FTSE Russell Convenes | Episode 11, Season 3

Distinguishing deflation

October 27, 2023

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Rob Arnott, Founder and Chairman of the board of Research Affiliates, shares his views on this year's markets with a focus on Fed policy, interest rates, the levers controlling inflation and 'heroic and horrific experiments' from a macroeconomic perspective.

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I view the current situation with soaring interest rates,with the worst bond market in historylast year as entirely the Fed's doing.Rob, it's great to have you back talking with us again.It's always such a pleasure. Thank youso much. Well, thank you.It's a privilege.Now, Rob, as we sit here,the market is facing quite a few macro headwindsand I'd love to talk them throughwith you. Why don't we start with the Fed?Because they seem to be, you know,front and center of most macroeconomic debates.Do you feel we're in a point where they're pausing?Do you think they're going to be easing?And how do you feel aboutthe general interest rate environment right now?You know, I think the whole focuson Fed policy is misguided.Whatever they do, continue tightening,pause, skip, and continue, reverse course.It has an effect over such a long period oftime that it is almost an irrelevant conversation.What makes it even moreproblematical is have you noticed how wellthese folks can forecast inflation, GDP, unemployment?Their forecasts are orless useful than an extrapolation of recent trend.It's worse than a coin toss.Now they have 400 Phd economists, Harvard and Mit.Between the two of them have 100,with four times as many Phd economistsas Harvard and MIT put together.They can't forecast a damn thing.Now, if they can't forecast anything,why on Earth do we think they havea clue about how to manage anything?I view the current situation with soaring interest rates,with the worst bond market in historylast year as entirely the Fed's doing.We're looking to the Fed to fix what they broke.I think there's a lot of deep structural error.It comes back to inflation itself.In Jay Powell declaredthat inflation was transitory in March of 2021,it was already 4% halfof which had happened in three months,8% annualized for three months,it was 4% and accelerating.And he says this is transitory.He retired the term transitory that November,It had a nice eight month lifespan.Now roll the clock forward eight months fromthe mid year of 2022.Think back to mid 2022,inflation was peaking at9.1 What do you think the Fed funds rate was?Make a guess, 3% 1.2 Was it ready?They were 800 basis points behind the curve.We expect these peopleto fix the mess that they're making.Australia has been calledthe lucky country becauseit went for 30 years without a recession.What did they do?Well, the long rate is set by the market.The long rate is the markets assessmentof what the cost of capitalshould be for debt that is free of any default risk.You can think of interest ratesas the reward for deferring consumption.Now if you think of it asthe reward for deferring consumption,it has to be above expected inflation.It has to be positive in real terms.Otherwise, you're not rewarding deferred consumption,You're rewarding acceleration of consumption,which in a Neocesian world is seen as a good thing.But it's not means there's no investment for the future.The cost reward for deferring consumption begreater for 30 days than for 30 years? Obviously not.An inverted yield curve is a perversionof the purpose of interest rates.What we've had isnegative real interest ratesthen inversion deeply flawed policies,put this on top of blowout deficit spending globally.That's beyond anything seen before in history.We've tried to heroic and horrific experiments,one being negative interest rates,negative real interest rates for a sustained period,and negative nominal rates in many parts of the world.And this yield curve inversionin a context of blowout spending.So think about that lucky country,What did Australia do for 25 of those 30 years?Without a recession, they had short rates,almost always a notch below long rates.It's almost as if, isn't that what slapping yield have?Yeah, it's almost as ifthe routine meeting wasto say what's the long bond yielding,okay, Should we nudge this up ordown to stay just under it now.In 1973, I think it was.There was a Colonel in US,Colonel in Vietnam who was famously quoted as saying,we had to destroy the village in order to save it in war.That's a bad idea ingovernment policy relating tothe economy. That's a bad idea.Why should you have to destroythe economy to save it from inflation?Now, inflation is just a matter of supply and demand.If demand is elevated and supply is suppressed,you're going to have inflation. It's that simple.If you have supplydepressed because of supply chain disruptions,because of people pretending to work from home,but not necessarily because of people paid to not work,then the supply of goods and services is diminished.If you have ear drops ofmoney into people's bank accounts,you have elevated demand,of course, you're going to get inflation.Are we dealing with any of these?Yes, in modest ways.The ear drops of money are