Global Chief Economist and Global Head, Investment Strategy Group
Mr. Davis is Vanguard's global chief economist and the global head of Vanguard Investment Strategy Group, whose research and client-facing team develops asset allocation strategies and conducts research on the capital markets, the global economy, and asset-allocation strategies. Mr. Davis also chairs the firm's Strategic Asset Allocation Committee for multi-asset-class investment solutions. As Vanguard's global chief economist, Mr. Davis is a member of the senior portfolio management team for Vanguard Fixed Income Group. Mr. Davis is a frequent keynote speaker, helped develop Vanguard Capital Markets Model and the firm's annual economic and capital markets outlook, has published white papers in leading academic and practitioner journals, and currently serves on the editorial board of the Journal of Portfolio Management. Mr. Davis earned his B.A. summa cum laude from Saint Joseph's University, his M.A. and Ph.D. in economics at Duke University, and is a graduate of the Advanced Management Program at the Wharton School at the University of Pennsylvania.
Fewer workers are participating in the labor force than before the pandemic, and the higher wages they can secure as employers compete for them threaten to take already accelerating inflation to a new, more worrisome level. Wage inflation is "sticky." Although it takes time for wages to climb in tandem with broader prices, when they do, they're fully along for the ride and ready to jump into the driver's seat.
Central banks have underestimated this strength in labor markets and the growing wage pressures. In my view, markets are underestimating the degree to which central banks will need to use their powerful tools to pull inflation back to acceptable levels.
Higher rates are in the U.S. economy's best interest, a point I emphasized in a previous commentary. Vanguard believes that the Federal Reserve may need to raise its target for short-term interest rates to 3% from its current range of 0%–0.25%. That would require steady rate hikes over the next few years, to a degree that markets haven't priced in beyond 2022.
(In a Q&A, Vanguard economists Josh Hirt, Asawari Sathe, and Adam Schickling discuss labor, inflation, our 3% figure, and the potential risks of the Fed moving too aggressively or not aggressively enough.)
Why higher rates can be a good thing
Bond investors should welcome the prospect of higher interest rates. Although rising rates may produce modest negative returns for a time, they're a long-term positive. We recently wrote about the silver lining in rising rates—how investors with a longer horizon than their portfolio's duration stand to benefit1 Raising short-term rates should also forestall a rise in long-term bond yields because expectations of future inflation should not rise further.
Equity investors may feel less hopeful, and that's understandable. In recent years they've come to enjoy some heady returns, fueled by negative after-inflation interest rates. The removal of such stimulus as central banks address inflation suggests turbulence ahead.
But negative real interest rates and the higher equity valuations they've promoted have come at a cost of future returns. That's why our long-term outlook for equities, as we discuss in the Vanguard economic and market outlook for 2022, is so guarded.
The theme of our annual economic outlook, "Striking a better balance," acknowledges the challenges that policymakers face in removing monetary and fiscal support that propped up economies during an unprecedented crisis. Surging inflation won't come down magically. The path for central banks is clear.
Accelerating inflation is a threat to economies that otherwise remain fundamentally sound. Raising interest rates to subdue it should extend the growth cycle, not shorten it.
Notes:
- All investing is subject to risk, including the possible loss of the money you invest.
- Investments in bonds are subject to interest rate, credit, and inflation risk.