The Fed's Inflation Conundrum?

Matthew Boesler of Bloomberg reports the Fed is on track to taper and says inflation will (eventually) come down:

The Federal Reserve is on track to begin tapering its bond-buying program and inflation should come down once supply-chain constraints pushing up prices ease, Fed Chair Jerome Powell said.

“We are on track to begin a taper of our asset purchases that, if the economy evolves broadly as expected, will be completed by the middle of next year,” Powell said Friday during a panel discussion at a virtual event hosted by the South African Reserve Bank. “I do think it is time to taper and I don’t think it is time to raise rates.”

Global supply-chain constraints and shortages that have led to elevated inflation “are likely to last longer than previously expected, likely well into next year,” Powell said, while adding that “it is still the most likely case” that as those constraints ease, “as they eventually will -- and as job gains move up -- inflation will move back down closer to our 2% goal.”

Powell and his colleagues on the U.S. central bank’s policy-setting Federal Open Market Committee are expected to announce at the conclusion of their upcoming Nov. 2-3 policy meeting that they will begin winding down the bond-buying program put in place last year in the early days of the pandemic.

Currently, the Fed is acquiring $120 billion of Treasuries and mortgage-backed securities each month, and the coming reduction in the pace of purchases will mark the central bank’s first step toward the exit from the monetary support measures rolled out in 2020 to shield the economy from the effects of the coronavirus.

Investors also increasingly expect Fed officials to begin raising their benchmark interest rate, which is currently just above zero, as soon as the middle of next year. The timeline for expected rate increases has been pulled forward in money markets in recent weeks amid unfavorable news about inflation, which is running well above the central bank’s 2% target amid global supply-chain disruptions that are boosting prices for a wide range of goods and services.

Powell said the risk is that the current elevated rates of inflation “will begin to lead price- and wage-setters to expect unduly high rates of inflation in the future.”

“If we were to see a serious risk of inflation moving persistently to higher levels, we would certainly use our tools to preserve price stability while also taking into account the implications for our maximum employment goal,” he said.

The number of Americans currently employed is still millions below where it was just prior to the pandemic, and the pace of rehiring slowed in August and September as the delta variant swept across the country. Fed officials see the level of job gains accelerating in the coming months as the latest wave of cases subsides.

Kate Duguid and Tommy Stubbington of the Financial Times also report that Bridgewater's Bob Prince warns fighting inflation risks derailing economic recovery:

A top investor at the world’s biggest hedge fund has warned that high inflation is here to stay and central banks may be powerless to fight it without derailing the economic recovery, following a week in which soaring energy prices rocked markets around the world.

Bob Prince, co-chief investment officer at Bridgewater Associates, said the Federal Reserve’s assertion that the current burst of inflation will prove transitory is likely to be challenged. Price pressures will be hard to fix, he said, given they are coming out of a shortage of resources that are in high demand as the global economy rebounds from pandemic lockdowns.

“If there is inflation, the Fed is in a box because the tightening won’t really do much to reduce inflation unless they do a lot of it, because it is supply driven. And if they do a lot of it, it drives financial markets down, which they probably don’t want to do,” he told the Financial Times.

“Deciding between the lesser of two evils, what do you choose? I think most likely you choose inflation because you can’t do much about it anyway.”

Prince’s comments echo a ratcheting up of inflation anxiety in markets this week, as intense competition for natural gas supplies sent prices for the fuel rocketing, fanning concerns of broader price rises and triggering a drop in bond prices, which are sensitive to inflation. The US 10-year Treasury yield, which rises as prices fall, climbed to a four-month high of 1.60 per cent on Friday as market-based measures of inflation expectations hit their highest levels since May.

Moves were even sharper in Europe, where the gas crisis is more acute. Ten-year inflation breakevens in Germany — a measure of investors’ inflation expectations over the coming decade — rose to their highest since 2013 at 1.68 per cent, lifting yields to levels not seen since May. In the UK, where the Bank of England has said it could raise interest rates as soon as this year in an effort to tame inflation, 10-year breakevens are at their highest since 2008 and gilt yields climbed to 1.14 per cent on Friday, the most since May 2019.

