Economist on inflationary pressures: ‘things will get worse before they get better’

Morgan Stanley Chief U.S. Economist Ellen Zentner joins Yahoo Finance to discuss the housing sales rebound, the trajectory of inflationary pressures, and the future of wage growth.

Video transcript

BRIAN CHEUNG: But let's stay on the theme of the economy here. Major theme through this earnings season has been inflation, inflation, inflation. So for more on this, let's bring in Ellen Zentner, chief US economist at Morgan Stanley, for this conversation. And Ellen, we just got that housing print. I guess I just want to ask, first off, is there any bleed-through on what we're seeing in the hot housing market to inflation? Without getting into the nuances of maybe how the CPI might account for owners' equivalent rent, is there a story tying those two narratives together?

ELLEN ZENTER: I think there's definitely a story tying those together. The housing market really is an overall snapshot of the economy. Even though it's a smaller share of GDP directly, its feelers stretch across the economy. And so when home prices are rising-- and they've been rising very rapidly-- we can see that at least in the new home sales market, it's more middle to upper-income folks that are able to afford to buy those homes, the existing home sales market.

Home prices have increased and inventories are quite limited for those at the middle to lower income range. And so it really shows that folks have a lot of buying power. We had no loss of income even though there was a severe downturn. We've had a lot of jobs coming back. And so that's supportive for home sales, but it's much more supportive-- it's been much more easy to attain for the middle and upper-income households.

BRIAN CHEUNG: And you actually had a note about a week ago that noted stagflation, no, but inflation, yes. And I think what is kind of interesting here is that it kind of fits into that theme of what you're describing with households being shored up, a lot of that because of the fiscal stimulus in addition to the help from the Federal Reserve on the credit side of things.

But I guess I just wonder, broadly speaking, what do you see as the expectation for inflationary pressures as it relates to wage growth? A lot of focus on the next jobs report, which we'll get in a few weeks, covering the month of October. How important is wage growth going to be? Because that could be the start of the wage price spiral, which could really be a big win for team permanent instead of team transitory in the inflation debate.

BRIAN CHEUNG: I like that team, team permanent versus transitory. We're going to start talking baseball stats here pretty soon again. What inning are we in? But I think that the important thing here is that there's-- I always say that economists are from Venus and strategists and investors are from Mars. So for economists, we want to see wage increases. We want to see very strong, healthy wage increases, because that means more spending in the economy, healthy credit conditions, households overall lift aggregate demand. Now, ultimately, that is good for companies as well because top line is growing.

But wage increases can be detrimental to those sectors where there's not a lot of ability to pass on the price increases, and so you get a lot of margin compression. And I think that's why we've seen a divergence between things like the Russell 2000, which has small and medium-sized businesses, versus S&P 500, where you can absorb those higher costs better. So I think for some sectors, certainly it's harder to weather. But we are seeing more ability for businesses to pass on those costs to the final consumer and that consumers are willing to pay those price increases because price tolerance and buying power is so high.

Now, where is the missing link here? Why don't we think this is the 1970s wage price spiral? Because households are still telling us that they believe that these inflationary pressures are temporary. We see that short-term inflation expectations are far outpacing long-term inflation expectations. So households are saying prices are high today. I don't like it, but I don't expect that to continue. So I don't see nominal wage growth being a problem here.

JULIE HYMAN: Ellen, it's Julie here. It's great to see you. It looks like that even if we are still transitory, that we are more permanent or more long-lasting than most forecasts, including that of the Fed earlier in the year. What are, at this point, the risks to the transitory view? I mean, I've been saying over the past few days, those ships are not going to stay off the Port of Los Angeles forever. Eventually, we're going to have a work-through of this. But what are the maybe risks to that way of thinking that could mean we're here at the same time next year seeing this same pace of inflation?

BRIAN CHEUNG: Yeah, so I think, Julie, it's a fair point. And just to lay all my cards out on the table, we too have been wrong on inflation this year in terms of how long-lasting the supply disruptions would be and how much upward pressure that would continue to have on inflation. There are the domestic-related components like shelter inflation we've been dead on with. I mean, it's a very fundamental cyclical story.

But what I'm hearing from our equity analysts across the firm is that things are going to get worse before they get better. And if I try to build a composite across the different sectors of when they think supplies could normalize, let's say probably into the middle of next year. Now, does that mean that's not transitory? I mean, here's the problem with transitory-- there's not an exact definition. Economists usually mean 12 months or more of disruptions. But I could argue that, hey, our lives are transitory. And so it's kind of difficult because we don't get a definition from the Fed.

