Bilal Hafeez on Inflation, Innovation, and Economic Recovery after COVID-19

COVID-19 has unified the Eurozone, undermined inflation, and catalyzed labor-displacing innovation in the services sector.

Bilal Hafeez is the CEO and Founder of Macro Hive and previously worked at JP Morgan, Deutsche Bank and Nomura. Bilal joins Macro Musings to discuss recent economic developments and the outlook for inflation after the COVID-19 crisis. Specifically, Bilal and David discuss the prospects for a K-shaped US recovery, COVID-19’s impact on the Eurozone and the UK, how the launch of the EU’s recovery fund has fared, and how the pandemic has impacted the outlook for the services sector, inflation, and the US dollar.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth: Bilal, welcome to the show.

Bilal Hafeez: Great. Thanks very much, David. It's great pleasure to speak to you again.

Beckworth: Well, it's great to have you on. We're kind of flipping the roles here. You had me on your podcast not so long ago. We'll provide a link to that in the show notes for the podcast. But now you're coming on my show and you're going to talk about some recent developments, kind of give us some perspective where we are in this cycle globally here in the U.S., the Eurozone, you're in the UK, you can talk about the UK. And then I really want to get into this issue of inflation later in the show, because a lot of people have been talking about inflation's really going to take off this time. This time, it is different. This time, we've built up so much debt, the government's really gone so far out, even more so than the last crisis. So I think that's an important conversation. You have a new article out on this very issue. I'm excited to talk about that and what you think is going to happen. But before we do that, tell us about yourself. How did you get into macro and investment banking and what you're doing now at Macro Hive?

Hafeez: Yeah, sure. So yeah, thanks a lot for that intro. Yeah, in terms of my background, how I got into macro, it wasn't really that planned in the sense that I didn't at a very young age think I want to go into macroeconomics. I grew up in a household that was very kind of mathematically focused in the sense that my parents viewed maths as the only subject that mattered rather than the humanities or anything else. So I had an upbringing, and I was raised mathematically inclined. My parents originally, they're from Pakistan, so kind of the Asian mentality when it comes to those sorts of things. And in high school, I ended up having a really good economics teacher. And like many things in life, often it's the people you come across that end up sort of determining your path in a certain field. And he was a fantastic mentor and a great teacher as well. His name was Mr. Drake, as I used to call him, Anthony Drake's his full name.

Hafeez: He's a great, and he really encouraged me to study around the subject, understand the subject really well rather than just learning the subject to pass your exams, and so then I kind of developed a love of economics during my teenage years. Then I went to university at Cambridge, I studied economics at Cambridge. And what I found there was that while I did like studying economics, what I found was that often, it was a bit too theoretical and felt a bit detached from reality. So many of the simplifying assumptions with economics just don't make sense, like the classic utility maximizing agents, rational expectations, and all of those sorts of things just didn't kind of make sense.

Hafeez: And many of the assumptions that were made in models, we knew were wrong, even theoretical economists would know, empirically they're wrong, yet they would kind of make those. So I kind of felt like if I did want to continue in economics in some way, I wanted to be in an area that was very applied. And so then, after university, I then got a job at an investment bank at JP Morgan in research and foreign exchange research. Why foreign exchange? It just happened to be the role that was available to me. And again, just like I had a great teacher early on, I had a great manager in foreign exchange research, a chap called Alfonso Prat-Gay, an Argentinian person who actually later went on to become the Central Bank Governor of Argentina, and later the finance minister of Argentina.

Beckworth: Really, huh?

Hafeez: Yeah. And we're still very good friends and everything. So just like my high school teacher, he was a great mentor. He really nurtured me, gave me kind of the right skill set to macro very well. And again, one of the things I like about foreign exchange, or at least starting off in foreign exchange was FX is kind of like the corner of economics or finance that nobody really wants to focus on too much. It's too complicated or it seems like it's a residual to everything and nobody really understands it that well. And so that's one of the reasons why I liked it so much, because nobody really knows what's going on in FX. And also what I liked about it was it's very global. Everything affects currencies. It draws in every single country and region in the world. So it gives you this real international way of looking at things which I really, really liked a lot.

Hafeez: So I did that at JPMorgan for about four years. This was in the late 1990s from around 97, 98. So I started off during the Asia crisis, then the Russia crisis-

Beckworth: Sounds like fun.

Hafeez: And then I left JPMorgan in around 2002. And one of the reasons for leaving was Chase Manhattan bought JP Morgan at the time. So there was a merger, lots of changes in people and it wasn't as fun anymore. And then I got approached by Deutsche Bank to join Deutsche Bank, which at the time was really building up a really impressive investment bank in the early 2000s and over the 2000s. And I joined, again, foreign exchange research at Deutsche Bank, and at the time, Deutsche Bank went on to become the biggest foreign exchange bank in the world. And they were a real powerhouse in everything to do with fixed income. And I focused on kind of the macro side of FX, of forecasting currencies and building models as well. So I did a lot of work around carry trades, which as an economist, one would know is uncovered interest parity, UIP, which in theory, carry trades shouldn't work. But in reality, they do, which moves back to my earlier point about sort of theory doesn't hold and carry trades are one of the most popular ways investors make money, and I did a lot of work around that, built a lot of models around that area.

Hafeez: Then the crisis hit, the financial crisis, and everything changed. Suddenly, banks became super risk averse, the whole mood music changed, a lot more regulation. But during that time, I transitioned to becoming more global macro, just looking at macro from a cross market perspective, because really, the global financial crisis was such that you kind of had to know a bit about everything, especially about parts of the market that nobody really focused on, which was short term interest rates and LIBOR and all of these areas, kind of the plumbing of markets.

