15: Rob Arnott on The Current State of Inflation & Fed Policy

Inflation is a popular topic these days, and today’s guest offers a unique perspective. Rob Arnott joins us to discuss how inflation calculations have changed over the last few decades, current inflation trends, Fed policy, his Fundamental Index™ approach, and more. 

Investing the Templeton Way with Lauren Templeton is a podcast that explores the world’s most intriguing investment topics from the overseas markets to mastering our own minds. Gather investment wisdom and educate yourself as you listen to interviews with exclusive managers, executives, and entrepreneurs on a wide range of engaging topics.

Meet Rob Arnott

Rob Arnott is founder and chairman of the board of Research Affiliates. Rob plays an active role in the firm’s research, portfolio management, product innovation, business strategy, and client-facing activities. He is a member of the Investment Committee and the Executive Committee of the board. With Chris Brightman, he is co-portfolio manager on the PIMCO All Asset and All Asset All Authority funds and the PIMCO RAE™ funds.

Over his career, Rob has endeavored to bridge the worlds of academic theorists and financial markets, challenging conventional wisdom and searching for solutions that add value for investors. He has pioneered several unconventional portfolio strategies that are now widely applied, including tactical asset allocation, global tactical asset allocation, tax-advantaged equity management, and the Fundamental Index™ approach to investing. His success in doing so has resulted in a reputation as one of the world’s most provocative practitioners and respected financial analysts.

In 2002, Rob founded Research Affiliates as a research-intensive asset management firm intent on delivering innovative and impactful products and insights.

Prior to establishing Research Affiliates, Rob was chair of First Quadrant, LP, which he built up from the former internal money manager for Crum & Forster into a highly regarded quantitative asset management firm.  He also was global equity strategist at Salomon Brothers (now part of Citigroup), the founding president and CEO of TSA Capital Management (now part of Analytic Investors, LLC), and a vice president at The Boston Company.

Rob has published more than 130 articles in such publications as the Journal of Portfolio Management, Harvard Business Review, and Financial Analysts Journal, for whom he served as editor in chief from 2002 through 2006. Rob has received eight Graham and Dodd Scrolls, which are awarded annually by CFA Institute to the top Financial Analysts Journal articles of the year. He also has received four Bernstein Fabozzi/Jacobs Levy awards from the Journal of Portfolio Management. He is co-author of The Fundamental Index: A Better Way to Invest (Wiley 2008).

Rob received a BS summa cum laude in economics, applied mathematics, and computer science from the University of California, Santa Barbara.

Rob Arnott’s Key Points on Inflation 

Rob Arnott has done a considerable amount of research on inflation, therefore, there are a few key points he highlights about the current state of inflation: 

1. The US Federal Reserve Bank's expectations for the speed of reverting to two percent inflation levels remain dangerously optimistic.
2. An inflation jump to four percent is often temporary. 
3. When inflation crosses eight percent, it proceeds to higher levels over 70% of the time.

His current view on inflation, which is the consensus across the Fed and Wall Street, is that the peak has passed and we are on our way back down. It will take time to get back to two percent, but it will happen and inflation will be reasonably benign fairly soon.

The United States has only seen about eight percent inflation twice in the last 50 years. To gauge the potential outcomes, Arnott looked across 14 developed economies. The research revealed that the median result needed seven years for inflation to return to two percent when it exceeded eight percent.

“I'm optimistic! Relative to the data we looked at, I think that there's a good 50/50 chance that the benign outcome will happen, but I don't want to make it my central expectation. The left tail risk of inflation getting under control even faster than that is unlikely. The right tail risk of inflation surging again, perhaps late this coming year, and or remaining elevated for some years, that right tail is given zero credibility in the marketplace. I'd say that's got a 50% chance too.” - Rob Arnott [5:53-6:32]

How Inflation Calculations Have Changed

In the 1970s, inflation calculations included the price of housing. Today, the Bureau of Labor Statistics (BLS) is focused on a measure called the “owners’ equivalent rent (OER).” This small change has an interesting impact on inflation and until a few months ago most people had neglected this change that took place in the 1980s. 

