Markets seem to be missing the risks on US inflation
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The writer is director of investment research at Bridgewater Associates
The US economy today is about as strong as it has been in generations, with the tightest labour markets and highest inflation rates seen in decades. That is even accounting for a recent moderation of growth driven by the spread of the Delta variant of Covid-19, reflected in Friday’s disappointing August jobs data.
Yet financial markets continue pricing in both that the inflation will prove transitory and that policymakers will barely need to budge in response. We see this potential combination of outcomes as unlikely.
Let’s first consider the outlook for inflation — persistent or transitory? We certainly would not expect the record-high consumer price prints from earlier this year to be sustained.
But aggressive fiscal stimulus (including another $2-3tn in spending likely to be passed before year-end), accommodated by money printing, is fuelling demand without commensurate supply.
Households are flush with cash with high levels of wealth and benefiting from low borrowing costs. They are spending, including on housing at a time when supplies are very limited and unlikely to materially improve soon.
That broad, strong consumer backdrop is also resulting in companies needing to hire — with job openings outstripping the number of job seekers and pushing up wages in a way we similarly think could be sustained and feed into a self-reinforcing economic recovery.
Not surprisingly, the reflationary trends we have seen in recent quarters has led to an increase in expected monetary tightening, with two 0.25 percentage point rises now discounted over the coming two years and asset purchases expected to be wound down by the start of 2023.
But the shift in expected tightening is modest relative to any previous cycle and remains extraordinarily easy compared with the strength of the US economy. At the same time, the inflation break-even curve is charting a path back to normality within just a few years, and both nominal and real rates are near secular lows.
Ultimately, the Fed will react to economic conditions, which gets us to the second part of this market vision of the future. Will the policy-setting Federal Open Market Committee “barely need to budge”?
There’s no question that central bankers are unusually challenged to read the economic tea leaves amid a pandemic. This difficulty at the Fed is evident in the increasingly vocal debate around how to interpret labour-market and inflation conditions.
Minutes from the July FOMC meeting highlighted, for instance, that employment remained well below its pre-pandemic level, reflecting elevated unemployment and people dropping out of the labour force. At the same time, though, it noted firms reportedly struggling to hire workers, and thus raising wages or providing additional incentives to attract or retain workers.
With both labour and inflation, the Fed is wrestling with the degree to which supply shortages reflect pandemic-related disruptions that can be easily resolved, and where conditions will settle when pandemic influences fade.
In recent weeks, several Fed officials have suggested that they may need to start the tightening cycle sooner and potentially at a faster pace than is currently discounted. For now, this is a minority view.
More dovish members, including the majority of today’s FOMC voters and chair Jay Powell, would prefer to wait for pandemic-related distortions to subside before judging whether inflationary pressures are persistent and whether labour markets are consistent with the Fed’s goal of eliminating “shortfalls”
These conversations are happening in the context of lessons learnt from the last few decades. Keeping monetary policy too tight and not being able to ease enough is seen as a bigger risk than allowing inflation to rise and needing to tighten and catch up later. With the Fed’s newfound commitment to allow inflation to overshoot 2 per cent, the more dovish perspectives are carrying the day for now.
Given the Fed’s goal to prevent low inflation or deflation from becoming entrenched, as it has in Japan and to a degree in Europe, we empathise and agree with the shift toward easier policy. We also do not envy how the Fed will have to balance the difficult trade-off between growth and inflation risks.
The Fed’s deliberations (and the composition of who actually votes and chair Powell’s inclinations) for now point toward slower tightening. We expect the Fed will still have to eventually do more than “budge” on rates.
More immediately, though, we think market pricing, data trends and the Fed’s evolving reaction function underscore a very real need for investors to protect portfolios against higher, more sustained inflation.
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