Hafeez: So I learned a lot around that time. So then that ended up making me focus more on global macro. And at the time, I'd always worked in London, and I wanted to work in a different center and I thought Asia was the place to be. So then I spent a year or two in Asia, where I was focusing on Asian markets for a period of time running the team there in Singapore. So that allowed me to understand China better, like when you're in the region, this was around 2010, 2011, 2012, around that time. And that was a really important experience, one in terms of just understanding just the power of China, just how influential and important it was.

Hafeez: And then also the the change in the mood music going from Europe and the U.S., U.S. I've traveled a lot to versus Asia, Asia was super optimistic while Europe and the U.S. were kind of pessimistic, still suffering from the aftershocks of the crisis, but you really felt like Asia was really creating its own dynamics. And for the first time then, it kind of it struck me that usually, the U.S. is the engine of world growth. But when I spent some time there, it really became clear to me there's two engines of world growth. It's China and the U.S.

Hafeez: And as it happens, a few years after that, when China went through a slowdown in 2015, that affected the whole world. I mean, the Fed was talking about it. Everybody was talking about it. So it became clear that China really is a true force to contend with. But then I ended up coming back back to London. And back in London, I set up a team looking at cross asset research, cross market research. And I also, as it happened, was part of a research advisory team to the CEO of Deutsche Bank. He wanted his own research team to provide him with insights. So that was good, that was fun, learned a lot about how banks operate and work. But then I wanted to kind of go to a smaller bank. Deutsche Bank was involved and, it was sort of shrinking, there's lots of issues that it had to contend with. So I wanted to move to a lower profile bank. And that's when I joined Nomura, the Japanese investment bank, and they were focused a lot more on trading more so than other banks, surprisingly so. They had a kind of a good hedge fund client base as well. And I spent around three years there, where I basically built out the European research team, which they needed to be built out. And I focused on kind of global strategy there as well so I kind of ran the global team.

Hafeez: And that takes me up to last year, 2019. And what I kind of felt during kind of my final years at Nomura was that I've spent almost 20 years in investment banks at big companies and I really wanted to sort of strike out and do something on my own. I've always had this kind of creative entrepreneurial side to me and within banks, I've always tried to do creative things. But as you may know, if you work for big institutions, there's only so much you can do. There's bureaucracy, there's the administration. There's all the risk aversion that managers have. And especially after 2008, I mean there's a lot of risk aversion in banks. The general rule of thumb is no to everything unless it's compliance, then they say yeah. If it increases compliance and regulation, yes. But if it's anything kind of inventive, no.

Hafeez: So I thought I want to leave and set my own research company up. And one of the reasons for that was I felt like there's so many changes in the way people consume research, and I felt like banks weren't capturing those. So one, for example, is the way research is delivered. So we're speaking on a podcast and podcasts, I love podcasts, and I've been listening to yours for many, many years, and I listen to lots of other podcasts. The bank were, I tried to set up a podcast at a bank, but it takes a long time to get them to understand that. So that's an example.

Hafeez: Or another thing is, one thing we've done at Macro Hive, which people have liked a lot is members, we've set up a Slack room, a Slack channel, where members, subscribers can talk to each other, which is really, really popular. Slack is kind of like a better version of WhatsApp, for people who don't know Slack. Now, if I was in a bank, you could never do that. There's all these regulations around how clients, you can't have chat rooms with too many people on there. But on a purely research basis, there's nothing wrong in doing that.

Hafeez: And also philosophically, I think research, the way I think about research is that it should be kind of as open source, as open as possible. Because I think nobody has all the ideas. It's all that idea about bouncing ideas off of each other. And I think the culture of research in banks is very kind of inward looking to say that, "Look, we have all the answers. Our team don't listen to the other bank.", whereas my approach is much more kind of cooperative, where I want to just talk to everybody and be as open and transparent as possible. And in that way, you end up with a much better set of ideas.

Hafeez: So the way I structured Macro Hive was to be a very open network. So we have WhatsApp groups with lots of other researchers. We speak to academics a lot, and it can be very open and transparent. And you just can't do that inside of a bank. And even private firms don't often do that as well. Every kind of private company thinks they have the secret sauce, but my view is there is no secret sauce. We're all blind, especially when it comes to markets. And so just being kind of generous with your ideas, you end up gaining a lot more in that way. And clients have told us they really like, they really value that, that we're so open. We connect clients to each other. We recommend rival companies to our clients, if we think that's useful to them. And you find that clients and investors kind of appreciate that as well.

Beckworth: Yeah, well, I like the name Macro Hive, I think of a hive, where bees are busy, but they're all geared towards an objective and they're complementing each other, but there's a lot of activity going on. So I think that is well named. And you have your own podcast, as I mentioned earlier, so I will encourage listeners to check it out. I've been on it. A number of really big names have been on it. I'm just kind of like down on the bottom of the list. You've had Mervyn King. Who else have you had on?

Hafeez: Yeah, we had Lord Mervyn King, who of course, was the former Bank of England Governor. We had Raghu Rajan, who's now in Chicago, was the Reserve Bank of India Governor and before that, the Chief Economist of the IMF. Then we also had Vitor Constancio, ECB Vice President recently as well. We had the Pakistan current Central Bank Governor as well. We had Laura Veldkamp, who was one of the keynote academics who spoke at the most recent Jackson Hole on COVID scarring. So we've had some really good policy people on.

