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Features;

The Fed bosses the markets about inflation

The Federal Reserve remains unconcerned about the prospect of too-high inflation rates but investors should remain watchful of markets buoyed by significant monetary support.

roll of US $100 notes

by
Charles Stanley

in Features;

19.07.2021

Be in no doubt. These share markets hitting new highs rest heavily on the continued goodwill and credibility of the main central banks, led by the Fed. The Fed’s reassurances that the sharp move up in inflation is temporary are important to market performance. If more investors thought the Fed wrong and anticipated the need to withdraw money support and raise interest rates, there would likely be a swift reversal of the bull market.

The last quarter has been a remarkable success for the Fed. US CPI inflation has shot up to 5.4%. House price inflation has hit 14.6%. Bond and share inflation in the last eighteen months have been pronounced. World commodities have gone up a lot, and now on reopening we see large price rises in many things from second-hand cars to semiconductors and freight rates. Despite this evidence of plenty of inflation, many buy into the idea that this will be a one-off and the Fed is right to carry on with a large monetary stimulus. It is true that the ten-year bond yield, languishing at below 0.6% at the peak of the Covid crisis, now sits at 1.3%, yet it has actually fallen from over 1.6% in May this year. The arrival of a fast-spreading variant of the virus is also dampening some expectations of too fast a bounce back.

What the Fed has succeeded in doing is building its own view of reality into the way people assess the risks and view the world themselves. Over the last quarter, the fall in Treasury yields has been facilitated by the Treasury decision to finance a lot of its excess spending by drawing down heavily from its balances at the Fed, instead of burdening the market with a lot more Federal borrowing. Some $900bn has been removed from the elevated balances in the Treasury account built up in the first massive monetary response to the pandemic closures. As a result, the Fed’s buying programme of $80bn a month has been quite sufficient to accommodate the government deficit and leave some firepower to help bring bond yields down a bit.

The Fed encourages the market to look at inflation expectations derived from the prices of government inflation-linked bonds, which in turn reflect the rates on general government bonds. The Fed can thus reassure that inflation expectations remain well-anchored for the medium term because bonds have performed well. The Fed has created its very own confidence loop, telling us the inflation will subside and then telling us that is what the market thinks given the performance of government bonds. We need to remember just what a big role they are playing in making the market.

What could possibly go wrong? The Fed is in charge and gets the market to the levels that reflect its views. The only thing that could go wrong is if the reality of consumer behaviour and prices turns out to differ too much from the reassuring Fed view. Consumers currently are sitting on large cash balances, and commercial banks have scope to lend more given the general liquidity in the system. For the time being the big increase in cash has been dampened by people using it less and saving it more. If that behaviour changes and the circulation of cash picks up, there will be more inflation. Then the Fed will need to act more quickly to rein in excessive liquidity before too much money chases too few goods and services.

So, what to watch? Were the inflation to broaden out more and become self-sustaining, we will see more rapid growth in wages and services prices. Money circulation will climb back to closer to former levels.  We should also watch the opinion surveys on prices that are not unduly influenced by bond prices. These have always tended to exaggerate inflationary fears but are likely to show a different picture to the Fed view. For the time being, we can enjoy being in markets bossed by the Fed but need to watch out in case the Fed changes its mind about inflation.

Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.

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