Franklin Templeton

In this article, Franklin Templeton discusses what’s fueling inflation and how policymakers are combating it without dampening growth. We also share our views on whether inflation will abate or accelerate as the year progresses.

Several sharp pivots

The arrival of the highly infectious Omicron variant of COVID-19 sparked fresh uncertainties about economic growth. As a result of inflation numbers continuing at high levels in the United States, Federal Reserve’s (Fed) Chair Jerome Powell indicated there will be quantitative tightening and possibly several interest-rate hikes in 2022. Meanwhile, China’s central bank cut a key interest rate for the first time in two years to boost growth. The future path of inflation and the corresponding response of central banks and interest rates are the biggest open questions among our economists. Below, we’ve summarized several key insights that caught our attention. 

Managing expectations

While the Fed and financial markets were still downplaying inflation as transitory, many households and businesses were concerned about how rising prices would impact their future spending power and how unanchored inflation expectations would impact wage-and price-setting decisions. We had assessed that price pressures were broad-based and not solely due to rising fuel and food costs which, coupled with the relatively slow pace of supply-chain normalization, continued extraordinarily loose monetary policy and massive fiscal expansion, would cause an acceleration in inflation in 2021.

Exhibit 1: Current inflation rates vs. central bank target rates

As of December 31, 2021

_{Sources: Fed, Bank of Canada, European Central Bank, Bank of England, Bank of Japan, Reserve Bank of Australia, China National Development and Reform Commission, Statistics Canada, Japanese Statistics Bureau, Ministry of Internal Affairs & Communications (Japan), Bank for International Settlements, Bloomberg, Macrobond. See footnote 1. Important data provider notices and terms available at www.franklintempletondatasources.com.}

Going into 2022, several Fed members are talking about quantitative tightening (QT), which means shrinking nearly US$9 trillion balance sheet. Franklin Templeton believes that an aggressive, hawkish approach, rather than gradual incrementalism, may be warranted to stave off longer-term inflation. The Fed is clearly behind the curve and should be more aggressive in fighting inflation. 

Supply-chain disruptions and the labor market

From Franklin Templeton’s perspective, the supply-chain disruptions driving up commodity prices for items like fuel and food will likely wane later this year as more countries move toward “living with COVID” policies to avoid the damaging cycles of lockdowns. That’s good news for Europe, where energy prices have been the primary inflation driver. Far trickier, however, is the issue of wage growth and labor shortages in the United States largely due to three US-specific factors:

Exhibit 2: Percent of US small firms that have raised or will raise compensation

As of December 31, 2021

_{Sources: National Federation of Independent Business, Macrobond. The data is part of the Small Business Survey in the US administered by National Federation of Independent Business. Important data provider notices and terms available at www.franklintempletondatasources.com.}

1. Expensive housing has priced a lot of people out of regional US labor markets—they simply can’t afford to live where many companies are hiring.
2. A big drop in legal and illegal US immigration is causing labor shortages.
3. An older cohort of workers is opting for earlier retirement, often by moving to lower-cost regions to stretch their savings. If US businesses have the pricing power to pass along wage increases to consumers, it could stoke inflation higher. In turn, this escalation could trigger a bigger policy response from the Fed than is currently expected and could increase the risk of dampening US growth.

China’s macro playbook

Looking at the global economy, we think that worries about a hard economic slowdown in China are overstated. In the past, emerging markets often followed the Fed’s lead on rate hikes. But throughout this pandemic, China has acted independently in how it has handled COVID-19 and its economy. With China’s recent rate cut, we see the start of a gradual reflation cycle that’s different from the United States, helping buoy China’s massive growth engine. China shut factories before the Winter Olympics to ensure blue skies during the event in Beijing. But after that, the Chinese government likely will deploy its ample policy toolkit to increase economic growth, while being careful to not kickstart inflation.

Exhibit 3: China’s Real GDP Growth 

As of December 31, 2021

_{Sources: China National Bureau of Statistics, Macrobond. Important data provider notices and terms available at www.franklintempletondatasources.com.}

How to respond

All the macroeconomic issues that we regularly discuss—inflation, supply shocks, wage growth, monetary policies and slowing economic growth—tie back to one catalyst: COVID-19. If we can live with COVID-19 safely, we might get back to the economic growth trends from before the pandemic. This pivot would also support the more rapid normalization of global supply chains, as the risks of shipping delays and labor shortages due to COVID-19 subside.

Given the outlook—for inflation in particular—is uncertain, our investment teams believe that a more bottom-up approach might be a more effective way to achieve returns while managing risk. 

_{1. Source: For Canada and Australia, the target inflation rate in the chart represents the mid-value of the target inflation range. The current inflation rates pertain to: US - Core Personal Consumption Expenditure Inflation; Canada—Total Consumer Price Index; Europe—Monetary Union Index of Consumer Prices, All Items; UK—Consumer Price Index, EU Harmonized; Japan—Core Consumer Prices Index; Australia—Consumer Prices Index; China—Consumer Prices Index.}