While maintaining an upbeat outlook for the U.S. economy’s short-term immediate future, John Flahive, director of fixed income at BNY Mellon Wealth Management—the world’s largest deposit bank and one of its largest wealth management firms—warns that inflationary risk could threaten global economic stability down the road.
Responsible for the strategy, policy and management of more than $25 billion in assets, Flahive shared these concerns, along with insights into fixed income strategies and the overall state of investment management, during a recent lecture at Adelphi University’s Robert B. Willumstad School of Business. His remarks come amid much uncertainty and volatility in the global marketplace, oil markets coming off multi-year lows, and interest rate pressures dominating the economic dialogue.
“The market is misinterpreting inflationary risk,” he told dozens of students and faculty members in attendance on April 20, days before the Federal Reserve decided to keep interest rates unchanged at 50 basis points, or half a percent.
Flahive’s outlook also preceded an announcement by the Basel Committee—the global banking regulatory advisory body—that it will allow big banks to continue using their own proprietary models for calculating interest rate risk, instead of utilizing stricter guidelines and recommendations that would act to prevent a collapse such as the global financial meltdown of 2008.
For now, Flahive is taking an optimistic, yet guarded view.
“The consumer is borrowing less and businesses are borrowing more, which means they are buying equipment and investing in their businesses. Typically these are positive signs,” he said, balancing this assessment with the prediction that lower energy prices and correspondingly lower capital expenditures on exploration and production will affect oil prices toward the upside.
“But productivity in energy will decline,” he warned. “Rig counts are down 60 percent from where they were a year ago, and there is little to any capex [capital expenditures].”
In a private Q&A session following his speech, Flahive admitted that his biggest future concern is reserved for inflationary pressures. With March 2016 Consumer Price Index data listing upward trends for inflation, he criticized the Fed’s stance on reacting to market pressures.
“There is a window where it’s not going to be overly worrisome,” he said. “The Fed wants 2-percent core inflation, and I think they are going to get it. But the risk is that the Fed is now beginning to follow the market, not lead the market.”
Flahive also commented on the effects that higher inflation will have on credit markets and lending. If the market has not priced in inflation properly and inflationary pressures persist, long-term lending rates could move significantly higher, he cautioned.
“If inflation goes considerably above 2 percent, the markets will start to price in higher rates, and at that point, then it will have a material impact on lending,” he explained. “Everything tied to lending goes up. Mortgages are more expensive, car loans are more expensive—anything lending-related goes up and becomes more expensive.
“Everything tied to the 10-year T-bill will go up, and most borrowing occurs off the 10-year,” continued Flahive.
His prognosis is corroborated by BB&T (Branch Banking & Trust)’s first quarter 2016 earnings release. The North Carolina-based financial holding company, one of the largest in the United States, announced a bump in its revenue from higher interest rates. Dubai’s biggest bank, Emirates NBD PJSC, reported that the Emirates Interbank Offered Rate, a credit market benchmark, climbed 29 basis points in the past year to its highest in nearly three years.
Flahive warned of a cause-and-effect scenario, in which the Fed ends up behind the curve and must play catchup, which hurts the Fed’s ability to control inflation and damages the confidence the markets have in the Fed’s role in combating inflation.
“It’s only going to be a problem when you have sustained inflationary pressures, and then the markets start to view that the Fed is not in front of it, but behind it, and the market starts to become more and more concerned, and the Fed starts to play catchup,” he told those in attendance.
Flahive predicted that even with lower-than-usual economic growth, inflation can still pick up, putting “stagflation”—characterized by a high inflation rate, stagnant economic growth, and steadily high unemployment—back on the table as a future possibility.
“Consequently, you have a lot of inflation without a lot of economic vibrance to support it, and in that particular case, it will become more troublesome, and you will start to see rates go up,” said Flahive.
He expressed concern about the disjointed efforts of not only central bankers worldwide to find a coordinated solution to avoid higher inflation, but also the lack of coordination between monetary and fiscal policy, in general—a disconnect emerging, he said, in “classic Keynesian economics.”
China’s current credit market troubles reflect Flahive’s fears. If present economic conditions deteriorate, the People’s Bank of China, which has slashed official lending rates six times since November 2014, will continue to cut rates to the point that concerns over Chinese inflation will spill over into world markets.
Yet in spite of the headwinds emerging for economies worldwide, Flahive was optimistic about short-term credit markets:
“Anything tied to shorter term should be fine,” he explained. “We have clients buying floating rates in their portfolios.”
For now, Flahive’s forewarned inflationary pressures have not yet materialized, and his observations do not suggest any significant threats in the immediate future. As the investment manager predicts, however, those challenges may lie just around the corner.