Beckworth: Yeah, absolutely. And I'll put a plug in for my sometimes co-author, Chris Crowe, who's also been on your podcast. He's written a lot about safe assets and a good friend of mine in the UK as well. Let's move on and talk about some of these issues that I think you have a good perspective on because you get paid to think about these issues. You are a firm that consults and ponders and considers and you write your own research, as you mentioned, and I think it's useful. Here we are many months past the outbreak of the pandemic, it's had a huge effect on the global economy. And just to kind of take stock of where we are and where you think we're going to go. I mean, we just had the IMF meetings, World Bank meetings. They had their own report out. So there's been a lot of discussion on what's going on. Today is October 21st. We're recording this. This probably won't be released until after the election. But today, Governor Lael Brainard had his speech out and it was interesting because for the first time, a Fed official has acknowledged the prospect or the inevitability of a K shaped recovery, the economy going in, depending on where you are, two different directions. And I want to get your take on that and let's start with the U.S. economy. Maybe we'll work our way through some of these other economies. But are we in the midst of a K-shaped recovery in the U.S.?

Will a US Recovery be K-Shaped?

Hafeez: Yeah, I mean, I think all of these letters, it gets confusing after a while, V, W, there's a Nike swoosh, K is the current one. I do think K does make a lot of sense. But I think another way of looking at this is we almost have two cycles going on right now. We have the COVID cycle, COVID shock, you could say, which was incredibly unusual, which none of us were really expecting, well at least I wasn't expecting. And that was a government induced shutdown of the economy in effect, and so that naturally would lead to a massive contraction in output. But it's not like a normal recession, because the government just shutting everything down, and there's no way for growth to pick up if everything's shut down.

Hafeez: But what you do know with that is that when there's a reopening, then everything will bounce right back. And that's what you've seen in all the GDP numbers around the world. During the shutdown quarter, numbers cratered by 30%, annualized. And then the quarters, the subsequent quarter, when it reopened, it just bounced straight back up by 30%, or something like that. And so that's kind of one part of the story. But then the second cycle is more of the classical recession, which is that there are some repercussions of COVID, where it dense investment consumption, people's belief about the long term part of the economy, and then all the life support mechanisms, which were put in place around COVID, once they get taken off, once economies reopen, then you suddenly say, "Okay, what's the true economic shock?" And that's more of a kind of conventional slowdown. And we have those two cycles going on at the same time. So at the moment, I think we're in the phase of trying to understand the second part of the cycle. What is the longer term impact? And how many bankruptcies will there be as you take the life-support off? And we're still, now that we're having second waves across the world, we're actually getting a return of the COVID cycle as well. So you kind of have two cycles put together.

We have those two cycles going on at the same time. So at the moment, I think we're in the phase of trying to understand the second part of the cycle. What is the longer term impact? And how many bankruptcies will there be as you take the life-support off?

Hafeez: But through both of these, one part of the economy seems to be doing fine. And that is the part of the economy that is not linked to people being in close proximity to each other, and in particular, the digital economy. And this I think is probably the part of economics that nobody really understands that well. Just like after the global financial crisis, we all suddenly became very attuned to the balance sheets and the role of the finance sector.

Hafeez: I think the last five, 10 years has been all about the digital economy and the role of intangibles, and we're just trying to grapple with how do we understand all of that, but obviously with the pandemic, that affects the real world, the physical world. It doesn't affect the digital world, and so if anyone works in the digital world, which tends to be people who are well educated or over educated, higher end of the income strata, they can carry on operating as normal. It's almost no difference. And it goes all the way from they can do their job remotely, but also small things, like they have bigger houses as well, where they can have a part of the house where they can have an office, where the people from low income groups don't have that.

Hafeez: And I think these things are quite important. So you end up with the upper strata of society, pretty much carry on as normal in some ways. There are some differences to before. Obviously, they can't go to fancy restaurants, but for all intents and purposes, their part of their world remains the same. And they were already benefiting from the earlier five, 10 years after the global financial crisis. But it's really the lower end that really suffers where number one, people at the lower end of the spectrum tend to work with their hands and interact with other people, right. And then also, many of them don't have kind of conventional full time jobs. Many of them have, they might be contractors, they might be on short term contracts, they might work in the cash economy. And so many of the support programs that were put in place maybe didn't necessarily reach them either, or maybe they don't interact with the financial system or the bank system so well.

Hafeez: And so that part of the economy really, really does struggle. So in that sense, the K shape makes a lot of sense, where the upper end kind of is bouncing, the upper part of the K and then the other side are declining. So it's kind of structurally, I can kind of see how that really kind of manifests itself. But as we know from the COVID part of the cycle, as we reopen, then even the lower end will benefit as well. So you will see some kind of recovery, and we have seen recovery in that part of the economy. The problem is that now, we get a second wave, you'll get a hit again to that side.

Hafeez: And the other issue is the bankruptcies where there's been all sorts of measures, whether it's actual guarantees from the state or central bank intervention or just moral suasion to stop forcing bankruptcies. Now, in the next three to six months, we'll start to see which businesses will actually survive or not. And that will have a big impact on the kind of overall economy. Now, interestingly, U.S. banks reported their earnings at the beginning of October, and they haven't actually increased their reserves for bankruptcies now, which is kind of optimistic at one level. At the same time, they haven't written much off yet either, which means they haven't realized those bankruptcies either. So there's kind of good and bad news in terms of bank earnings. But this is for me one of the big uncertainties around what point do businesses just call it a day and switch everything off. One issue there is do businesses view the COVID side of things as being temporary or not. Do some just run out of cash, whether you think it's permanent, whatever your belief around COVID is, and the other side is, has COVID fundamentally changed the outlook for certain industries as well.

Hafeez: So if you did have a restaurant business, maybe that type of restaurant just never will survive and you will instead go for deliveries. And this is one of the other sides of COVID, where I think one of the effects of COVID is it's essentially accelerated the adoption of multiple technologies at a mass level that we would never have seen so quickly. So many of the technologies already existed and there's been a big puzzle amongst economists around productivity.

