January 26, 2022 | Expert Perspective
Inflation won't come down magically
To appreciate the strength of economic recovery from the sharp 2020 COVID-19 recession, look no further than the labor markets. Unemployment rates around the world have fallen toward pre-pandemic lows. In most developed markets, pretty much anyone who wants a job can find one.
Fewer workers are participating in the labor force than before the pandemic, and the higher wages they can secure as employers compete for them threaten to take already accelerating inflation to a new, more worrisome level. Wage inflation is "sticky." Although it takes time for wages to climb in tandem with broader prices, when they do, they're fully along for the ride and ready to jump into the driver's seat.
Central banks have underestimated this strength in labor markets and the growing wage pressures. In my view, markets are underestimating the degree to which central banks will need to use their powerful tools to pull inflation back to acceptable levels.
Higher rates are in the U.S. economy's best interest, a point I emphasized in a previous commentary. Vanguard believes that the Federal Reserve may need to raise its target for short-term interest rates to 3% from its current range of 0%–0.25%. That would require steady rate hikes over the next few years, to a degree that markets haven't priced in beyond 2022.
In a Q&A, Vanguard economists Josh Hirt, Asawari Sathe, and Adam Schickling discuss labor, inflation, our 3% figure, and the potential risks of the Fed moving too aggressively or not aggressively enough.
Why higher rates can be a good thing
Bond investors should welcome the prospect of higher interest rates. Although rising rates may produce modest negative returns for a time, they're a long-term positive. We recently wrote about the silver lining in rising rates—how investors with a longer horizon than their portfolio's duration stand to benefit.1 Raising short-term rates should also forestall a rise in long-term bond yields because expectations of future inflation should not rise further.
Equity investors may feel less hopeful, and that's understandable. In recent years they've come to enjoy some heady returns, fueled by negative after-inflation interest rates. The removal of such stimulus as central banks address inflation suggests turbulence ahead.
But negative real interest rates and the higher equity valuations they've promoted have come at a cost of future returns. That's why our long-term outlook for equities, as we discuss in the Vanguard economic and market outlook for 2022, is so guarded.
The theme of our annual economic outlook, "Striking a better balance," acknowledges the challenges that policymakers face in removing monetary and fiscal support that propped up economies during an unprecedented crisis. Surging inflation won’t come down magically. The path for central banks is clear.
Accelerating inflation is a threat to economies that otherwise remain fundamentally sound. Raising interest rates to subdue it should extend the growth cycle, not shorten it.
1 Duration is a measure of bond prices’ sensitivity to a change in interest rates.
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