But certainly, I think it's more sobering for the Fed, and there's more recognition in the Fed today that [INAUDIBLE] pricing. Now, as you say, 70 ships are not going to stay parked off of the Long Beach Los Angeles Port, and we're going to start unloading those at some point. And so do we get then a sudden supply surge with inventory building and possibly hoarding inventories and the like? And that could be a second half of next year event where you get a lot of inventory building coming through, a lot of pent-up demand that's finally met. And that can create a surge in activity.

So I think the bizarre offshoot of this is that I would be revising forecasts up, if I were an economist next year, the longer the supply chain disruptions last. I think there's going to be some demand destruction, but not nearly all of it. I think people will wait as long as they need to wait for that new car, for instance.

JULIE HYMAN: Ellen, that's a really interesting thesis, and I think it's not one that we've heard about, so I want to tease that out a little bit. So what you're saying is once we start to get the supply chain issues resolved, we could see a rapid catch-up in inventory. And you didn't say this-- I'm maybe introducing this in there-- if we are going to continue to see an increase in wages, even if it's not a spiral, even if it's a steady increase-- I mean, could we even see a pretty significant surge in growth then in the second half of the year? Is that what you're saying?

JULIE HYMAN: Yeah, so I think on the wage front, another reason why economists like to see wage pressures rising is that it tends to be a precursor to capital deepening because companies have to figure out how to maintain the labor share of profits at some steady rate. And so what does that mean? That means you do a lot of investment in efficiencies in order to drive productivity, which drives profits, so that you can continue to pay up workers, but your labor share profits remains the same.

So we see this as a precursor to capital deepening. In fact, we have a fairly strong global capex cycle that's underway, including net trade picking up. And so I think we can view that in a positive light where you're going to get higher productivity, higher investment out of that. The supply chains are obviously a limiting factor there. But yes, once you alleviate or unclog those bottlenecks, companies are severely under inventory. It's not just a motor vehicle issue where we're about 4 million units undersupplied right now, but it's broad across a number of sectors.

And think about how much we've come to rely on real-time inventories, being able to wait to the last minute to build inventories. We're not going to just have to build inventories back to more normal inventory-to-sales ratios, but we're probably going to hoard a bit or overbuild inventories so that we can withstand the next shock and not be caught off guard for so long with a shortage of inventories. I would also say, Julie, just to-- not to spend too much time on it, but I think it's a really interesting story-- in some areas, we're so under inventory that when we get those goods into the US, they're not even going to get counted in inventories. They're going to go straight to the end user.

So think about how many millions of auto units were under-- either under-built or were just under-imported. And a lot of those are just going to go straight from either production or imports to the end consumer that's placed that order six months ago and has been waiting on that vehicle. So I just think there's a lot of activity that's going to come through next year the longer it's delayed this year.

BRIAN CHEUNG: Ellen, lastly, I want to ask about what is the policy implication here that the Fed's not doing nominal GDP targeting right now. It's just inflation and unemployment. So what do you figure they'll do? It seems like they're pretty much on the table for November tapering. But looking ahead, what do you see for possible interest rate hikes next year?

ELLEN ZENTER: Yeah, so I think we can see that the market is fully pricing in a rate hike in the fourth quarter of '22 and a good deal of probability that the Fed could deliver two hikes next year. I think that's way too far, too fast for market pricing, rate hikes. The Fed is going to finish tapering its balance sheet in the middle of next year. It will then turn to talk about when might it be appropriate to raise interest rates.

Nothing's changed here in the framework. They still need data in hand to tell them when they have fully reached maximum employment and sustain inflation moderately above their 2% goal for long enough that they feel that it's appropriate to start hiking rates. That's a conversation that the center of the committee is really going to be willing to have as they're winding up the balance sheet taper, not before.

And so at that time, that's when those discussions will happen. So it doesn't mean they won't get to a hike as early as fourth quarter of '22, but I do think the market is going to be caught offsides here because the bets on them delivering even more than one hike next year, I think, are misplaced.

BRIAN CHEUNG: We will see. More commentary actually coming from the Fed chairman tomorrow in an appearance at 11:00 AM Eastern time. We'll watch out for that. But again, Morgan Stanley Chief US Economist Ellen Zentner, thanks for stopping by this morning.