Prince described the BoE’s rates warning last month as a “wake-up call” to investors. However, he suggested that central banks also needed to adjust to their limited ability to fight back.

“We’re in this situation where you still have this inertia from demand, it is pushing up against constrained supply and that has pushed inflation up,” he said. “And while the consensus is that that will be very transitory and bounce right back, we don’t think so, because there is plenty of inertia from that spending to continue and it’s just not going to be that easy to resolve these supply constraints, particularly as Covid remains an issue.”

The comments represent a departure from Prince’s view in June, when he played down comparisons between the present and the “Great Inflation” of the 1970s.

“It starts to look a bit like the 70s and the oil shocks,” he said this week. He explained that in the 1970s, oil prices rose on Opec supply cuts, pushing inflation higher. That dynamic drove the economy down while it was also driving inflation up. “Raising interest rates isn’t going to increase oil supply.”

Despite the latest bond selloff, and a pullback in stocks over the past month, many investors are sticking to their view that a large part of the current round of price rises will prove temporary, and central bankers will hold their nerve unless they get more compelling evidence of broader demand-induced inflation.

“Central banks should respond to inflationary pressures if demand is exceeding supply on a consistent basis,” said Gurpreet Gill, fixed-income strategist at Goldman Sachs Asset Management. “Today they are in isolated areas. We are expecting to come out of this crisis on a higher inflation path but it’s not a return to the 1970s when you had double digit inflation.”

Others argue that the spectre of stagflation — a combination of rapid price rises and slowing growth — is holding bond markets in check. A steep climb in the cost of living could quickly become a drag on growth and even fuel fears of recession, argues Luca Paolini, chief strategist at Pictet Asset Management. In that environment central banks could be expected to keep rates low — or reverse any premature hikes — making long-term government bonds more attractive and limiting any selloff.

“Inflation is like a tax that kills demand,” Paolini said. “In a sense if it gets too bad, it kills itself off — but that’s not a positive scenario.”

Great food for thought from Bob Prince and I agree with him, if inflationary pressures are mostly supply driven, it's very hard for central banks to rectify them "without raising rates by a lot."

But raising rates by a lot will lead to a financial market meltdown which will spread into the global economy, leading to a potential global recession.

Still, allowing inflation to rise isn't good for the economy either. 

The great economist Milton Friedman once noted: "Inflation is taxation without representation."

Higher inflation acts like a tax on consumers, it impacts sentiment and it definitely dampens demand. 

And it's clear that inflation isn't as transitory as people think because even the Fed is warning that global supply-chain shortages are causing elevated inflation that is likely to last longer than previously expected. 

Moreover, some well known bond gurus are also warning inflation will stay elevated throughout next year:

That all remains to be seen but clearly the market is starting to price in elevated inflation for longer. 

Mitch Bollinger of Markov Processes International shared this on Linkedin today:

In regards to inflation, I recently said call me when the 5 year breakeven breaks 3% and we will know that we have moved from transitory to systemic. It has jumped by 23 bps in the past two days so I am expecting that call.

A month ago, Brian Romanchuck of the Bond Economics blog noted this on the untransitory-ness in the TIPS market

As the chart above shows, the forward breakeven has recovered from the usual collapse we see in financial panics during the lockdown period, but are still well below where it was last cycle. 

I would argue that the only sensible takeaway from that figure is that inflation market participants are not deeply concerned about a secular rise in inflation. Beyond that, I do not have enough information to be more specific. My immediate concern is that the above time series is an approximation, and we really would need to dig in the details of bond-specific pricing to have more confidence in the exact level of forwards.

I wonder if Brian has changed his mind now that the 5-year breakeven inflation has broken 3% but I doubt he has changed his views much. 

The reality is there are global supply-chain issues adding to the persistence of inflation but these issues will be resolved over the next year. 

What is harder to gauge is whether CPI shelter will start biting as housing prices keep rising and how this will impact inflation over the medium term. 

Clearly, there are "sticky inflation" issues that the market is grappling with.

So are central banks and it makes their job very difficult as they try to adopt a policy which doesn't derail economic activity.