Beckworth: Yeah, that's interesting. I had on the show, Adam Ozimek and we discussed remote work, and he's done a lot of research on this and how this COVID crisis appears to have been an inflection point or at least a catalyst that has permanently shifted a lot more remote work and changes the nature of business. So I think it's an interesting point that even though there's a lot of hardship and suffering, there'll probably be a lot of innovation that comes out of this crisis as well. Interesting to see where it goes. But I want to go back to an earlier point you mentioned and that is the K-shaped nature and how big corporations seem to be doing well, particularly digital ones. I mean, we all have been taking advantage of online services, and Google, Netflix, things like that. But the difference between, in general big corporations and in small businesses, I mean, they've been doing better, because they're, I think, better positioned.

Beckworth: But also even the relief programs were more accessible, as you noted, to the big corporations, everything the Fed did. Now the PPP did reach some smaller businesses, but in general, the small businesses have been hammered hard while the big corporations have done well. And one of the critiques, for example, of the Fed programs is you've been able to reach into corporate bond markets, but those are only big corporations. You've not been able to reach Main Street as well as we would have liked. And I don't think the Fed could have probably given away its design. But there is this disconnect between medium, small sized businesses and big ones. And I do worry about that because if you look at for example, personal income, it's actually done relatively well because of the generous programs and at least in the U.S. here, but total income, total national income is a product of both business income and household income.

Beckworth: And in the side that I worry about all these small and medium sized businesses going forward. Now, you mentioned there's a V shaped and I guess, what's your sense overall? I mean, so there's going to be winners, there's going to be losers. There's going to be a great sorting that goes on here. But do you see us having permanent output loss or returning back to the trend path we were on? So after the last crisis, we've permanently lost a level that we could have been. Where do we go moving forward?

Hafeez: Yeah. I mean, I think that's a kind of a good question. I mean, my bias at this stage is I think we will, just like the 2008 crisis, there will be a permanent loss of some kind. And I think in this regard, I think the work of Laura Veldkamp on COVID scarring, I think, is really, really useful. When you get these very large, unexpected type shocks, it essentially does just leave these permanent scars in terms of investment outlook, in terms of consumption behaviors, and it takes time for that to heal.

Hafeez: So my bias, my inclination is there will be this permanent loss of growth. Now, that can be avoided with the right policy measures, which probably has to do with some combination or providing support to these smaller businesses. And I think going back to your point, I think one of the issues with the U.S. probably more so than Europe, is that the U.S. is a very capital market centered financial system. It's much easier for the central bank to just operate at the capital markets level, rather than through the banks.

My inclination is there will be this permanent loss of growth. Now, that can be avoided with the right policy measures, which probably has to do with some combination or providing support to these smaller businesses.

Hafeez: Now, Europe is a much more bank-based economy. And so European Central Bank knows how to use banks to transmit credit to the right place.

Beckworth: Interesting.

Hafeez: And all those sorts of things. Now, the U.S. just doesn't have that same practice, and businesses use banks more than, your small businesses use banks more than the capital markets. And so ideally, what you would have wanted is some mechanism where the Fed would have said to all the big banks in the U.S. that we will kind of guarantee a certain amount of loans that would go to small businesses, and/or provide liquidity to banks linked to loans to the small businesses in some way. So that could have been one way it could have worked. But I think what has happened in the COVID crisis is that central banks have essentially used the playbook from 2008, just multiplied by 10 and done it in two days rather than two months. And this, for me was more about saving smaller businesses, which were private banks, rather than capital markets, more than trying to save the big banks. I think in this case, the U.S. kind of missed a trick here.

I think what has happened in the COVID crisis is that central banks have essentially used the playbook from 2008, just multiplied by 10 and done it in two days rather than two months.

Beckworth: Yeah, so permanent scarring, hysteresis as we say in economics. And your view, I think, is borne out by forecast, at least. And this is something that I don't see stressed enough. And that is if you look at consensus forecasts, for example, I'm looking at Blue Chip forecast that came out for the month of October. And it shows, I'm sure you're familiar with these numbers already. But it shows for 2020, overall real GDP in the U.S., contraction of about 4%. And then next year, 3.9% positive, so almost complete opposite number in the other direction, so we lose 4%, overall, we get 3.9%. Now, that sounds great on the surface, but what that misses out is that you really should be making up for the loss in the previous year. If you're going to return back to full potential we were prior, you'd want to have 8% growth, or at least spread that extra 4% loss out over so many years. And if you look at the long term forecast in the blue chips, you don't see it. You just see steady kind of 2% real growth. You have a year or two above 2% growth, but you don't have full makeup of what we've lost. And that's what I find troubling.

Hafeez: Yeah, no, exactly. Yeah, you're absolutely right there. And so I think all the, we will have big positive numbers next year. But as you say, they need to be more than the negative numbers this year to kind of get you back to where you started. So the numbers just aren't big enough next year to bring us back to it.

Beckworth: Yeah, I think it's easy for us to think in terms of growth rates, not in levels. I think another big challenge that policymakers face and economists face. Well, let's segue over to Europe, we're talking about the U.S. and some of this plays to Europe as well. But help us understand what's going on in Europe over there. Tell us about the UK briefly and the Eurozone. How are those economies faring?

COVID’s Impact on the Eurozone

Hafeez: Yeah, I mean they've also struggled a lot this year. So in many ways, similar growth trajectories as the U.S., very weak first half, bounce backs in the second half. I think, I guess what's interesting is some of the differences between the two, where in Eurozone, particularly lesser than UK. But you haven't seen a big jump in unemployment in the Eurozone compared to the U.S. In the U.S., you kind of saw an explosion in unemployment rates, and even now, jobless claims is still stubbornly high. It's actually weakening very recently.

