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As the economy accelerates to 2021, investors may grapple with unexpected inflationary pressures, if only for a short time.
Bond market traders and Wall Street experts signal rising inflation from current dormant levels.
In fact, many are seeing inflation moving towards and perhaps a little above the Federal Reserve’s 2% target rate, which has been elusive for most of the past decade. The main driver is an economic reopening fueled by more Americans being vaccinated, which will create upward price pressure in industries held back during the coronavirus pandemic.
The trick is to keep it there.
The Fed sees a certain amount of inflation as good for the economy, as it signals growth and gives the central bank room to intervene in the next crisis and asks for help from monetary policy. However, a number of factors have conspired to keep inflation down and are likely to help limit any increase in the coming months.
“We expect interest rates to stay lower for longer and we expect inflation to be contained,” said Sunitha Thomas, national portfolio advisor at Northern Trust Wealth Management. “We think there will be some fleeting prints on inflation, and the market will react to that and try to decipher what that means. We think that’s more cyclical than permanent.”
At the Fed meeting earlier this month, Chairman Jerome Powell acknowledged that the economy could experience some price pressure, perhaps from rising energy.
However, policymakers should see a steady level before taking action, a position now codified under the Fed’s flexible approach to average inflation it adopted a few months ago.
“It will not be easy for inflation to rise … It will take time,” Powell said at his post-meeting press conference. “What we say is that we will keep policies very accommodative until expansion is well on track. And we are not going to preemptively raise rates until we see inflation actually hit 2% and on track to reach 2%. %. That’s a very strong commitment, and we think this is the right place to be. ”
The issue of rising inflation and the expected policy response from the Fed is critical as the market enters the next stage of a vigorous recovery that began with the pandemic lows in late March.
Investors are increasingly wondering whether the market is entering a bubble phase, similar to the dot-com collapse in 2000, exacerbated by rising interest rates trying to keep up with growth.
“As we look at the market commentary landscape in 2021, ‘the return of inflation, perhaps with vengeance’ is a very, very common theme,” Nick Colas, co-founder of DataTrek Research, said in a note this week.
Colas pointed out that the 5- and 10-year break-even rate, or the difference between government bond yields and inflation-protected Treasury bills, are both just under 2%. This represents the high point in two years and is a measure of where the market sees the consumer price index leading.
Such an environment, Colas said, is generally not favorable for inflation-sensitive securities such as longer-dated bonds “unless it is believed that the market’s enthusiasm for a global economic recovery in 2021 is very misguided.”
Hoping for a sharp rebound
Goldman Sachs, for example, is at the forefront of hopes for the economy in the year ahead.
The firm’s economic team sees full-year GDP growth of 5.9%, about 2 percentage points higher than consensus estimates. Along with that growth projection comes the expectation that core inflation, as measured by the Fed’s preferred measure of personal consumption spending deflator, will “briefly rise above 2% next spring if we circumvent the weakest pandemic base effects”, said Goldman economists Alec Phillips and David. Mericle said in a note.
Several categories should recover from the direct and indirect disinflationary effects of the pandemic, including airline tickets, hotels, clothing and financial services, they added. “But the pandemic has also had temporary inflationary effects in categories such as used cars and medical services, and the full impact of a weaker economy on shelter and other slack-sensitive core services is likely not yet realized.”
The Goldman team said only a “very tight labor market” would create sustained inflation that would lead the Fed to hike rates, and that’s not likely to happen anytime soon.
Likewise, Citigroup economists expect inflation to rise above 2% in April and stay there for several months, but then “settle back towards the 2% target by the end of the year.” The company is seeing rapid swings in travel and clothing prices offset by lower costs for used cars and medical services.
Those expectations for a controlled inflation environment add to the mostly positive outlook for Wall Street for another year of strong returns.
“All of this has led us to have positive expectations around the reopening of the economy and have more confidence in earnings outlook next year. We expect the Fed to remain very accommodative and interest rates to stay lower for longer,” said Thomas. Northern. Trust advisor. “We look forward to 2021.”