Surveillance: Inflation Fears With Fed's Harker

Federal Reserve Bank of Philadelphia. And good morning to you, Pat, Thanks for joining us today. Uh, good morning, Mike. Inflation team in February, but that's not what the Fed expects going forward. The Philly Fed index that came out this month was the highest for prices paid since nineteen Do you anticipate a really, really rapid rise in prices? Is that what people in your district are telling you. Now,

that's not where we're hearing across the board. We are seeing in certain pockets like manufacturing their supplied they're seeing price price pressures, but what they're not doing is planning on passing much of that along to their consumer, to their own customer. So I think it's the inflation stories complicated. As you said, we're going to see March April drop off. They were low months, obviously because we were shutting down the economy. So we're going to see a spike in inflation.

But I think we're our forecasts for inflation to creep up the two and our goal is to have it hit above two percent this year. Our forecasts around two, but we don't see it running out of control. What about the idea that UM on the spending side, people are reluctant to go out. What are you hearing in Philadelphia? We're getting more jabs in arms, and yet we see personal spending decline in the month of February. It's been chopping right because the viruses UH in variable. We've had

good months, bad months. We're seeing numbers rise now in this region. And so until we get through this period, we're going to see a lot of volatility in all these measures and that makes them hard to read. So for me, as a policy maker in that kind of situation, I want to hold steady, make sure we get through this period. Then we can start to normalize once we get through this. When you say get through this period,

how long do you think it lasts well. Again, if you talk to epidemiologists not economists, uh, they'll say sometime in the fall, we should start to get hurt of unity. I'm a little concerned though. Some of the things we're hearing right now is vaccine hesitancy Israel. We even hear this from our healthcare contacts. Right. Healthcare workers themselves are reluctant to get the vaccine. So we need to make sure we get this vaccine into people's arms as quickly

as possible. What are he's telling you about finding employees? You're you're focused now on getting unemployment down as low as you can. Some companies seem to be saying they can't find enough people. Other companies say, uh, we don't need any more people yet. It varies again by sector. In manufacturing, skilled labor is a real shortage, and we're hearing this from our contact warehousing jobs. There is a warehouse in central Pennsylvania that the starting salary for people

there is twenty three dollars an hour. So again it depends a lot on the sector of the economy. Hotel, hospitality, and leisure. Some of those are having problems getting people back to work because those people have decided to switch careers to something that they think is more stable. I know that a lot of people say the FED doesn't have tools to boost employment, but you've got a new

one at the Philadelphia FED to help people switch careers. Yeah. So, through our community development function at the FED and at the Philly FED, we've been doing work now for a long time on what are the skills necessary to help people get into the middle class where you don't need a four year college degree. We call those jobs opportunity occupations, jobs that pay above medium wages where you don't necessarily need a four year college degree. So we've been doing

that work for a while. We we've looked at thirty three metro areas along with our colleagues of Cleveland UH and looked at these areas. We saw an average increase of about fifteen thousand dollars. That is, people with some skills, with some upskilling to get a better job and improved a lot of for themselves and their families. We then now built this tool, and this tool is meant for job seekers, employers, community colleges, and other training organizations policy

makers to see what's available in their region. Let me give you two examples of what you can find. So let's say your receptionists been billed out there, Well, you have skills that you can upskill to a medical secretary and see an average, on average, an increase of twenty six percent in your salary. Or say you're in Cleveland and you're a cashier. Were all with some training you could be a customer service rate and there you could see an average increase in salary of a hundred and thirty.

It's not just white collar jobs or blue collar jobs. So it's nice about these tools. You can lay out a map of what skills you need to get to get the jobs that are growing or shrinking. Can also see whether those jobs are growing or shrinking in your region. Now, I know, if I ask you about market interest rates, you'll say markets do what markets do? They go up or down. But here's what I'm Here's what I'm interested in.

