A Fed without inflation fears should deter investors

Last week, Fed Chairman Jerome Powell underscored the last two steps: looking at where inflation really is, rather than worrying about where it is expected to be, and making it clear that neither the current wild stock market surplus, nor the recent run-up in bond yields bothers him.

The shift should lead to a re-evaluation of the dominant market narrative. Until now, the assumption has been that the Fed will tolerate some short-term inflation caused by President Joe Biden’s $ 1.9 trillion stimulus, but that in the long run the Fed will reaffirm control over whether inflation will go away on its own.

In the bond market, this version of the story is reflected in elevated inflation expectations for the next five years – a break-even rate of 2.51%, albeit on a measure typically higher than the Fed’s preferred inflation rate. For the next five years, inflation expectations are much lower, only 2.11% on Friday; if so, it would almost certainly mean that the Fed’s preferred inflation measure would be below its 2% target.

An alternative narrative is much more political and is increasingly popular with investors looking at economic history. It starts with the transformation of the deficit debate. After the Obama stimulus of 2009, even Democrats were concerned about how it would be paid, and the popular parallel was with troubled states like Greece.

This time around, the Democrats’ general concern, as it is now, is that overspending could cause inflation.

Certainly, Congressional Republicans have rediscovered fiscal equality since losing the White House, and the majority of Democrats couldn’t be more vulnerable. But in the past decade, virtually everyone has come to understand the core tenet of modern monetary theory, which is that the issuer of dollars does not fail.

Here the story moves to the Fed. An aggressive Fed can counteract a high-spending White House by raising rates. But Mr. Powell has committed not to increase until inflation is sustained at the Fed’s target and the country is at full employment. Most policymakers think this means there is almost zero for at least three more years.

The question is what will happen if the goal is reached earlier. If inflation picks up quickly, say 3%, is the Fed willing to raise interest rates early and run the risk of unemployment rising? How about 4%?

Fed policymakers have emphasized that achieving full employment helps the marginalized in society the most. The downside is that boosting unemployment to curb inflation will hit that group the most. Politically, this makes a tighter monetary policy more difficult to justify.

There are also broader issues leading to higher inflation, as Pascal Blanqué, chief investment officer at French fund manager Amundi Asset Management, points out. Growing national rivalries, as well as export restrictions on protective equipment and vaccines, are encouraging companies and governments to secure domestic supply chains, even if it increases costs.

A synchronized global recovery this year will put upward pressure on commodity prices, a classic source of inflation. And Covid-related disruption has led to widespread manufacturing problems, including shortages of shipping containers and critical parts for cars, again pointing to higher prices.

“There is a constant shift from the story of secular stagnation to what I call the way back to the 1970s,” said Mr Blanqué.

I think it is safe to leave the flowery bell bottoms in the cupboard. Severe inflation is still very unlikely, but more likely than it used to be. The labor market is much more flexible than it was in the 1970s, making wage-price spirals difficult, while there is still plenty of international competition to limit companies’ ability to boost prices. These trends may reverse, but it will take years for unions to build power and refocus economies on domestic production.

However, everything is in place to avoid at least an attack of market fear over inflation.

Inflation appears to be springing up in the coming months as a result of a sharp drop in prices a year ago, as Mr. Powell himself pointed out on Wednesday. He said the Fed would ignore what it expected to be just a blip. The economy is also likely to grow rapidly; For example, the New York Fed’s Nowcast model predicts annual growth of 6.3% in the first quarter.

Combine that with a commitment to low rates and a president already working on his next spending plan, and it stands to reason that people are more concerned about rising prices.

“Investors are ready for an inflation scare,” said Dario Perkins, an economist at TS Lombard strategists, even though he thinks it’s unlikely to last.

The obvious guesses for taking advantage of an inflation crisis are the reverse of what worked last year: dump treasuries, dump high-quality bonds, dump growth stocks, buy cheap economically sensitive cyclical stocks, buy commodities, buy junk bonds.

The market in general could go up or down depending on the components, as it turned out last Thursday: the S&P 500 was pulled down by large declines in growth stocks, even as the cheap and cyclical members saw fewer members and banks rose. In Europe, the same pattern led to a rise in the market as cheap and cyclical stocks have a higher share.

Much of this has already happened, as the same trades are benefiting from economic reopening. The fear will therefore have to be great to overcome what is already expected in the price.

Still, a permanent regime shift is clearly not priced in Treasurys. Even after last week’s jump, the 10-year yield is still only about 1.7%, and long-term bond market inflation expectations are stable. Investors generally accept Mr. Powell and believe that after a short period of higher price hikes, the Fed will be ready to assert its independence and keep inflation up.

If the market loses confidence, long-term government bond yields should rise even faster, the dollar would fall, and stocks most dependent on earnings far into the future, Tesla thinks, will be hit hard.

Real fear of inflation hurts.

Write to James Mackintosh at [email protected]