diminishing the supply chain.Disruptions are fixing slowly but surely,but the problems are still there.So let me ask you about that specifically,which one of the levers controlling inflation rightnow do you think is kindof the most important as you say,we've had this unprecedented stimulus packagesfor not just the past few years, but for several years.You know, we have supply tensions still going on.I know the US is currentlyin intense discussions with China.We'll see how that affects,but then this huge deflationary pressure of technology.And I'm interested on your viewsabout which of these thematics,which of these headwinds ortailwinds do you think it will come out?On top, I was talking with a central banker,a senior central banker.It was in a session wheredirect quotes are notallowed or at least attributed quotes are not allowed.But anyway, I was saying,it's clear to me that central bankersover the world are allergic to deflation.Is any distinction made between the types of deflation.Deflation can be a crashing economy.Deflation can be technological innovationrevolutionizing some industry andleading to a surgein productivity and hence economic activity.To my astonishment, he said it doesn't matter.Deflation is deflation.Now, it seems to me the argument is often sticky.Wages, you get deflation.You can't reduce salaries.Well, what if you don't have to reducesalaries because it's productivity surge?What if you have productivity suddenlygrow 5% a year, some humongous number?You have 3% deflation and 2% wage inflation.What's wrong with that?There's absolutely nothing wrong with that.We do have issues withmisunderstanding of the role of interest rates,the role of money, and the nature of the macroeconomy.All of this goes hand in hand witha global takeover of central bank policy by Neo Cesians.They'll argue that we have a host ofdifferent views represented and arguing tremendously.A little like arguing over whereto place deck chairs on a Titanic.If you have only one set of views rangingfrom Neoknesian to hardcore MMT to Marxist or whatever,that whole spectrum, youcan argue that there's a spectrum.But Kines himself would beexcommunicated from the Nekesian community.He would be because he had the view that you are welcometo use deficit spendingto stimulate your way out of a recession,and then to use subsequent economic expansionto replenish your coffers for the next round.That idea has been out the window ona bipartisan basis and ona global basis for the last dozen years or more.I was listening to Stan Drakenmiller talkrecently and he was saying that he feelslike monetary policy makers are sitting onthe Santa Monica pier andthere's a ten foot wave coming their way,and that's what they're focused on.But there's a 200 foot waveabout a mile behind that they should be focusing on.And that's really the deficit inthe US is around 7% of GDP now, which is huge.I mean, France is like two to 3% And by his calculations,in order to reduce that deficit gap,you would need to either raise taxes by 40%into perpetuity or cut spending by 35% into perpetuity.I mean, these are really big moves,huge number in order to, and my question is,has the US been able to get away withthis huge amount of spending because it'sthe reserve currency because, you know,like in the UK where I'm from,if they try to get away with this, you know,spending to stimulate, typicallythe home currency gets hit hard as sterling did.But the US dollar because it's the reserve currency,does America just have this get out of jail free card?To some extent that's true.Reserve currency status iswhat was it termed an exorbitant privilegeor an extravagant privilege?Our reserve currency status is not at immediate risk,although we're sure sowing a lot of seedsfor potential eventual demise.Uk. The pound wasthe reserve currency for well over 150 years.The US has been reserve currencysince the 1920s, more or less.Now, are we putting that at risk? Yes, we are.But Larry Summers put it very succinctly.He said, what are you going to replace it with?Japan's a nursing home,Europe is a museum,and China's in jail.Well, his comment wasan exaggeration on all three counts.It makes the point in a very vivid way.Yeah. The definition of reserve currency is very simple.It's what currency do people like to transact in?Yeah. Yeah. And if the majorityof transactions have the dollar on one side of the trade,then it's by definition the reserve currency.Right now, I think the last numbers I saw was60 to 70% with the Euro and Yen,far behind in the Euro I think was inthe 20 to 30 pound and Yen in the ten to 20.It's not at risk, but the policies we'repursuing do have the riskof debasing the currency even as a reserve currency.Reserve currency status doesn't mean thatthe purchasing power of the dollar can't tumble anyway,it just means that it's apreferred vehicle for transactions.Yeah, Rob, it's been so fantastic chatting to you.Thank you so much for your time.It's always such a great conversation.Well, I have thoroughly enjoyedthis nearly two decade longpartnership and I look forward to many years to come.Thanks Rob.

Video recorded on June 05, 2023 at FTSE World Investment Forum

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