes that the fed will aggressively react to upside inflation risks if they do start to occur.

Text on screen: Marc P. Seidner, CIO Non-traditional Strategies

Marc Seidner: Yeah. I mean, I would reinforce what Tiffany mentioned, Tina, it's a great question. It's probably the conundrum of 2021 and 2022, why do so many talk about an increasing inflation concern but there's so little response or action by the bond market.  

I think part of the answer, and Tiffany mentioned this, is looking through the cycle. We are in the late stages or we are rapidly entering the late stages of an economic cycle and longer term bond yield while we think there may be pressure to rise gently from here, or moderately from here, are probably looking through the cycle.

Text on screen: Longer-term bond yields should reflect a terminal short-term interest rate plus a risk premia

Images on screen: PIMCO cyclical forum

Let's remember that longer term bond yields should reflect a terminal short-term interest rate plus a risk premia.

And so it's not surprising that given the uncertainty that we're pricing a terminal interest rate, that it's somewhat lower than we were in the last cycle. It basically reinforces PIMCO's new neutral secular theme. And so again, while cyclically we think there's not enough of a risk premia in longer term bond yields, and there is the room for financial conditions to tighten from here, it is quite possible that this isn't that great of a conundrum in the sense that the bond market is looking through the current cycle, thinking about a longer term terminal neutral level of interest rates and anticipating that it may very well be lower in this cycle than it has been in the past for many of the reasons that PIMCO has relied on for really the last half decade in terms of new neutral thinking and new neutral levels of yields.

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