Hafeez: In Europe, we didn't see such deterioration in the labor market, and part of that has to do with the job support schemes that Europe has had, where very quickly the Europeans put into place all these different furlough schemes, which essentially were paying companies to keep people employed. So they basically say, the German model, the Kurzarbeit program, which is what they call it, they basically would say that if a company reduces the hours somebody works, then the government would kind of make up for some of that income so that the person ends up getting their full salary or something close to the full salary.

Hafeez: And many of these countries, France and Germany, the two big economies have extended them into next year and beyond. So from the labor market perspective, you've got a lot more stability than you would have had in the U.S. That didn't stop the economy from weakening. But at least in the U.S., if you look at the consumption side, retail sales, it didn't fall as much as the U.S. did. But in other parts of Europe, you did still see some weakness. So that's one thing.

Hafeez: The other difference, interestingly enough, was the U.S. fiscal response early on was much bigger than the European fiscal response. So the U.S. did a really aggressive early fiscal stimulus. And now it's kind of faded and depends on Congress and so on. Whereas Europe instead went for more of a slow burn, where it's kind of spread out over a couple of years. And so the fiscal response of Europe wasn't as big compared to the U.S. But theoretically, at least, it should be more balanced for the coming few years. So that's kind of another difference between the two.

Hafeez: Now, of course, as we go into Q4, Europe is facing a much sharper second wave than the U.S. is. So the U.S. never flattened the curve fully in terms of COVID. The U.S. had a big first wave, and it never really fell to zero. Whereas Europe, it fell to zero. And so during the summer, Europe was looking quite good in terms of a nice take off, but it's hit Europe everywhere, even Germany. And so suddenly, all the numbers are starting to roll over one by one, the service sector in particular. So that's kind of a big challenge for Europe.

Hafeez: So Europe is likely to kind of slow down into Q4, probably have a weak Q1, similar to the U.S. in many ways. So I would say in general, it's kind of roughly matching the U.S. maybe one or two months off. Europe might be one or two months ahead or behind depending how you look at the COVID case. Labor market's probably healthier in Europe, compared to the U.S. The fiscal support is probably more spread out in Europe compared to the U.S. Now, in terms of the UK, UK is kind of somewhere in between the U.S. and Europe on this, with the additional issue of Brexit, where the UK with Brexit negotiations to see whether the UK, what type of deal the UK will have in January. So that's introducing some additional uncertainty in the UK. So investment's been anemic in the UK for a number of years now. COVID didn't help. And now with Brexit, that's not helping either. So the UK has this additional shock. So UK growth overall has been very weak over the course of this year.

Investment's been anemic in the UK for a number of years now. COVID didn't help. And now with Brexit, that's not helping either. So the UK has this additional shock.

Beckworth: Yeah, very interesting. And I'll mention since I'm a big connoisseur of the safe asset shortage problem that Europe has now introduced its own Treasury equivalent, at least it's dipped his toes in the markets. And I'm interested to hear your take on this, what you're hearing from your clients and stuff. But there's an article out this week in the Financial Times titled “EU enjoys ‘outrageous demand’ for first COVID related bond.” And the EU Brussels issued these bonds, they were oversold. People wanted more than they had made available. They were excited the banks who helped get them out, so they hadn't seen anything like it. And so the EU Brussels may be issuing more debt, will be issuing more debt than Germany, which has been the other kind of place you'd go for bonds in Europe. But has this got people excited over there? I mean, is this like a big deal as I think it is?

High Demand for EU’s Recovery Fund

Hafeez: It is a big deal. And when it got announced, the European Recovery Fund, which is around 750 billion euros and then the additional kind of pandemic bonds, which I think comes to the EU's pandemic bonds, which come to around 70 billion, 80 billion euros. There's been a huge amount of excitement around it. And especially from international investors, so when you speak to investors, especially in Asia and China, they've been really interested in the idea of a euro equivalent of the U.S. Treasury. The excitement has eased up a bit, mainly because the full contours of the recovery fund haven't formally been agreed yet. So the issuance hasn't kind of all been mapped out the next few years.

Hafeez: And secondly, the COVID second waves hit. So that's suddenly kind of brought everyone, shifted everyone's attention. But overall, I would say there is a lot of interest in this. And I think that many people were surprised how quickly Europe came round to this idea of common bonds. Many people at the beginning of COVID thought this could be an event that would lead to a breakup of the Eurozone. There's always these euro bears, and they thought that the breakdown of the free movement of labor between countries and things like that would be the thing that would break the whole region, but instead has actually led to more union, you could say in terms of sharing fiscal risks. So I think there's a lot of excitement. There's a lot of buzz around this. But we're kind of in the implementation stage, which is a bit thornier at the moment. So that's kind of where we head to.

There's always these euro bears, and they thought that the breakdown of the free movement of labor between countries and things like that would be the thing that would break the whole region, but instead has actually led to more union, you could say in terms of sharing fiscal risks.

Beckworth: So the recovery fund, as I understand it, is 750 billion euros the total size, and not all of that has been used in terms of issuing bonds. But could there be up to 750 billion euros issued in new euro debt at the end of the day?

Hafeez: Yeah, essentially, yes. Yeah, there could be over a space of four or five years, which is kind of the European Union budget cycle. So that could be the total issuance. And then if you add in some of the other pandemic bonds that have been issued, you could almost end up with like a trillion euros worth of these bonds over the next five years, if it all goes to plan. So that's a very sizable market it's created.