Earlier this week, was invited to a dinner where Marko Papic, partner and Chief Investment Strategist at the Clocktower Group, presented his geopolitical views. I discussed some of his views in a comment going over the world's best and worst pension systems

As I stated, unlike me, Marko doesn't think policymakers are fighting the global war against deflation,  but rather there's a tradeoff going on between inflation and recession.

He thinks the Fed will avoid raising rates for as long as possible but he does believe tapering lies ahead. 

I agree with him, I think the Fed is comfortable with this inflation, for now, and some inflation is good because it inflates away debt.

Of course, when all the developed world is trying to inflate away massive debt, it doesn't work well. 

And debts are massive but Marko doesn't expect fiscal contraction to occur like in the past (no appetite from Democrats or Republicans as inequality has reached epic proportions during pandemic), so he believes inflation will likely remain stickier than in the past. 

Longer, longer term however, he agrees with me that deflation or disinflation will continue because of massive technological advances (and other structural factors which I cited here).

What does all this mean for investors and markets?

As I've covered in detail, all this inflation uncertainty is weighing down markets, investors need to position their portfolio for uncertain times and the October bond bull surprise might turn out into a bond bear bloodbath if inflation expectations keep ramping up, sending long bond yields higher.

This week, the yield on the 10-year Treasury note backed up to close at 1.65% today.

As shown below, it's close to making a 6-month high and very close to its 52-week high of 1.765%:

Will it keep going to hit 2% or more? Possibly, that remains to be seen.

In terms of S&P sector performance, this week Real Estate (XLRE) led the pack, up 3.22%, followed by Healthcare (XLV), Financials (XLF) and Utilities (XLU) which gained 2.87%, 2.78% and 2.35% respectively:

 Industrials, technology, consumer discretionary and energy also posted decent gains. 

The fact that rate-sensitive real estate and utilities performed well along with financials in a week where long bond yields rose is a bit odd, indicating to me that people are hedging their bets both ways but steering clear of tech in a rising rate environment.

One thing is for sure, if rates keep backing up, there is a risk to long duration assets:

Lastly, since I am writing about the Fed's inflation conundrum, in his latest weekly market wrap-up, Martin Roberge of Canaccord Genuity notes this:

Earlier today, Fed Chair Powell provided an economic update. He said that “risks are clearly now to longer and more persistent bottlenecks, and thus to higher inflation.” Moreover, while the central bank still takes the view that inflation is transitory, Powell confessed that “we don’t know how long it will take for inflation to abate.” To account for rising inflation uncertainties, the Fed Chair announced that it is the time to taper with full completion by mid-2022. He also stressed that tapering is not hiking, which is to say that the Fed reaction function will remain dictated by labor market conditions no matter how high actual and expected inflation get between now and full employment. For now, Jerome Powell continues to believe that inflation is mostly driven by supply shortages, and once fixed, inflation will abate. The reality appears different through our lens. As our Chart of the Week shows, inflation is emerging from three different silos, that is from wages, goods, and housing. Multi-week lows in jobless claims argue for further wage gains. The lack of capex from commodity producers argue for sticky good-price inflation and apartment market tightness conditions at a multi-year high means a further rise in shelter inflation (about 1/3 of core CPI) going forward. As such, we urge investors keep an eye on the US 10y-2y yield curve because we believe a flattening below the uptrend that began in March 2020 could signal that the bond market is front loading the Fed, hence posing a risk to cyclical stocks.

Great insights and it will be interesting to see how the yield curve reacts in the coming weeks.

Alright, let me wrap it up there and wish everyone a great weekend.

Below, Fed Chair Jerome Powell participates at the BIS-SARB Centenary Conference Panel Discussion at the Virtual Bank for International Settlements-South African Reserve Bank Centenary Conference.

And bond investor Jeffrey Gundlach said Friday that inflation in consumer prices likely will remain elevated through 2021 and stay above 4% through at least 2022. 

Citing pressures from shelter costs and rising wages, the head of DoubleLine Capital told CNBC that he sees the current inflation run as non-transitory and instead likely to persist well into the future. "We believe that it's almost certain that 2021 will end with a 5-handle on the [consumer price index], and it's going higher in the next couple of readings, thanks primarily to the price of energy," Gundlach said on CNBC's Halftime Report. "And we don't think inflation is going below 4% anytime in 2022."