Markets give the Fed the benefit of the doubt – but there is doubt

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The inflation scare on the back of April’s CPI ‘blowout’ appears to have abated somewhat.

A concerted effort from key Federal Reserve speakers, who have sought to cast any inflation as “transitory”, appears to have worked, as bond yields have retreated from their highs and equity markets have ground out rallies.

Fed Vice Chair Richard Clarida this week stated that he believed recent inflation pressures would “prove to be largely transitory,” arguing that the details of the report were consistent with that view, but did add that “in upcoming meetings, we’ll be at the point where we can begin discuss scaling back the pace of asset purchases…I think it’s going to depend on the flow of data that we get.”  And last night the Fed Vice Chair for supervision, Randal Quarles, suggested that at some stage it will become important for the Fed to discuss plans to adjust the pace of asset purchases.

There are some dissenters at the Fed who wish to bring the tapering discussion forward, but for the main part the “transitory” inflation view holds sway.

However, while the efforts by various Fed speakers appeared to have assuaged market concerns, doubt remains.

Both Obama era Treasury Secretary Larry Summers and former Pimco Head and Allianz adviser Mohamed El-Erian this week reiterated their concerns regarding inflation, as well as some of the latent financial stability dangers, that are inherent in the historically high – some say “excessive” – levels of monetary accommodation.

They cite inflationary pressures as mounting from the boost in demand created by the $US2 trillion-plus in savings that Americans have accumulated during the pandemic and from soaring stock and real estate prices.

Further they say that a variety of factors suggests that inflation may yet accelerate – including further price pressures as demand growth outstrips supply growth; rising materials costs and diminished inventories; higher home prices that have so far not been reflected at all in official price indexes; and the impact of inflation expectations on purchasing behaviour.

The Biden agenda, including higher minimum wages, strengthened unions, increased employee benefits and strengthened regulation all push up business costs and prices.

Moreover, they assert that this is not just conjecture. The consumer price index rose at a 7.5 per cent annual rate in the first quarter, and inflation expectations jumped at the fastest rate since inflation-linked securities were first issued almost 25 years ago. Already, consumer prices have risen almost as much as the Fed predicted for the whole year.

Also in the frame is the Fed’s move toward an ‘outcomes-based’ framework for monetary policy which some claim locks the Fed into a process whereby it acts only if inflation persistently surprises on the upside. By that stage the inflation genie might well be (persistently) out of the bottle.

The move to an ‘outcomes-based’ framework for monetary policy at a time of intensifying inflation pressures and growing financial market imbalances increases the probability of a policy mistake, with the Fed getting behind the curve on the withdrawal of the current stimulus. Such a mistake may mean that later in the piece the Fed has to jam down hard on the monetary brakes, leading to sharp upward movements in bond yields and a significant correction in equity markets. Such a scenario looms as a major challenge for investors in the future, including how multi-asset investors react to a potential reversal of long-held assumptions regarding asset return correlation.

Should inflation be more persistent than the Fed appears to believe, and which markets appear to have accepted, albeit guardedly, then the sorts of accidents conjectured by Summers, El-Erian and others might result in a period of upheaval for markets. The CEO of Australia’s Future Fund hinted at such an outcome in his appearance before a Senate Committee yesterday.

Clarida’s comments imply that the Fed may be a little bit more advanced than the “not thinking about thinking” about monetary tightening that Chairman Powell characterised as the Fed’s stance last year –  but only just a bit. What that means is that after a period where monthly inflation reports have largely been sidelined as a market focus, that they once again assume primacy they once enjoyed as the statistical report that matters.

By Stephen Miller, investment strategist

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