Jeffrey Meli: Welcome to The Flip Side. I'm Jeff Meli, the head of research at Barclays, and I'm joined today by Mike Pond, who's the head of Inflation link research. Thanks for joining me, Mike.

Michael Pond: Thanks for having me, Jeff.

Jeffrey Meli: All right. Given Mike's expertise, it should come as no surprise that we're going to talk about inflation today, and in particular, what we should make of the sharp decline in inflation from its peak in the middle of last year. If that trend continues, then going to be close to the target range set by the US Federal Reserve by the end of 2023, but if it stalls, policy makers will need to take even more aggressive action to tame inflation, possibly risking a recession.

Michael Pond: Well, Jeff, this question is still top of investors' minds these days.

Jeffrey Meli: Yeah, I bet. I'm sure you've been in high demand lately.

Michael Pond: Absolutely. I've covered inflation at Barclay's for 18 years, and without a doubt this is the most well-informed investors have ever been about all its nuances. My view is that inflation will continue to fall and that will get below 2.5% on headline CPI, the consumer price index, by the end of this year without the need for significantly higher interest rates. In short, the recent optimism in financial markets is justified.

Jeffrey Meli: Well, I disagree, Mike. I think what we've seen so far is the easy part, the decline in inflation that was basically destined to happen. Progress from here I think is going to be much more difficult and much more closely linked to wages and employment than to the aftershocks of COVID on the cost of some specific goods. I think the market is set for a rude awakening once the decline in inflation stalls.

Michael Pond: Before we jump into the debate, it's worth setting the stage a bit. By this point, the origins of the surge in inflation are fairly well-known. Disruptions in supply chains spending driven by COVID stimulus bills, ultra-low interest rates, and a broad commodity price shock, especially gasoline from the war in the Ukraine, all combined to create massive surge inflation. In the US, CPI rose dramatically. At its peak, CPI inflation reached over 9% in the middle of 2022.

Jeffrey Meli: Now at first, both policymakers and investors thought that this surge in inflation would be transitory, meaning that all the COVID related stuff that you just named would fade over time and then inflation would kind of normalize back to where it was pre COVID, which was very low. But the surge in inflation proved to last much longer than experts thought it would, and it started to combine with a tight labor market and strong wage growth forcing the US Federal Reserve to raise interest rates, which they did at the fastest pace ever last year. But over the past six months, inflation has cooled. The latest CPI shows that inflation fell to 6.5%. That's still well above the 2% target set by the US Federal Reserve, but it's clear that the recent trend has been in the right direction.

Michael Pond: And I would argue that a lot of that decline was not related to interest rates. Those take much longer to influence the economy, with the exception of housing where it's certainly possible that higher rates have helped cool housing prices. But the bigger reason is that most of the supply side COVID influences did finally fade. Just for example, long haul shipping rates rose over 500% during the pandemic, but most freight rates are almost back to early 2020 levels. And I could spend all day going through some commodity prices such as lumber, cotton, fertilizers, gasoline, and many others which have fallen far from peaks. Some price levels might still be high, but high prices which stop going up is no longer inflation.

Jeffrey Meli: Well, I agree Mike, and that's actually a good segue into my view on the path forward from here. Now, for all the reasons you just mentioned, inflation was destined to fall. Some of the surge was in fact transitory, just the meaning of transitory was maybe a little bit different than people thought. It took longer for the inflation effects to fade. They have, but that's the easy part.

Michael Pond: I'm not sure any investor out there thinks that the transition we went through in 2022 was easy, but I would agree that the inflation path from here remains highly uncertain.

Jeffrey Meli: Well, you're right. Last year was not an easy one for investors. Fair point. That's part of why I think the market is in for a rude awakening. The problem I see is that inflation lasted long enough that it's now become embedded in wages. Wages have been growing at or about 5% lately. This wage growth basically sets a floor on inflation, particularly services inflation. Now, for all the reasons you cited, goods inflation is in fact falling. But services inflation is a bigger worry now and may become more firmly entrenched. Remember, the United States economy is 70% services. Services inflation that we're seeing won't change as long as the labor market remains this strong. Now of course, we have near record low unemployment rates right now. When you put these pieces together, I think the only realistic way to get inflation lower from here will be to cause a recession, which will raise the unemployment rate and take this pressure off of wages.