Beckworth: Yeah, and as someone who takes market signals seriously, the fact that this is in the pipeline and people in the bond market have skin in the game. They know this. They're looking at this closely. They've also looked at the huge amount of debt the U.S. is issuing and will continue to issue and yet, yields remain low across the world. And I know some people would say, "Oh, it's because central banks are backstopping." but my retort to that is the central banks were repressing rates, and you would see some pressures elsewhere and inflation and spending pickup, which we don't see.

Beckworth: So it's to me telling that the EU can issue this additional debt. The U.S. issues additional debt, and yet we have low yields across the world. And that provides a nice segue into what I'm going to get to next and that is inflation. All this debt that's been issued by these advanced economies, and yet we don't see a lot of inflation. But there are a lot of people who will talk about this. They're like, "Oh this is it, this is the straw that's going to break the camel's back. COVID will push us over the top." I mean, I see it on Twitter all the time. Yet, if you look at break-evens, you look at the bond market, they're not forecasting inflation. And you have written a nice piece. It's titled “How COVID-19 Kills Inflation.” So you're taking kind of the other direction on this argument. So walk us through your piece and your thinking on what COVID-19 pandemic means for inflation moving forward.

How COVID-19 Kills Inflation

Hafeez: Yeah, sure. I mean, I wanted to put a provocative title because just like after the 2008 global financial crisis, mainly people calling for an inflation, I think something similar is happening now. And kind of the argument for inflation this time is that, one is, there's bigger government deficits than last time, so it's bigger. Second, what the Fed has done is more than ever before. So the magnitude of everything is bigger than before. And also, there's kind of an important argument, which is that somehow the government spending and the combination with central bank printing money is more directly leading to demand in the economy in some way.

Hafeez: So that's kind of probably the big, important difference from say, 2008, where it was unclear whether that would happen. Now, my kind of retort to that is the template we have for that is really what we saw in Q2, where the government shut down the economy, and then provided some support to keep certain functions alive. Now that the economies are reopening, all of their supports are going. So it's not as if there's perpetual injections of government money in the economy. Moreover, I think that the increase in government debt and increase in fiscal deficits is really a symptom of an underlying issue, which is that you have incredibly weak demand in an economy.

Hafeez: So there's different reasons why you have runaway debt. But at the moment, the reason for runaway debt is the economy is incredibly, incredibly weak. And so you often see this in countries with high debt. It's often because the economy's weak. And Japan is the classic example of that, where you've had record high government debt levels, and you see no inflation, and that's because it reflects this chronic weakness in the economy. And same with Italy as well. Italy is at incredibly high levels of debt, yet no inflation. And again, high debt could be a symptom, or it could be a cause. And in this case, it's a symptom of something bigger, which is there's no demand in the economy.

Hafeez: If demand was to pick up, then fiscal deficits would disappear. I mean, there'll be no big fiscal stimulus then and suddenly, all the numbers will look better. So the policymakers are responding to what everyone else is seeing. It's not as if they're doing something that's outside of what we all are seeing. They're responding to everything that we're seeing. Moreover, if you look at the, I just crunched the numbers, we looked at the debt levels of all countries around the world, emerging markets and developed countries over the last eight, 10 years, look to see, is there a relationship between countries with high debt levels and inflation? And there's no relationship whatsoever. If anything, the relationship is almost the other way around, where in developed countries at least, high debt countries tend to have lower inflation than low debt countries.

Hafeez: So for example, Norway has probably had the highest inflation in the developed world, yet it barely has any debt. It's a very successful economy, where Japan is at the other end. And even in emerging markets, there's barely any relationship between the two. Some high debt countries had inflation, some didn't. And if you go back before the financial crisis, 10 years up to the financial crisis, again there's no real relationship between the two. So I think it's really important to understand why is debt growing? Is it growing because there's weak underlying demand, in which case it's disinflationary? Or is it growing because the economy is overheating, and the government is just going on a spending binge, like what you've seen in Turkey or all these sorts of countries that you often see. So I think one is understanding why the debt is going up. That's very important. There's no empirical relationship to say that high debt leads to high inflation. Statistically, there's no basis for that. So instead, you have to kind of look at the rationale for it.

I think it's really important to understand why is debt growing? Is it growing because there's weak underlying demand, in which case it's disinflationary? Or is it growing because the economy is overheating, and the government is just going on a spending binge.

Hafeez: And the second reason why I'm very cautious around all of this is that there's another argument to say that because of populism and greater kind of societal unrest, somehow that will lead to more wages, higher wage growth, for your employees, maybe more unionization, those sorts of things. Yet, one thing we've found over the last 10, 20 years is that the relationship between wage growth and inflation has been very weak as well. So the Phillips curve, which is what everybody focuses on, tends to work okay with wages, so the output gap of wages seemed to have some kind of relationship where tight labor markets lead to higher wages and vice versa.

Hafeez: Yet, it's really the link between wages and inflation that seems to have broken down completely. So there's almost no relationship between wage growth and inflation. And the reason I think that's the case is one is I think, some of it could be capturing productivity in the sense that we don't have a good sense of productivity, especially in service-based economies, where measuring productivity is very hard. I'm a researcher and how do you measure my productivity? Is it my number of notes I produce or not? I mean, I don't know how to measure my productivity and accountants or lawyers, consultants, academics, what was the right measure of productivity?

Hafeez: And so one, I think, is that we don't really know how to measure productivity. And so that makes it hard to map wages to inflation. And then the other thing is, and this is perhaps a bit more subtle is I actually don't think that central banks, including the Fed, are really targeting inflation per se. I actually think they're targeting wages. And the Bank of Japan has been a bit more explicit about this, where they talk a lot about wage growth. That's more important than inflation. And I think if you look at the rhetoric of the Fed, the way they talk about inclusion now, the distribution of income and so on. What they're really talking about is they want wage growth to be very positive.

