In a dialogue with RBC Capital Markets, LLC Chief U.S. Economist Tom Porcelli, Jim Allworth looks at prospects for inflation in the context of a U.S. economy in the process of reopening. This interview was conducted Nov. 20, 2020 and edited prior to publication.

Jim Allworth: Tom, we’ve seen some bumps in the Consumer Price Index (CPI) in recent months that seemed kind of large. Is this a trend we should be concerned about or is it just transitory?

Tom Porcelli: Keep in mind that inflation is experiencing a reflexive bounce back from weaker readings in the spring. We shut the economy down and then turned it back on. Inflation is responding to the “turning back on” part. Inflation has bounced back in the context of the economy reopening. Importantly, the Fed is not thinking about recent inflation as something pernicious at all. I think it’s very aware this is a normalizing bounce after a massive growth decline.

Where we go from here is a bigger, more important question. And when considering that future path, we should remember the CPI will likely bounce rather sharply in mid-2021 because of weak year-before readings. The CPI could be easily sitting around 2.5 percent, where we expect it will linger into the second half of next year.

And that is just our baseline estimate. Prospects for 2021 are looking more promising on the back of good news on the vaccine front. The eventual positive impact on the consumer psyche could embolden households to draw down on their historically bloated savings profile. That could make the inflation dynamic look quite different in 2021.

Make no mistake, we are not arguing for some type of rampant/pernicious style of inflation, rather just enough inflation to get the market wondering when the Fed will respond to it.

There is worry among investors that all the “money printing” that has come with the massive stimulus is going to inevitably cause some damaging inflation down the road. But there were the same worries after the financial crisis. Instead, we had a decade of benign inflation. Is there something different this time that should keep us on guard?

I think a lot of people wrongly have compared what the economy has been enduring now to the global financial crisis. However, there’s one comparison I think is reasonable—even if slightly different—and that’s about inflation.

I vividly remember people fearing inflation was about to ramp up during the financial crisis because of all the stimulus that had been put in place. But we kept on saying there were obstacles in the way that would prevent all of this stimulus from turning into an inflationary impulse. Primarily back then, people weren’t in the mood to borrow and banks weren’t in the mood to lend. That really stunted the build-up of inflationary pressures.

Today, there’s another impediment in the way. For all the stimulus that’s been put in place, the only way that stimulus becomes inflation is if the economy is fully open. And it’s not.

One of the interesting ways of capturing the essence of the idea is to look at where growth is relative to potential. And right now we’re still three percent below potential (see chart) because the U.S. economy is not fully open. In theory, stimulus in and of itself can be inflationary. But in practice, you need a path for that stimulus to flow into the economy.

If magically these things all just went away, if the economy jumped into high gear and the unemployment rate, still very elevated today, continued to materially improve, then yes, I do think that’s a set of circumstances under which we would worry about inflation.

U.S. nominal GDP and pre-COVID-19 potential

$ trillions

Source - RBC Capital Markets, U.S. Federal Reserve

So you have to use up all the excess capacity in the economy before businesses and labor get pricing power?

Yes, but I wouldn’t think of it so much in terms of capacity utilization, which is a manufacturing concept. The U.S. economy is a service-dominated economy. Services account for about 60 percent of the CPI inflation basket. So arguably, to get a real handle on this you need to see how much of the services capacity is not yet fully utilized, which the Fed’s capacity utilization data does not capture.

It’s better to think of it in terms of what I just defined—how far below potential the economy is. I think that does a great job of capturing an economy-wide utilization.

Late in the last cycle while inflation was consistently running below the Fed’s two percent target, you pointed out that when you dis-aggregated the inflation data it turned out that the prices of goods were actually deflating while services prices were inflating at a brisk 2.5 percent to three percent.

I think this really gets to the heart of the challenge for people when they see the monthly inflation report that shows inflation running comfortably below the Fed’s two percent target.

There are two major components to inflation. One is goods inflation, the other is services inflation. As you point out, prior to the downturn services inflation was running between 2.5 percent and three percent, while the more closely followed total economy inflation readings—in particular, the Fed’s preferred measure, the Core Personal Consumption Expenditures Price Index—were consistently between 1.5 percent and two percent.

If you really want to know what the underlying inflation dynamics are of a service-dominated economy—which the U.S. is—then look at services inflation, where the core measure has been running near three percent.

Goods prices, on the other hand, have been in a sustained state of disinflation for the past 20 years. That’s not a guess; that’s the reality, which the data clearly shows.

U.S. services inflation running ahead of core inflation

Source - RBC Capital Markets, U.S. Bureau of Labor Statistics; semiannual data through January 2020

The question is why. And the answer to that is mostly because the U.S. imports quite a lot of disinflation because it doesn’t produce a lot domestically. As I’m sure is widely appreciated, the U.S. is a big importer of goods. And many of the countries the U.S. imports these goods from are able to land them here at a much lower price than domestic producers could do here in the States. That’s the key reason why the U.S. imports this disinflation.

I think people need to be aware that services are far and away the largest component of the U.S. economy. Services account for 60 percent of the weight in the overall inflation calculation. So here you are with inflation from this gigantic services segment that has been running at close to three percent, while the overall inflation number, which includes that services component, has been growing at a much slower 1.5 percent to two percent rate. That really drives home how much disinflation you’re dealing with on the goods side.

There’s one category that always seems to be a bit of a mystery in terms of how it’s looked at, and that’s asset price inflation. Central bankers seemed to have operated as though that didn’t count, or at least that wasn’t the thing they were going to lean against. What do you think the Fed’s position is? Is it going to pay attention to asset price inflation?

