The Immaculate Disinflation: Opportunities for Growth

In their first walk of 2024, Olga and Hugo discuss how the U.S. Federal Reserve (Fed) managed to bring down inflation without causing a recession, why growth prospects for the coming year are strong, and what could dampen their optimism.

Hugo: Olga, if the story going into 2023 was that inflation was too strong and that interest rates would be higher for longer as a result of persistent, sticky inflation, that’s not what we have walking now in January. We actually got an immaculate disinflation in the second half of 2023. (The phrase “immaculate disinflation” is used to describe a scenario in which inflation cools without causing a spike in unemployment.)

But in 2024 are we going to reverse all this? Will inflation accelerate again because there are structural forces driving it, such as the baby boomers retiring or geopolitical risk, or because the demand for capital is higher as the world builds redundant supply to improve security? Have we tamed the beast or not?

Olga: Hugo, as we walked in January 2023, the consensus—as recorded by Bloomberg—expected a recession in the United States over the next 12 months. It was seen nearly universally as the price the Fed would have to pay to bring inflation down to an acceptable rate.

Obviously, as we’re walking here now, that didn’t happen. The immaculate disinflation, as you just described, happened precisely because the inflation we saw in 2022 was a temporary supply-side shock, not a persistent constraint or a case of runaway demand.

As such, I don’t expect the inflation beast to rear its head again in 2024. I think we’ve tamed inflation, and I think it is well and truly on its way down to the 2% cruising altitude, let’s call it. I think we can get there without a significant further deceleration in economic activity.

But this scenario depends on one large caveat, and I think that caveat largely will shape economic growth in 2024. Now you get to ask me a question.

Hugo: So what’s the caveat?

Olga: As we’ve experienced disinflation, the Fed’s policy stance on interest rates has now de facto become ever more restrictive. Monetary policy is measured in terms of its impact on real interest rates. If we keep nominal rates at current levels, with a significantly lower inflation rate, that means our real rates are going up. The U.S. real rate is now significantly north of 2%.

In a mature, developed economy, operating at the technological edge, the real rate at which we can continue to expand comfortably is probably in the neighborhood of 1.5%. That means somewhere between 1% and 1.5% would be considered a neutral monetary policy stance.

If the Fed does happen to break something and the economy grinds to a halt, it can respond very quickly.

It shouldn’t require a recession to get there. The Fed effectively needs to bring down its monetary policy setting to maintain its neutral stance. Now, the Fed has indicated that it projects three rate cuts of a quarter point each next year, which demonstrates that it is well aware of this dynamic. But if the policymakers fail to move with appropriate speed or even change their stance, we still may be at risk of a policy-imposed recession.

Hugo: The Fed had its critics who said they were too late in raising rates, so you could maybe see why they might be a little too slow in bringing them back down. But it’s pretty clear that when real rates are too high, that creates restrictions on the economy. The risk of a Fed mistake is something we need to be aware of, but if the Fed does happen to break something and the economy grinds to a halt, it can respond very quickly.

Olga: Yes, the idea is that the Fed means to act before something breaks. If a recession were to materialize, it would unlikely be deep. But the hope for 2024 is that the Fed will move in advance of something breaking.

Hugo: Where we stand today, we’ve got quiescent inflation and a nice equilibrium of reasonable nominal gross domestic product (GDP) with quite good real GDP, given that we’re talking about a mature economy in the United States, and the United States sets the tone for most of the rest of the world. All of that paints a relatively attractive backdrop for equity investing.

What is changing in terms of where growth is coming from? We’ve had fiscal expansion, in the United States in particular, along with many other countries in their responses to COVID. For those that are bond bears, that’s seen as a problem. We’ve had a lot of debt issued.

But on the other side, how productively has that money been spent? Could there be a previously underestimated economic benefit coming that shows up in better infrastructure, which allows for more productivity? Could this be a fiscal expansion resulting from COVID?

We believe growth of 2.5% is very doable in the 2020s.

Olga: Let’s unpack the so-called fiscal expansion a bit. First, we’ll put aside the fiscal transfers in 2020 and 2021, which in and of themselves are not productive. What is more interesting is things like the Inflation Reduction Act and the CHIPS Act. These gave companies lots of incentives, in the form of subsidies or tax credits or various other breaks, to develop infrastructure to bring about the green energy transition, to foster our production of semiconductors, and to incentivize the further development of artificial intelligence (AI).

That arguably is already very productive. We’re already seeing an increase in nonresidential investment as a result, though it remains to be seen if that will continue. The expectation is that it should. And, you know, we are obviously all familiar with productivity gains from AI—from learning faster on the job to automating some routine basic tasks.

So the scenario that you outlined is very much our base case. It’s not unreasonable to expect a structurally sturdier growth rate in the United States and arguably elsewhere this decade, compared with the anomaly of the last decade, during which economic growth was abnormally low. We believe growth of 2.5% is very doable in the 2020s.

Hugo: That’s encouraging, Olga. When you think about GDP as a function of lots of different parts of the economy, are there areas that look a bit different in this decade versus the 2010s, when growth was quite concentrated in technology and healthcare? Will it be broader this time? Will we see greater infrastructure spending? More consumption growth?

Olga: I guess there are two components to your question: the sectoral contributions to growth at the economy level, and the earnings growth of the listed companies.

The first part is more straightforward. To get higher aggregate GDP growth, that growth needs to be broader. More industries, more companies, and more sectors need to record an improvement in growth and ultimately an uptick in earnings.

Healthcare companies are fast becoming data companies.

For the second part, where growth shows up in earnings for listed companies is a little more downstream from that. You’re quite right to point to strength in infrastructure. It’s worth noting that the companies that build infrastructure usually are not the biggest beneficiaries in terms of accumulating the earnings from a new technology they enable, relative to the companies that exploit the technology in their particular industry.

What do I mean by that? In AI, for instance, the companies that provide the infrastructure are enjoying the biggest gains right now, because there is a vast shortage of super-smart chips. We’re still working out the inference, the architecture, the data optimization, and the foundation models for a lot of these AI applications, and it’s challenging to get the computer power required to operationalize AI at a company level.

But what’s already emerging is that healthcare companies, for example, are fast becoming data companies. How they manage to commercialize these vast AI opportunities is what will ultimately show up in their earnings. At this point, it’s too early to tell who will win. There will be companies that we haven’t even heard of today.

Hugo: The idea of what you call the perpetual growth machine—this dynamic aspect of a modern economy to seek out capital with which to solve problems—how does that lens affect how you look at growth and investing?

Olga: When you look at a single company, there will always be this tendency to revert to the mean.

We want to invest in companies that are on the upward trajectory of their growth.

Once they reach the pinnacle in growth, they might cease to be as interesting from an investment perspective. But they still have laid the foundation for someone else, who will pick up the baton and take the innovation to the next level. Yes, an individual business may revert to the mean, but the economy as a whole does not.

That’s the nature of growth. Growth is always happening somewhere. It’s not in the same place at the same time. If it was, there would be no investment. That’s what makes our profession exciting.

Olga Bitel, partner, is a global strategist on William Blair’s global equity team.

Hugo Scott‐Gall, partner, is the head of William Blair’s global equity team, on which he also serves as a portfolio manager.