Hafeez: And so they don't care if inflation is low. What they care about is that wage growth should be high and should continue be high. Real wage growth should be higher. So in some ways, I actually think central bankers are somehow targeting wage growth rather than CPI inflation or inflation. So that's kind of the second point that it's not clear to me even if people get higher wages, that will not necessarily map onto inflation or CPI inflation. Then the final point is very COVID related, which is that COVID has basically decimated the services sector, which is very unusual for recession. It's usually the manufacturing sector that sees a big collapse rather than services. This is the first time we've ever seen services drive the economy. And what's the biggest component of inflation in developed countries, including the U.S. is services, services inflation.

In some ways, I actually think central bankers are somehow targeting wage growth rather than CPI inflation or inflation.

Hafeez: And so you're basically, you've sort of created a shock on the service sector, completely disrupted it, you're scarring that sector. And so for me to then think that okay, somehow, services prices are going to surge higher doesn't make sense. And this is even more important, because over the last 20 years, goods price inflation in the U.S. has been zero, whereas services inflation has been 2% to 3%. The only inflation the U.S. has had and rich countries have had is services inflation. But now we've had a shock to the service sector. And I think that lots of the technological changes that we're seeing are all about replacing people in the service sector. That's what's happening right now. We're seeing a huge amount of innovation on how do you take humans out of the equation in the service sector or how do you remove the need to have people in person provide a service.

Hafeez: And so that could affect medical services, where you can now perhaps have remote treatments in some ways. So you don't need to have an expensive local doctor. You could have a cheaper doctor from some other part of the country. Tuition fees have over the years been very high, especially in the U.S. Now, are people going to be willing to pay such high fees, if half the classes are remote or they can take all of those lessons remotely? And the other part, the biggest component of services inflation is rent or shelter prices, which is derived from rent. And if you look at the data in the U.S., it's very interesting at the moment, whereby you're seeing that there's been a surge in housing, housing starts and construction and so on. And that's mainly in single family housing, but away from multifamily housing.

Hafeez: So people are moving away from apartments and moving to houses. And geographically within the U.S., people are moving to the south. So what COVID is doing is through the prospect of remote working, people are saying, "Look, I'm not going to live in expensive urban areas. I'm going to move to a bigger place where I can move out from an apartment to my own house. And I'm going to move to a sunnier part of the country." And so for me, that's disinflationary. That's going to kind of take the pressure off housing prices, rents and so on. People will just go to wherever the cheapest places are. And so over time, I think we'll see more of those effects will feed through. And so I think that that will end up being a factor that will see inflation fall or stay very low.

Now we've had a shock to the service sector. And I think that lots of the technological changes that we're seeing are all about replacing people in the service sector. That's what's happening right now.

Beckworth: Yes, that was the most interesting part of your paper, for me was the whole service sector angle on this, the idea that this recession is very unique, because it was a service sector recession, by and large. In fact, going back to that K-shaped recovery, a lot of the K-shaped recovery is occurring in industries where you have, I mean there are the high tech or the big corporations, but manufacturing, housing, all these tangible industries are doing well. But the service sector has been hit really, really hard. And it was interesting to think about that and the fact that inflation, like you said, that we see has been in the service sector.

Beckworth: But I wanted to try to clear some of my confusion upon this particular issue. So you're going to get supply shocks and demand shocks. And so the story I think I hear from you is that the immediate recession was like a demand shock on the service sector. Things just shut down people. And since that's where all the inflation is coming from, we don't have much inflation. But there's a second supply shock story going forward. COVID is going to force innovation in the service sector because people are moving or you're finding more efficient ways to deliver because you can't do it in person on the remote work plus some of the housing issues you mentioned. So in the short run, there was a negative demand shock that lowered inflation but going forward, it's more like a positive supply shock and services that's going to keep inflation going down. So between the two of them, the service side of the economy is screaming, that is low inflation moving forward. Is that a fair interpretation?

Hafeez: Yeah, that's absolutely correct. And a kind of additional point I would make about kind of remote working and so on is that in some ways, what that is also doing is it's unlocking capital, physical capital that wasn't being utilized before in the same way as people were renting out their houses through Airbnb, which lowered the price of being able to rent a room when you go to a different city. So you basically had a capital item, a house that was now being utilized more productively than before. That's also happening now by people working remotely. Now they're using their houses, not just for leisure to live in, but also to work from, which basically unlocks the house as a potential kind of capital good, so to speak. So suddenly, we're kind of untapping all of these different kind of unutilized pieces of capital that people had are now being used more efficiently going forward.

Beckworth: It will be interesting to see if higher ed in the United States also benefits from this, because that's been one area, one sector that really has not changed much in terms of productivity for a long, long time. And will this crisis lead to a reexamination of how we deliver higher ed? Now let me use this inflation point and raise a question I have about the dollar and use that as a segue to the last part of our program on currency.

Beckworth: So one of the arguments I've made in the past in terms of how this crisis will lead to lower inflation moving forward relates to the Federal Reserve's response in the almost near financial crisis we had. The Fed stepped in and stopped it from happening. But what the Fed did is it opened the playbook, like you mentioned, from 2008, but times 10. It opened up massive amount of dollar swap lines, for example, for the rest of the world. And it opened up all of its facilities to effectively prevent shadow banking from crashing around the world, all the dollar funding markets around the world, but it's on a much larger, much more aggressive scale. And as you mentioned quickly too, it was also shocking.