I think every Fed under any Fed chair always pays attention to asset price inflation. It always matters.

In the current context, the Fed will very closely monitor any imbalances that develop in asset markets. That’s the factor driving its thought process. It’s not enough just to say that asset price inflation is doing “x.” Rather, the pertinent question is, is asset price inflation indicative of imbalances building that could pose a risk to the economy? That’s almost always what is going to get the Fed to perk up and pay attention.

I realize you focus almost exclusively on the U.S., but this general pattern that you talked about—the closing and then reopening of an economy, and then seeing where you are with respect to inflationary forces—is playing out in almost all economies. Do you see the developed economies generally in the same position as the U.S.?

Yes, I do. And you know most of the developed world, including the U.S., is facing another challenge as it relates to inflation that we haven’t touched on. And that’s the reality of aging populations. Because, as the population on average grows older, their spending habits and patterns tend to change. They tend to slow down. And we’ve seen this across many of the developed economies already.

Japan is the economy that probably comes immediately to mind for most people. From the 1950s right up until the early 1990s the Japanese economy grew consistently faster than the rest of the developed world. From that point on, the working age population of Japan started to decline and the over-65s came to dominate. Japan’s GDP growth since then has been decidedly slower than that in North America and much of Europe.

Now we’re seeing that same dynamic play out in Europe. Trend rates of growth are slowing down as the population rapidly ages. The U.S. trends just happen to be trailing some of those economies, but we’re going down the same path.

I love that great Mark Twain quote, “History doesn’t repeat; it rhymes.” I don’t think the U.S. will necessarily suffer the same kind of disinflation that Japan has gone through on the back of an aging population. There’s a host of other additional factors that were at play in Japan as well. But I do think the rhythms of it will be very similar.

So in the U.S. you can easily make an argument that over time, just on the aging of the population, you could see trend rates of economic growth slow from what is about two percent today closer to one percent over the coming decades. And that will put some disinflationary forces into play if that whole dynamic is left unchecked.

How might this demographic headwind be fought off?

There are a few ways of addressing this challenge. The most critical way, and I think the most effective approach, would be to encourage a productivity boom.

Of course, the pieces need to be in place to have a productivity boom. And usually that comes from the fiscal side of the equation. But that’s one of the things that could help save the day. So the fiscal authorities need to recognize that we’re headed down this path.

This big demographic shift is out there for anyone to see if they choose to look at it. At some point, it’s going to have to become a big conversation that people are having in D.C. But I don’t know if that’s a conversation that’s been widely happening, either before the pandemic or now. The reality is, it will take years to put in place the pieces necessary to create a productivity boom. And then it will take years longer for that improved productivity to emerge. I think the fact that we continue to ignore that conversation is much to our detriment.

If you don’t mind, I’m going to go further down that path. Is there any chance there’s a hidden productivity gain that might have been triggered by the pandemic? Many people working from home the past eight months report their productivity has gone up. Could the pandemic have provided a plausible path toward improved productivity?

Anytime these big seismic events occur, I think it always gets people thinking about how they can address some of the long-term challenges in their business. A useful, tangible example would be the restaurant business. You can now basically scan your menu onto your phone, so you don’t need to hold a menu. Changes like this will almost certainly usher in some dramatic productivity enhancements for the restaurant business. So will the phenomenon of home delivery.

Working from home may have some lasting productivity benefits. As undoubtedly will the explosive adoption and acceptance of video conferencing as a way to meet with colleagues, customers, and suppliers.

I can see that happening in an even broader way. And there are changes that may be hard to see, particularly from where we are today. But I think we’re moving into a different environment now on the back of COVID-19.

So let’s wrap up with what we should be watching. Is there any particular string of things that would start to get our attention about inflation on the horizon?

Before we see any potential for inflation to trend higher on a sustained basis we want to see the economy open more, more than it is. That’s especially true now that we are dealing with cross-currents of “second wave” shutdowns and vaccine optimism.

So what are some things we can look at to gauge how the reopening is proceeding? Well, there are a host of ultra-high frequency data points that I think will be really helpful. For instance, Open Table, the app where you can make restaurant reservations, provides daily data and across each state. From there we can see how the reopening is unfolding in one segment that has been deeply affected by the pandemic. Early on, this data rose pretty dramatically. But it has flattened out over recent weeks and months. This will be a really useful indicator to keep track of.

Then there’s credit card data that comes out on a weekly basis and provides a sector breakdown. That’s incredibly helpful to gauge how the consumption backdrop is evolving. And there are the old standby employment gauges like weekly unemployment claims and continuing claims, both of which have been trending sharply lower since their spring peaks, as has the unemployment rate, although none are as yet anywhere near the low levels that prevailed prior to COVID-19.

There are a host of others including layoff and available job openings data, average hours worked, as well as automobile and airline traffic.

This gives us a way to think about a big issue that we know has been on a lot of people’s minds, so thanks very much.

I would just say in closing that this is just the tip of the iceberg. This is a very big conversation that is likely to intensify over the next year or two. There’s quite a bit more to drill into. But if you’re trying to consider the outlook for inflation in high level terms, then I think that this is the right framework.

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Non-U.S. Analyst Disclosure: Jim Allworth, an employee of RBC Wealth Management USA’s foreign affiliate RBC Dominion Securities Inc. contributed to the preparation of this publication. This individual is not registered with or qualified as a research analyst with the U.S. Financial Industry Regulatory Authority (“FINRA”) and, since he is not an associated person of RBC Wealth Management, he may not be subject to FINRA Rule 2241 governing communications with subject companies, the making of public appearances, and the trading of securities in accounts held by research analysts.