A worker restocks chicken in the meat product section at a grocery store in Dallas, US, on April 29. Rising prices for a variety of commodities are contributing to a jump in prices, with Americans paying more for meat, petrol, items they keep in their homes and even the homes themselves. Photo: AP
Opinion
Nicholas Spiro
Nicholas Spiro
US Federal Reserve walking fine line with approach to rising inflation
While US policymakers might be willing to accept a period of higher inflation that lasts longer than a few quarters, markets are not as patient
The Fed is probably right that the spike in inflation will be short-lived, but its handling of the surge in prices is exacerbating concerns
The single most important matter in financial markets this year, and the one that will bedevil investors for some time, is the recent surge in inflation, particularly in the United States. The question is whether this is a temporary blip or the beginning of the end of a decades-long period of subdued consumer prices.
It is no exaggeration to say that low, well-behaved inflation is the foundation upon which rests everything in markets – prices, sentiment and asset allocation. For nearly 40 years, investors have not had to worry about the threat posed by inflation as central banks and governments around the world pursued policies that kept prices in check.
However, the Covid-19 pandemic has changed the policy landscape significantly. Unprecedented levels of monetary and fiscal stimulus have been unleashed to counter the economic devastation wrought by the pathogen.
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Moreover, the US Federal Reserve adopted a new strategy last year that is more tolerant of temporary rises in inflation above the central bank’s 2 per cent target.
The combination of large stimulus packages, the mass roll-out of vaccines and the start of one of the biggest booms in history has pushed up inflation, putting pressure on long-term government bond yields. The benchmark 10-year US Treasury yield has risen nearly a full percentage point since early October last year to about 1.7 per cent.
Where there is smoke, there is often fire. An inflation scare that began earlier this year intensified this week. Technology shares, whose lofty valuations hinge on an upbeat outlook for earnings far into the future, are under strain amid fears that the Fed will be forced to raise interest rates sooner than markets anticipate.
Price pressures are increasingly rapidly. The publication of data on Wednesday showed the headline rate of US inflation last month hit 4.2 per cent year on year, its highest level since 2008. The increase was fuelled by a fierce rally in commodity markets, with the Bloomberg Commodity Spot Index, which tracks 23 raw materials, rising to its highest level in nearly a decade.
Supply shortages are also a key factor. Input prices of materials as diverse as semiconductors, steel and cotton are rising sharply, putting pressure on companies to pass on the higher prices to consumers.
The Fed rightly views the US recovery as far from complete – there are still 8.2 million fewer Americans working than in February 2020. It is willing to allow a period of higher inflation to help the economy reach full employment, and it continues to insist the surge in prices is transitory.
A jobless man begs for money at an intersection in Falls Church, Virginia, US on April 3. Photo: Reuters
There are good reasons to believe this is the case. The acceleration in inflation is amplified by “base effects” from lower prices last year when lockdowns were imposed. Supply bottlenecks and other pressures associated with the reopening process are likely to ease as the recovery progresses. Most importantly, virus-ravaged labour markets are hardly screaming inflation.
Yet, the more the Fed insists the surge in prices is transient, the more investors question whether a sharper and more sustained rise in inflation is under way. By committing itself to keeping policy super-loose until the recovery is more advanced and making it clear the days of pre-emptively tightening policy to rein in inflation are over, the Fed risks making the inflation scare even scarier.
While year-on-year inflation readings are heavily distorted by pandemic-depressed data in the first half of last year, the rate at which prices are rising is startling. This is unsettling an investment community that has not fretted about inflation for decades.
As JPMorgan noted in a report published on May 5, “many of today’s investment managers have never experienced a rise in yields, commodities or inflation in any meaningful way”. This is increasing the uncertainty about the severity of the threat posed by inflation.
The Fed’s definition of a transitory rise in prices and its tolerance of higher inflation differ markedly from investors’ assessment. While US policymakers might be willing to accept a period of higher inflation that lasts longer than a few quarters, markets are not as patient and are starting to worry the Fed is falling behind the curve.
To be sure, there are no signs that bond markets have lost confidence in America’s central bank. The two-year Treasury yield, which is more sensitive to changes in monetary policy, remains just above zero, while markets expect interest rates to begin rising at the end of next year at the earliest.
However, by insisting the surge in inflation is a blip and not even hinting it will begin unwinding its massive bond-buying programme, the Fed could be unnecessarily boxing itself in. Not only is its policy stance fanning fears about inflation, it increases the risk that, if the Fed is wrong about price pressures being transient, policy will have to be tightened more abruptly than anticipated.
The irony is that while the Fed is probably right that the spike in inflation will be relatively short-lived, its handling of the surge in prices is exacerbating concerns about a permanent increase in inflation.
Nicholas Spiro is a partner at Lauressa Advisory
This article appeared in the South China Morning Post print edition as: Fed is walking fine line with approach to rising inflation