Michael Pond: One point on wages I would make is that we have to be careful to clarify that the concerns are on the source of wage growth rather than the simple fact that wages are growing so strongly. Real wage growth is a good thing. It raises the standard of living across the country as long as it happens because productivity is increasing. When workers produce more, they can get paid more without the higher wages resulting in more inflation. Remember the old adage, inflation is too much money chasing too few goods. If productivity rises, then there are more goods to buy, so prices don't have to increase.

Jeffrey Meli: Well, good point, and I think you're right that under those conditions, higher wages are a good thing. Obviously, we want people to get paid more and have higher standards of living and have more purchasing power, but if wages grow, but productivity is stagnant, which is the situation we're in now, and higher wages mean there's more spending power, more money chasing the same number of goods. So prices almost mechanically have to rise.

Michael Pond: That's an interesting economic theory. It just hasn't held up in practice for some time. Recall that pre COVID economists kept expecting that a tighter and tighter labor market would lead to higher inflation, but that never happened. Inflation stayed low and stable. We had record low unemployment rates then too with a complete absence of inflation, or at least inflation worries.

I believe that wage growth will naturally slow as inflation slows. Wages are rising in part in response to high consumer inflation expectations, which have been falling quite hard recently. Falling expectations can break the wage price spiral that the Fed fears. In economist terms, the Phillips curve is still very flat. We just can't see it yet because the headline inflation numbers that have nothing to do with wages.

Jeffrey Meli: I'm not so sure we should expect a return to that pre COVID experience. Actually, and to a lot of economists, the pre COVID experience was a bit of a puzzle. It was so far out of the norm of other historical experience and a lot has changed. The economy's very different today than it was before the experience with COVID. Notably, we've had a big decline in the labor force participation rate, otherwise known as LFPR, which reflects a lot of people having left the workforce.

Michael Pond: That is true, especially lower wage earners in service industries. So I certainly agree that there is a risk that there has been a structural shift in the labor market for those workers in particular.

Jeffrey Meli: And wages have been growing faster in those service sectors than in other parts of the economy. In fact, some traditionally high-flying sectors like tech are currently seeing layoffs. Now, an expanding workforce was a big contributor to the flat Phillips curve that we experienced pre COVID, but we are in the exact opposite situation now.

Michael Pond: Actually, I think the stress in sectors like tech will accomplish a lot of what you think needs to happen on wages. As you said in a prior episode, in a [inaudible] days of zero interest rates, a lot of really high skilled tech talent, computer scientists, software engineers were employed at fantastically high wages on moonshot projects.

Jeffrey Meli: Well, I did say that and I was thinking about projects like the Metaverse or crypto. We've seen a lot of news lately from companies like Apple and Alphabet that some of these moonshot projects are being slowed or canceled as they rethink their investments in this world of higher interest rates. And of course, a lot of the crypto ecosystem is under an extreme amount of pressure right now.

Michael Pond: And if that happens at scale, not only are wages at the high end likely to come down, but these workers will get recycled. In other words, they don't stay unemployed, but very possibly will make less money in their new roles. So possibly the wage story sorts itself out.

Jeffrey Meli: Now there are two other structural changes that have arguably been accelerating since COVID that could also have the potential to influence the dynamics of inflation going forward. Now, one is the energy transition away from fossil fuels and into renewables. Now that may be necessary transition from an environmental standpoint and it may well bring longer term benefits in the form of cheaper, more consistently available energy, but it will come at a near term cost and in that transition period, energy will be more expensive as a result. So that's point one.

Point two is de-globalization, which has really been spurred by COVID tensions, with China in particular, are particularly high right now. Companies are starting to rethink their supply chains, rethink their sources of inputs like labor and raw material. And again, as they undergo a transition to rework some of those supply chains, costs might have to rise.

Michael Pond: Jeff, I agree that those are important issues. I do not dismiss them and I agree that they may well prove quite inflationary at least during the period of transition. But I also think these are both long-term issues. The reality is that 2023 inflation will depend a lot more on shorter term issues like rents and goods inflation than either of those longer-term structural issues.