Here’s how Rob explains OER:

In 1980, inflation was out of control when we were coming out of the Vietnam War and coming into a spending blowout under President Carter. Inflation crested at 14.7% in March of 1980. Paul Volcker, then the Chair of the Federal Reserve, took it seriously and lifted the Fed funds to 20% around the end of that year, which was 5% above the peak inflation. 

The BLS was appalled, so they came up with owners' equivalent rent. The rationale was: if you're a homeowner and your home goes up 20% in value, it doesn't feel like 20% inflation unless you're a new buyer or unless you're a seller. So to the homeowner what matters is what they would pay for the house in rent. You can't look that up in the newspaper. So when we look at owners' equivalent rent, how on earth do you measure it? 

Flash forward to recent years, and here is how OER impacts inflation: 

Home prices went up 20% in 2020 and OER went up two percent. In 2021, home prices went up 19% and OER went up four percent. Homeowners started noticing that home prices were up 32% in two years while OER was only up six percent.

“What happens to that missing 26%? It shows up in OER over the course of the subsequent years, about half of it happening within two to three years. So that means we should be expected to be unusually high last year, this year, and next year. So you can predict OER based on the gap between OER and home prices.” - Rob Arnott [11:28-11:55] 

Home prices crashed in 2007-09 while OER went up during those years. Why does this matter? OER is 25% of inflation and rent is also calculated in a fashion that creates an inherent smoothing and lag. If we use the 1980 methodology in 2020, by September 2022, inflation would have been in the 12%-13% range. If we use today's methods back in 1980, inflation would have crested at about 11%. We just had a surge of inflation that was very similar to the cresting inflation in 1980. But it was understated, smoothed, and lagged, which means it'll take time for it to come down.

Rob's Thoughts on Fed Policy

The Fed is determined to bring inflation under control, and Arnott expects the Fed to ease around mid-year. He sees this as likely if 12-month inflation dips to around three or four percent.

“If that happens, then it makes complete sense for the Fed to say, ‘Okay, inflation is three, we don't need a Fed funds rate of five.’ And so for the Fed to back off is very plausible, but then what do they do when inflation starts to march upward in the second half of the year? That'll be very interesting to see how they play that.” - Rob Arnott [16:55-17:16]

Rob’s Fundamental Index

The concept of the fundamental index was inspired by the tech bubble. Along with a few colleagues, Rob came up with the idea to weight companies based on how big their business is instead of by price.

“We tested it and we thought well, the net worth of a company, its book value, [is a] perfectly reasonable basis for choosing the 500 largest companies, perfectly reasonable basis for weighting an index or do it on company sales. The Fortune 500 was launched in 1954. Imagine if they'd said, ‘Hey, we're doing all this work to find the 500 largest sales companies in the US. Why don't we create an index of those 500 companies weighted by sales?’ Interesting thought experiment, because if they'd done that, the fundamental index would have preceded cap-weighted indexing, and cap-weighted indexing would never have caught on.” - Rob Arnott [29:01-29:45]

Rob and his colleague rolled out the fundamental index in 2004. They chose the 500 largest companies in the US based on these factors:

1. What are the company's sales as a percentage of all publicly traded businesses? 
2. What are its profits? 
3. What are its dividends? 
4. What is its book value?

“And because these are four very, very different financial measures, you just average the four weights and say, ‘Okay, that's about the right size.’ So we're going to hold that stock if it's one of the 500 largest, and we're going to weight it according to its economic footprint.” - Rob Arnott [31:28-31:43]

Rob’s Thoughts on Cryptocurrency and Digital Assets

“As a libertarian, I want to like crypto. Simple fact is, it's not a currency.”-  Rob Arnott [49:13-49:20]

Currency has three purposes:

1. The measure of its worth
2. The measure of an individual's hourly worth
3. A store of value

Crypto fails at all three of these purposes. 

“It has no stability or predictability as a store of value. It is an utterly unstable measure of the value of goods and services. It's almost useless as a medium of exchange.” - Rob Arnott [50:19-50:33]

Connect With Rob Arnott

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