Is U rates have gone up, mortgage rates have gone up, car loans have gone up because the market is pushing rates high or not the FED Are people more sensitive to that when they have been so low? In other words, is it more of a risk that we see activities slow because the markets have pushed up rates some Well, let's start with business. I've not heard anybody say they're not investing because of the the rates. Just don't hear it.

It's because the demand side or the uncertainty that they're facing. So we need to resolve this uncertainty so that people can make the right decisions. I'm not the consumer, maybe, but again, we're not talking about massive increases historically in rates when if you really step back, we're not. We're talking about what a hundred basis points maybe. Uh, this is historically not really something that's really affected people's decision to buy a car, maybe on the margin by home

or the size of the home they get. But again, this is a good sign in some ways that rates, say the ten years, going up. We don't know exactly why, but one of the plausible reasons why is that real rates are going up. People are more optimistic about the economy, and we've been hovering a zero or negative neutral real rates for a while. So the fact that that's rising

is a good sign because it shows optimism. The question I put to the chairman after the news conference that didn't quite get an answer to, I'll put to you, Uh, you mentioned real rates, and you mentioned, Uh, the long term, when do we get to that two and a half percent neutral rate that is considered the long term rate for the Fed? In other words, if you get to two thousand twenty three through through thousand twenty three and we don't see inflation out of control, do we just

leave rates at zero indefinitely. Yeah, We'll have to see when we get there. I'm not sure that that would be my and I can only speak for myself, Uh, my policy prescription. I mean, if we're seeing very strong unemployment back to where we were before the pandemic, right, low inflation, great unemployment numbers, that's where we're going to get back to and so there. I mean there are some risks of keeping rates too low too long as well, and it's really a matter of bouncing off these risks.

But it's very situational. I mean, you can't just make this decision right now. You really need to see the data and see how things are unfolding. Well, you talk about the risk of keeping rates too low for too low on a lot of people point to the stock market or bitcoin and say, you know, the FED is really inflating bubbles here. How much of my concern is that to you. It's something that I keep in mind

all the time. That and the cost to savers. People will say on fixed income, Uh, there there's a cost. So again, this is a balancing act. We need to get the economy to recover. We need to get the economy to heal with minimal scarring. That's what was the whole goal of what we did at the FED for the past year is trying to preserve as much as we can of the infrastructure of the economy. So, you know, I think once we get through this, we can start

to then think about how we normalize. Well, we get to maybe two point one percent inflation is as you forecast, or a little bit higher as some of your colleagues forecast, the market's going to start pushing up rates. And the question is is this a showdown between the markets and the FED? And will the FED blink? You've got a new uh framework to work in that you never have before. In the markets are gonna want to test it. I'm sure. Can you look through rate increases or is there is

a level at which you get concerned. I mean, there's obviously a level which concerned to being some exorbitant level, But if they're within the realm of reason. I am of the camp where we stick with our framework and we let inflation run above two percent for a while, not running out of control past two percent, but above two percent for a while. That is what we've committed to with our framework, and I am committed to that

as well. Well. Everybody's gonna be looking to wage inflation to tell the story of whether or not we're seeing inflation rise too quickly. In the last Beige Book, the Philadelphia sector said that wages are rising because of demand for labor the fifteen dollar minimum wage. They quoted one Philadelphia CEO is saying, is already here, are you seeing

a rise in wage pressures? Yet? Yeah? Again, if you look at that warehouse in central Sylvania paying twenty three dollars an hour, they're getting their workers from somewhere, and those firms in turn respond by trying to raise wages to retain or attract new workers. So yeah, we're starting to see that, but again, it's not across the board. It's in certain sectors right now. Not a wage price spiral. I don't say it right now. I mean it could happen,

but we're not. We're not seeing it running out of control. Now. Patrick Harker, thank you very much for joining us this morning.