Jeffrey Meli: I'm not so sanguine that these structural factors aren't going to escalate quickly.

Michael Pond: They may, and in fact, I agree they will, but not this year. I would say the inflation market isn't priced for this risk. Usually, the worst time to buy flood insurance is right after a storm because it's so expensive. However, despite just going through a 40 year high in inflation and issues you mentioned adding to the upside structural risk in the economy, inflation assurance via the long end entity inflation market is quite cheap. But in the near term, meaning this year, China reopening is more important than de-globalization. The chance of further supply change disruptions just went down a lot. Sure, if we look beyond the next couple of years, the issues you name might matter quite a bit, but right now, supply chains are working again and that is disinflationary.

Jeffrey Meli: Well, given the recent rally we've experienced in markets, asset prices from equities to fixed income, you name it, certainly don't reflect my view.

Michael Pond: That we agree on. Not just equities, but inflation markets themselves are priced that way. Headline CPI is priced to be at or below 2.5% as early as this June, so just a few months away and basically remain consistent with the Fed's target as far as the eye can see thereafter.

Jeffrey Meli: So, either markets are wrong or -

Michael Pond: Or inflation's going to come down quite a bit, at least for a year or so, and I can tell you why there's still a lot of easy progress to be made, to your term, that has yet to come. Much of the near term expected drop in year over year headline by the summer is from energy price base effects. Gasoline prices are already down 30% from last June, so as long as gasoline prices don't surge again in the fairly near term, energy CPI is set to fall hard on a year over year basis. And then on autos, even after the recent declines, the CPI for used cars is still up 40% from early 2020 levels and new car prices are up 20% over that period. Normalizing new car inventories and higher borrowing rates for autos will likely mean downward pressure on the auto prices ahead.

Jeffrey Meli: Yeah, it is the case that the price action in used cars during the pandemic was something completely out of the historical experience. Used car prices rose faster than they have ever before. According to some measures, certain types of used cars were actually more expensive than new cars. I guess because of various shortages you couldn't actually get a new car, so the price of the new car was sort of moot, but obviously it must be the case that goods like that have to normalize.

Michael Pond: And the list of bottom-up stories just isn't done. Medical insurance, CPI, purely because of BLS methodology having little to do with pricing is expected to decline 4% month over month, not annualized, every month through this September. Plus, there's shelter costs measured via rents have provided a significant boost in CPI lately. This category matters significantly because it's about 40% of core CPI. Most private data has shown very weak rent growth recently. Some have even shown rents falling over the past few months. These tend to lead the CPI rent series by about nine months, so they point to shelter CPI coming in much slower at some point later this year.

Jeffrey Meli: All right, Mike, but what about energy? We're, at Barclays, currently forecasting an increase in oil prices. Now, the warm winter that we've been experiencing has been a major factor in the temporary decline in energy prices, but at some point, we see that effect fading.

Michael Pond: So, I absolutely agree with you. It's just not clear that it's really important to the inflation story. So first, the scale of the increases we expect are not sufficient to be a worry, particularly since the Fed and other central banks tend to look through temporary swings in energy prices. Second, the oil curve is currently in backwardation. That means that futures prices are below the current spot price. Of course, this doesn't mean that prices will actually fall, but it does mean that anyone exposed to energy prices can hedge their future needs at today's current low prices, and that will limit the secondary inflation pressures that come with any realized price increases.

Jeffrey Meli: I still think that the more wage sensitive parts of the economy, like core services, particularly away from the housing sector, are going to be keeping inflation high.

Michael Pond: I do think that sector may continue to worry the Fed, and we could certainly do another Flip Side on just that, but it is not likely to keep headline CPI from slowing quite dramatically taking all the inputs I just gave, even with fairly strong service sector inflation. So I'll concede that my forecast is that CPI will drop to about 2.5% before the year is done, more or less in line with the markets are priced.

Jeffrey Meli: Well, Mike, I certainly hope that you're right, and I also think financial markets have a lot riding on this view. Clients of Barclays can read our latest take on inflation and the uncertainty of its path going forward in Known Unknowns, available on Barclays live, along with a host of other inflation related research in #shrinkingwallets.