A Fed without fear of inflation should scare investors

It lasted four decades, but the Federal Reserve finally shook off its fear of inflation. The markets are only now waking up to the implications of the shift.

The perimeter of the turnaround has been evolving for some time, as the Fed’s focus shifted from its inflation mandate to the continuing emphasis on its goal of full employment. Meanwhile, its benchmark for rising prices has moved to an average target, allowing inflation to exceed a 2% target to compensate for past mistakes.

Last week, Fed Chairman Jerome Powell underlined the last two steps: to look at where inflation actually is, rather than worrying about where it is forecast and to make clear that not the current wild excess in the stock market or the recent run-up. in mortgage returns bothers him.

The shift should cause a re-evaluation of the dominant market narrative. So far, the assumption has been that the Fed will tolerate short-term inflation created by President Joe Biden’s $ 1.9 billion stimulus, but that in the long term the Fed will regain supervision or inflation will disappear on its own.

In the bond market, this version of the story appears to have increased inflation expectations for the next five years – a break-even rate of 2.51%, albeit by a measure that is usually higher than the Fed’s preferred measure. For the next five years, inflation expectations are much lower, just 2.11% Friday; if it is right, it would almost certainly mean that the Fed’s preferred inflation measure would be below its 2% target.

An alternative story is much more political and has become popular among investors looking at economic history. It begins with the transformation of the deficit debate. After the Obama stimulus of 2009, even Democrats were worried about how it would be paid for, and the popular parallel was to troubled states like Greece.

This time, the Democrats’ concern, as it is now, is that spending too much could cause inflation.

Sure, Congress Republicans have rediscovered fiscal probability since losing the White House, and the Democrats’ majority could no longer be fragile. But in the last decade, virtually everyone has understood the core principle of modern monetary theory that the issuer of dollars is not engaged.

Here the story moves to the Fed. A Hawkish Fed could counter a large spending White House by raising rates. But Mr. Powell has committed to no increases until inflation is sustainably on the Fed’s target and the country is fully employed. Most policymakers believe this still means at least three years of rates that are almost zero.

The question is what happens if the target is reached earlier. If inflation picks up fast, say up to 3%, will the Fed be prepared to raise rates early and risk an increase in unemployment? What about 4%?

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Fed policymakers have emphasized that achieving full employment helps the marginalized in society the most. The other side is that the pressure on unemployment to curb inflation will affect most. Politically, it makes stricter 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. Increasing national competition, as well as export restrictions on protective equipment and vaccines, are encouraging businesses and governments to ensure safe domestic supply chains, even if this leads to higher costs.

A synchronized global recovery this year will mean upward pressure on commodity prices, a classic source of inflation. And the disruption associated with Covid has led to widespread production problems, including shortages of cargo containers and critical parts for cars, which in turn indicates higher prices.

“There is a constant shift from the story of secular stagnation to what I call the road to the 1970s,” he said. Blank.

I think it is safe to leave the flower blocks in the closet. Serious inflation is still very unlikely, although it is now more likely than it was. The labor market is much more flexible than in the 1970s, which complicates the wage price spiral, while there is still a lot of international competition to limit the ability of enterprises to increase prices. These trends may reverse, but it will take years for unions to build up their power and for economies to return to domestic production.

However, everything is in place for at least some anxiety in the market about inflation.

Inflation will be able to jump higher in the next few months due to a sharp fall in prices a year ago, as Mr. Powell himself remarked Wednesday. He said the Fed would ignore what he expected to be merely a blip. The economy is also likely to grow rapidly; the New York Fed’s Nowcast model, for example, forecasts 6.3% annualized growth in the first quarter.

Combine that with a commitment to low rates and a president already moving on to his next spending plan, and it makes sense for people to be more concerned about rising prices.

“Investors are aware of an inflation scare,” said Dario Perkins, an economist at strategist TS Lombard, although he is unlikely to hold back.

The obvious commitment to take advantage of an inflation scare is the reverse of what worked last year: dump Treasurys, dump high-yields, throw growth stocks, buy cheap economically-sensitive cyclical stocks, buy commodities, buy clutter effects.

Federal Reserve Chairman Jerome Powell tells WSJ Nick Timiraos that there is no plan to raise interest rates until labor market conditions are in line with maximum employment and inflation is sustainable at 2%. Photo: Eric Baradat / Agence France-Presse / Getty Images.

The total market could rise or fall, depending on its ingredients, as last Thursday showed: the S&P 500 was dragged down by large declines in growth stocks, even though its cheap and cyclical members suffered less and banks rose. In Europe, the same pattern has led to an increase in the market as cheap and cyclical stocks make up a larger share.

Many of these have already happened, as the same trade benefits from the reopening of the economy. The fear will therefore have to be great to overcome what has already been expected in the price.

Yet a permanent shift of government was clearly not praised in Treasurys. Even after last week’s jump, the ten-year yield is still only about 1.7%, and long-term inflation expectations in the bond market have been stable. Investors mainly accept Mr. Powell’s pitch and thinks that after a short period of higher price increases, the Fed will be willing to assert its independence and keep inflation in line.

If the market loses confidence, the Treasury’s long-term returns would rise even faster, the dollar would slip and the stocks that are most dependent on profits, Tesla thinks, would be hit hard.

Real inflation scare hurts.

Write to James Mackintosh by [email protected]

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