He's the president of the Philadelphia FED and reasonably optimistic Outlook there, Mike, you see that in the commentary around long term rates, reflecting the optimism, sticking to script, and I think, what you've got to do, and I know you're gonna do a great job of it over the next couple of months when we start to see the data, see who is committed to the new framework of the FED and maybe who isn't. Troy joins as natural Guysky

Skybridge Capital co c IO and senior portfolio manager. It's transitory, and then you see the data, you get slapped around with Troy and you think, oh, is it? Is it trying to Troy? How do you think people will respond when we actually see the numbers over the next several months. Yeah.

So I think the debate whether it's transitory or more permanent will continue to lead to elevated volatility, not only in fixed income markets, but also in equity markets, because you know, what we've seen this year so far is certainly the risks of the recovery. Another stimulus package that could have potentially not been signed by the Trump administration.

Check right, a vaccine rollout that started somewhat boxes accelerated dramatically. Checked, we've now gotten almost nine percent of GDP uh in another physical steamless check. But the downside, of course is higher interest rates, higher inflation, and that's really taken some of the steam and froth out of markets. If we

do is a healthy process. Where we'd certainly become more concerned is if we start seeing those higher numbers stick and that causes the FED to prematurely withdraw aggressive balance sheet expansion and money supply growth, because without you know, money supplied growth sustainably above nominal GDP, it's really hard to justify the valuations that equites are at right now, you know, somewhere around twenty one and a half twenty one point seven times earning. Let's get to the money question.

Then what's the game client for Q too? For for the FED in particular use Oh yeah, no, so for us? Yeah, Now, we're we're pretty pumped about this year. You know, we're fortunately off to a really good start. And this is really one of these years where the first show bey last and the last shall be first. So, you know, some of the high performing, high flying tech and growth stories.

Last year, I've really turned into duds and portfolios like ours that are more focused on value or cyclical exposures like structure credit or distress credit, which are by definition turnaround cyclical stories have done exceptionally well. Um. You know, convert upon arbitrage continues to be a strategy that's very attractive because of higher degrees of realized vutility. UM. On top of that, you have multi strategy managers like Ganlobe.

They're adding material value as activist not only in in Disney, but also it Tell. And then lastly, we're very fortunate in taking a meaningful Bitcoin position towards the beginning of December, and we think that is the purest macro expression for so many things that are going on right now. So many phenomenon. One, massive money supply growth more m two than we had pre pandemic to budget deficits as far

as the eye can see. Three, you have the natural dynamics the having cycle where when you artificially reduced new supply cutting in half, you tend to have a very strong bold market. And then lastly, you know what's happening in crypto now is you're aware because you guys cover it so uh accurately. Is you're going through an adoption story very similar to what happened to gold from oh six through two thirteen, and you're seeing that happen at

a much more rapid pace. Is not only hedge funds, but also life insurance companies, corporate treasurers sobeign wealth fun get involved. And so you know when you when you put that all together, we think each of our themes had a reasonable probability about performing equities, but doing it with some correlation benefits, and so you know, we're we're super excited for for Q two, Troy, Let's dig into this bitcoin position. How big is a sizeable bitcoin position

that you took in December? Have you adjusted it? Are you building? Are you going to reduce it? Is it active or is it a long term holding? Yes? So for us, we we it was rare. Most themes that we pursue, we we laid into and as we get more data relative to other opportunities, then we size it up over time. In this case, it was fairly clear to us that if we were there was going to be a big move, it would be somewhere in the near term, and so we needed to front load that,

so we started nibbling in mid November. We bumped it up to five and a half percent at cost in December, and that's our full at cost side. So from here we're not adding any capital. We will manage the position over time. But we think we're in the sweet spot of all three of those factors in terms of money supply growth, in terms of UM near the adoption cycle, and and we're not even a year through the first having. You know, the pull markets tend to last eighteen months

plus your minus during the having cycles. So for the next several months, we're gonna continue to let it appreciate. It's grown to about a thirteen percent position size to appreciation. Fortunately the rest of our it has done well to