Beckworth: But to me what this says and it signals to the rest of the world is the Fed has your back. If you want to transact in dollars, the Fed has your back, so if I'm an investor overseas and I'm looking at my portfolio of assets, and I'm asking, "Well, should I continue to hold dollar denominated assets?", this is one more reason to do that on the margin. And so the demand for dollar denominated assets has on the margin actually increased because of this crisis, because the Fed has been so aggressive. And as a result, that means higher demand for treasuries, for anything, even private sector dollar assets, which at least for the U.S. economy would imply lower inflation, so more senior rich for the U.S. government, more demand for dollar denominated assets. So one maybe smaller point, I think, is that I want to hear your thoughts on this is that the Fed has made it loud and clear that you can trust dollar denominated assets moving forward. Therefore, the demand for dollars are up and we'll see as a result lower inflationary pressure in the U.S.

Hafeez: Yeah, I think that's absolutely correct. I mean, I think the Fed's had numerous tests or the dollar's had numerous tests. And each time the Fed steps up, and in some ways, what the Fed tells us is that it will always provide liquidity for the dollar. So in that sense, I think you're absolutely right. And that's what maintains the dollar's dominance globally. The Europeans, the euro, the ECB, they just don't have that same sort of philosophy. It's almost Germanic kind of view, which is that having a dominant international currency, somehow you lose your discipline as a central bank, because it's too easy to issue euros. There's kind of this philosophy.

Beckworth: Really? So they actually explicitly think those thoughts that they don't want to have the exorbitant privilege?

Hafeez: Exactly, yeah. I've spoken to many people at the Bundesbank. That's their view, that it ultimately would lead to a loss of discipline, that there will be over issuance of euros. And so they prefer not to have that. So the Europeans, you don't have that. The Chinese are perhaps more interesting, where you have the renminbi. It's still a small share of overall world transactions compared to the dollar and even the euro. And the Chinese are trying to increase the internationalization of the renminbi. More countries are using China's equivalent of Swift settlement system. There's more Chinese swap lines with different countries.

Hafeez: But at this stage, it's more ad hoc, more regionalized. And generally, there's this concern amongst international investors that China can always introduce capital controls, whereas with the U.S., you don't have that same fear. I think the challenge for the dollar, I think, is that and this is one of the reasons why the Chinese do want to internationalize their currency is there's a fear that the U.S., through the dollar gets extra territorial powers, where anybody who uses the dollar suddenly comes into the U.S. system and then the U.S. can then pursue them criminally or legally. And so there's an issue around the legal system and territoriality, which I think is the the big potential weak spot for the dollar, depending on how the U.S. uses that power.

Beckworth: So let's segue from there then into the actual current state of the dollar, the Chinese currency, the yuan. Before this crisis, Trump was always concerned about the strength of the dollar. It had gone up quite a bit since 2015. Where does the dollar stand today? Are we at a tipping point or is the dollar going to get weak? Or has it weakened since the crisis started? Where are we in terms of the dollar?

Current State of the US Dollar

Hafeez: Sure, sure. Just for kind of overall context, I would first of all, kind of say that the dollar generally follows these long cycles, when the dollar goes up for four, five, six, seven years, then goes down for four, five, six, seven years. So the first half the 1980s, the dollar went up for five years, when Volcker came in, crushed inflation, inflation real rate shot up. And then for five, six years, the dollar went up against all currencies up until 1985, when you had the Plaza Accord, where global policymakers came together to bring the dollar down, then you had two, three years of very abrupt dollar weakness, 85 to 87. And then kind of a slow downward move in the dollar generally, for the next five, six years, and then you had another run up in the dollar in the second half in 1990s, driven by the dot com mania, higher productivity, high U.S. rates, then in the early 2000s, dollar fell up until the global financial crisis.

Hafeez: And then since then the dollar has generally been on the stronger side. And actually, interestingly, after Trump first got elected in 2016, the first year or so after that the dollar was on the weak side. And partly, and that was partly because Europe was bouncing back so the dollar weakened a bit. But then later, when the Fed started to hike rates, the dollar came back and strengthened into COVID. During the COVID crisis, generally the dollar was on the stronger side. But since COVID, the dollar has fallen.

Hafeez: So for much of this year, the dollar has been trending down against most currencies. And the main reason for that I would say is because the Fed has effectively cut rates to zero and done massive QE. So in that way, Europe already had very low rates, negative rates. Japan had very low rates. And so now the U.S. kind of unwound all of its hikes that it did earlier. And so that kind of made the dollar less attractive. And then also, when rates kind of collapse like that, then current accounts start to become a bit more important. So Europe's current account's surplus, Japan's surplus, U.S. is deficit. And so those flows start to become more important for driving the currency.

Hafeez: So generally, the dollar has been sort of heading down. And I think interestingly, for me, one of the biggest drivers of this weak dollar trend has been the Chinese yuan, the renminbi where the dollar's weakened particularly against the Chinese yuan. And that actually has an effect on the euro as well, because the Chinese target a basket of currencies, so if the renminbi is strengthening against the U.S. dollar, what the Chinese do is they then buy euros to make sure that the renminbi is weaker against some other currencies, so that on balance, the Chinese trade weighted basket doesn't strengthen too much. And so whenever the renminbi's strengthening a lot, you also end up seeing Chinese buying of euros and Japanese yen by the Chinese who are trying to ensure that their currency doesn't get too strong compared to its competitors. So there's kind of this loop that goes back to the currencies, whatever's happening in Europe, even if Europe's weak, that you'll still see that China's doing kind of very well. So there's that kind of dynamic to the whole equation as well.

Beckworth: Well, with that, our time is up. That has been a fascinating discussion. Our guest today has been Bilal Hafeez. Thank you so much for coming on the show.

Hafeez: My pleasure. Thanks a lot.

Photo by Daniel Roland via Getty Images

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.