Paul Carroll
We not only had strong job numbers in the U.S. for May, which would reduce the need for the Fed to cut interest rates, but also had 4.2% annual inflation in the latest report, which would tend to encourage the Fed to keep rates flat or even to raise them. Has your outlook on inflation and economic risks evolved since we last spoke, particularly given what's happening in Iran?
Michel Léonard
You're entirely right. Since we last spoke, I've grown more cautious.
When the conflict started, nobody expected it to go into a third or fourth month. As a result, we didn't expect the conflict would last long enough for increases in oil and gas disruption to be transmitted into the price of gas and petrochemicals and as sunk costs throughout the economy. We made the same assessment about the conflict being unlikely to last long enough to significantly alter our P/C replacement forecasts.
But that transmission is taking place and driving up the price of products key to our replacement costs: construction plastics, PVC, rubber; construction materials; not to mention increases in the cost of transporting all these goods and more.
That said, I would to share some caution. The price increases we’re already seeing are not solely due to actual price transmission; they're also about the anticipation of transmission. Some companies are pricing up before the higher costs hit them. We saw that during and since COVID. We can’t deny that there is price gouging: Why wait until your margins get compressed? Especially when the wider price narrative in the press and elsewhere is increasing consumer willingness to accept price increases.
Paul Carroll
What does this mean for P&C insurers next year in terms of replacement costs relative to inflation in the broader economy?
Michel Léonard
Because of the anticipation, I think the trajectory—the pace of increase in inflation, including P/C replacement costs—is above what the underlying supply disruption would warrant. That’s partly because some people have been expecting a bigger disruption than has happened and partly because of gouging by some, who say, "Okay, we can charge a bit more." Right now, the regular CPI and the CPI-core (without energy and food) are increasing in lockstep. What it means is that we should expect P/C replacement costs to increase at the same pace as CPI-core (without energy), at a faster pace than they should given transmission alone, before gouging.
Paul Carroll
Given the strong jobs report and high inflation, what is your outlook for Fed policy?
Michel Léonard
The Fed has put rates on hold but, in my opinion, still within the wider framework of an easing cycle. The unemployment rate is improving, and though one quarter is not a trend, it’s likely telegraphing to the markets that it the Fed is going from holding rates within an easing cycle, to holding rates between easing and tightening. I would be very surprised if the Fed went directly to telegraphing tightening.
There are a few things to consider here, especially for P/C insurance. Let's put this in context:
The Fed continuing to delay on interest rate cuts, or telegraphing a shift to tightening interest rates, would likely once again reduce homeowners and commercial property insurance’s underlying growth.
Concerns about inflation, especially if the Fed gets fully on board with shifting to tightening rates, will further accelerate increases in P/C replacement costs – by signaling to producers that they can raise costs ahead of actual price increases. This is before we see more actual transmission from oil prices in to the wider economy.
This is bad news for P/C’s combined ratios – and it could not come at a less opportune time.
We had COVID inflation and post-COVID inflation that led to carriers working with regulators to implement, in some cases, double-digit or high-single-digit year-over-year increases in premium rates. That's where we came from.
We had finally reached an equilibrium that would justify premium rate increases returning closer to historical averages—low single digits, around 2% to 4% year over year. Now that equilibrium is being challenged.
Now we’re faced with renewed inflation – but instead of doing so in a hard market, we’re doing it as we’re heading into a soft market. Depending on how fast we get there, the impact on combined ratios may be significant.
Paul Carroll
What's your assessment of the state of the U.S. economy, given all the stresses?
Michel Léonard
I’m still an optimist and think the U.S. economy remains resilient. Looking at the core drivers of monetary policy and how economists assess the economy —employment, inflation, and growth—let's start with employment. There have been a few months of improvement. If we look at nominal growth, it's healthy. But if we take out inflation from nominal growth, we see the problem. Real GDP is struggling. And inflation is getting worse.
Two out of the three, growth and inflation, are facing headwinds, which I read as the “balance of risks” is still tilting toward the downside. At best, we’re at an equilibrium. I would be wary if the Fed started to talk about raising rates – that would likely worsen the unemployment rate again, accelerate inflation, and bring growth to a halt. In my assessment, such talk would be a significant miscalculation.
Paul Carroll
Given the enormous amount of geopolitical risk—from the situation in Iran to the Ukraine-Russia conflict to concerns about China and Taiwan—would you point to that risk as a major source of uncertainty that maybe hasn’t been priced into expectations about the economy?
Michel Léonard
Geopolitical risks keep piling up, and, at least for the time being, I would suggest that they aren’t being fully priced across unemployment, growth, and inflation. I did geopolitical risk stress tests 20 years ago about Iran, Taiwan, and war in the Middle East – they all resulted in equity and interest rate corrections much more significant than we are seeing now. Consequently, the tests showed economic performance deteriorating much further than it has now – not to argue that we’re in a good place at this time.
You asked about what kind of other geopolitical risks are out there that may not have been priced in economic forecasts? A few truly raise alarms for me and not just as an economist: Putin attacking Finland or the Baltic states; China deploying cyber warfare against the U.S. and shutting down transportation, electric cars, or power grids; a new pandemic such as Ebola ,with few of the institutional capabilities we had during COVID; the looming threat of Jan. 6 on the coming midterms in the U.S.
Paul Carroll
Where do tariffs figure in all this? I certainly have no idea what the tariff regime will look like in six months.
Michel Léonard
Thanks for bringing that back up. The tariff issue hasn’t gone away. There's an economics principle about risk tolerance. For example, folks winning at a casino become more risk-averse and prudent. Folks losing become more risk tolerant and bid more aggressively. With all that's going on in our world right now, folks are actually getting more risk-tolerant, and that's always the problem.
Paul Carroll
What final words of wisdom would you leave us with?
Michel Léonard
I don't know if it's wisdom. But I would say that, regardless of everything, I remain optimistic. The U.S. consumer is resilient, U.S. companies are resilient. There's a lot of strength there.
For the P/C industry, we’re coming from a good place, even if we’re heading into a soft market. We’ve seen a lot of improvement in the last two years on replacement costs, and more recently we’re seeing better trends for combined ratios. Both provide some protection against the risks ahead of us.
Paul Carroll
Thanks, Michel. I always feel smarter after we talk.