upset that. But we we look back at this, we think at the end of this year, people could potentially look back and say, um, if you had a meaningful Bitcoin position, you had a good, great year, and if you didn't, it could be much tougher to perform given all the phenomenon we were discussing in terms of chopping monetary policy raids valuations, which is very similar. Let the jump out of time, you can get that point in the second of the portfolio just how much volatility is

in your portfolio right now? Yeah, So so look that that's one of the prices that you'll have to pay to have better performance in the year like this. So we typically target a forty eight percent standard deviation UM. We think this year will be somewhere between eight to twelve because of how much the bigcoin position has grown.

But it's you nique opportunity where you're actually getting paid for that risk, where in many other strategies it's more difficult to get paid for taking market market altility risk.

You wanted to get that final point in Troy, Oh, yeah, the final point was so it's very when when I think back over my career in the history of US managing our funds, Oh, it's very similar to oh seven, Or it could be where oh seven was a year that if you had the subprime short on you had a good, great year, and if you you didn't, it was much harder to make money as we were transitioning from you know, a housing bubble into what ultimately turned into a bear market. UM. And so that's how the

years played out so far. We're not saying that definitively at the end of two thousands twenty one that that's gonna be how it plays out. But we think there's a reasonable chance that most active managers look back and say, hey, if I had a decent Bitcoin position, I had an odd year, and if I didn't, it was much more challenging. Troy unbelaivable, You've gotta come back saying, so we could tell more about this as that we had a curb Aby Bernstein, co head of investment strategist, We had a

great t have you with us on the program. I want to start right here. These stories are so obvious, We've been talking about them for three months, but for some reason, it takes a while to see them play

through markets cleanly. Why do you think that is? The story is under vaccines and reopening and Europe versus the United States, specifically the discussion that Lisa and I were just having Europe the news incrementally bad, the news out the United States incrementally good, and yet europe dollar held in there through much of the last couple of weeks. Until the last couple of days. Financials in Europe performed nicely. Traveling and leisure stocks have performed nicely despite what we've

seen stories were all aware of. Yet we keep asking it's well known, is it well priced? Yeah, I hear you on that, But I think we have to be conscious of the fact that the vaccine alone and the COVID story alone does not tell the whole story. You know, what we think about it, Bernstein, as global investors is what are the companies that are headquartered in this region

and how are those companies affected? But their slow rollout of the vaccine, and while the domestic consumer and the domestic implications are negative, many of these companies are actually exporters. Many of them are their cyclicals. And when you see the US and what we would call a great reopening, their opportunity for export is actually high. And so I think you have to look at the whole big picture in terms of the earning story. And then there's the valuation.

Right as fundamental investors, when we think about the stock opportunity abroad compared to the stock opportunity in the US, the spreads have been enormous between the valuation of the US and other countries. Obviously, US growth versus US value. There's a real opportunity building for selection and whether that selection is an asset allocation in sector selection or security selection. I think it's bigger than the headlines. Jonathan, picking up

on something you've just said. I think was in the data this morning, Bonast. We saw that in the e FO data. Business confidence in Germany despite what we've say, and has been picking up. The outlooks brighter. Why is the outlook brighter because what's happening to get a swear is looking better. It's not just about what you see plan out in Europe, it's the international story that's right. De carry on. I was just gonna say, that's why we're remaining committed to being a global investor. I think

it totally depends on your perspective. I heard the conversation on bitcoin an hour ago and all your follow up. You know, at Bernstein we're investing for our clients for decades, not days, and we think about all the trade offs and the decisions we make. We think it's a mistake to be a US only investor, right and the geography, you're gonna have trade offs within the individual countries and

their growth potential. And there's no doubt about it. Europe is really behind the US in terms of COVID today, but you have to think more long term. To your point, global businesses or headquartered there. The great reopening in the US is going to drive outcomes there materially. Alright, So what's the biggest bet right now that you see is being perhaps undervalued in a world that seems for the most part completely overvalued. Well, I'm gonna argue that active

investing maybe the biggest bet that we're making. The idea that you can't just on the index. We know a look at the sp last year, SMP incredibly concentrated the top seven stocks, representing really the highest concentration we've seen in the index ever. We know what those companies are. They're all in tech. There the work from home beneficiaries, and with this great reopening, work from work is going

to start to matter more. And that means cyplicals matter, That means industrials matter, that means small matters and utilities and consumer stables and value. These sectors so underperformed last year, and our theme with our clients was really balanced, Let's not get whipside trying to pivot from growth to value, value to growth. Let's maintain exposure over time, but let's be active let's make sure that security, election and focus on fundamentals is our guiding light, and that remains the

case today. Well, perhaps this will be the year of active management. People have been saying this for a long time, but people are saying this time really is different based on the index construction, because we're talking active management and portfolios. Let's go back to where we started this hour. John was talking about that interview that we had with Troy Gayski of sky Bridge where he said that the key aspect of a portfolio which will be the big winner

or not for one is bitcoin. Are you investing in bitcoin? We are not investing in bitcoin on behalf of our clients. When we think about outcomes for our clients, we think about number one, what is the fundamental case for the asset class, what's the return of risk and diversification story, and importantly, can we research that story with an edge. We think we've got a long way to go in the crypto space in terms of determining the edge and

ultimately what the valuation should be. The influence of the individual investor is not going away. But when you look at the influence of the individual investor on bitcoin today, it's huge and it's pretty hard to predict that behavior. We feel much more confident investing in aska classes where

we can base a fundamental story. So for our clients that are concerned about inflation because they're spending a lot from their portfolio, don't have wages that would be going up if we do hit an inflationary period, we think about a balanced position of inflation linked bonds and diversified real assets. Those are asked the classes that we have decades of experience in driving the fundamental story Bitcoin, we're simply not there yet, Basica. Great to catch up of

a p event. Stein rob the Tip joins us now page in chief investment strategist. Ahead the global bonds, Robber, let's start there. What on earth is going on in the belly of the curve? Lisa, I think it's got to be a discussion that we need to have a whole lot more. Yeah, because honestly, people have been expecting somewhat of a decline in demand. So it's surprising that even given that John even that we saw that that really weak bid to offer, or as Tom might say

a bit to NEGRONI spreads Nerony. Yeah, Tom called it. The bondmark was a bit drunk yesterday to Robert Tips back with us now paging chief investment strategists Robert, Well, know, we had a technical issue just then for a couple of seconds. I'm not sure if you heard what we were discussing, but on the seven year is the belly of the curve? What's happening there? What's the debate? The spilling go over to supply? The uncertainty, the delicate dance

has taken place at the moment. Yeah, I think it's just the uncertainty about the course of the FED and the book of the Assurance. I mean the frequency with which the belly of the curve is getting hit two's, five, sevens, your cans, your threes. Uh, you know, every month, Treasury pounding those parts of the yeeld curve and massive size. Uh. You know, different parts of the curve are just taking turns,

getting walloped because of the macrobackdrop. Your investors are afraid to to step up and uh, you know, evaluate what's going on in the world, and you know, you know, feel like they're lying down on the tracks ahead of the the inflation train that that everyone is expecting. I think that's that's the problem. And that's setting your point is kind of an inflection point, you know, on the curve um you know, for maximum yield volatility, given the

bulk of issuance, Is it just an inflation story? Is it Fed fund story? To Robert for further down the road, you know, I think that the FED in some ways is getting buy in, and you have to dive into the old curve. But when you look at the break even at the five year point of the curve, coming up two d seventy basis points, what that tells you is people are pricing in success for the FED in

terms of achieving the inflation target. Right, the market has increased yields a decent amount, and the market has its choices. It can increase the inflation expectation component of treasuries or the real yield, and the real yield is incredibly low. And that reflects in some respects uh an expectation that the Fed will remain hold keep the FED funds rate incredibly low, and all of this expectation for FED rate heights and all that. What it really is is an

inflation premium in the front end of the curve. So I think, though, when you look at the critical question is is the market usually right on that front? And the answers that usually is not, and that creates usually okay, the market is usually not right on that the opportunity being by bonds. Is that what you're saying? Yes, So what what's happened the last few times that we've seen this surge in break evens like we're seeing right now, big fear of inflation in any economic recovery. We saw

it in two thousand nine. You're at a peak in nominal yields. And I think that's really the challenge that investors are having as they're fleeing to all of these micro themes, whether it's your Bitcoin or your game stop or looking at deep cyclicals for the recovery, when the real variable that's going to drive their portfolios is the

macro return. And the macro return profile of the bond market has improved tremendously, and we're probably, you know, within months of the beginning of the next stage of the secular bowl market in bonds. In the meantime people are looking at, you know, is that the real yield is that the break evens should be in deep cyclicals. In the meantime, break evens are telling you you're probably near cyclical peak and yields. Can you take a little bit more into what this means in terms of what you

guys are doing with your investments. Have you been buying steadily tenure treasuries as they sold off at expecting yields to go much lower? Is this meaning that you should rotate into a higher quality credit? How are you rearranging based on this thesis and based on the rising yals

so we've seen of late. Yeah, well, I think that the the easier trade has been uh not on the right side of the of the bond market equation, but the credit side and the recovery from COVID and and the fact of the matter is that is likely to remain the predominant uh driver and the easiest source of

alpha at this part of the recovery. Usually looking a year two years after this kind of arise in rates, with the strong economy, your credit product, even though spreads have come into tighter than average levels, generally continues to perform well. The trickier part is the right side, and the market tends to go into this overdrive of extrapolating the rapid growth of the recovery stage into the indefinite future,

and that's what we're looking at right now. In the reason why it's difficult to make a call whether it's over and in the my last uh privilege of being in the bonus round. You know, I suggest your next twenty base points and rates could be higher and then lower.

It's because there is the stimulus hitting right now, money dropping into people's checking accounts, checks in the mail, and that, you know, sets us up for the potential for another boom in the economic data over the next three sixty days. Robert wish Tom Kane was with us because that was a reference to real yield and your appearance on Friday, and if he's watching, I'm so happy that you made

that reference. Let's finish on this your point about recency bias and extrapolating gout the next couple of quarters and how that infects and shapes the long end of a bond curve tents and thirties. Do you think that's why front month crude prices punch above their weight to just that phenomenon. Well, I think that's you know, your typical commodity market phenomenal where your your short term supply constraint.

It runs first through the front end of the market. Uh. And only if that bias is persistent, you know where you see it go into the back months of the curve. And obviously we're having a short term this location there. Um. I think you know, on the treasury curve, I think the the one thing that is overpriced, or those those five year tips, but that over the course next twelve to twenty four months you're likely to see a good return to to risk premium. The biggest problem investors are

going to have is sticking with the markets. Uh. And you're gonna be surprised by the fact that in this environment of beds staying on hold providing a lot of accommodation, the next twelve to thirty six months, your macro markets are gonna work for you, including the bondom market likely to to outperform cash. Once we get through this last burst of economic activity, that last best come and right up might be Thank you, sir ATM Chief Investment Strategies.

This is the Bloomberg Surveillance Podcast. Thanks for listening. Join us live weekdays from seven to ten am Eastern on Bloomberg Radio and on Bloomberg Television each day from six to nine am for insight from the best in economics, finance, investment, and international relations. And subscribe to the Surveillance podcast on Apple podcast, SoundCloud, Bloomberg dot com, and of course, on the terminal. I'm Tom Keene, and this is Bloomberg.